Market Outlook: Cracks in the Commercial Real Estate Foundation
Hike Until it Hurts
The historically fast rate of Federal Reserve rate hikes, targeted at containing the highest inflationary levels in the last 40 years, is having a noticeable impact on the real estate market generally. While most CWM commentary has focused on the residential markets, CRE investors are feeling the pinch of rising interest rates which have led to a tightening of loan availability and increased borrowing costs. As the chart below shows, the Federal Reserve has increased interest rates at a much faster rate than in previous rate hiking periods.
It takes time for rate hikes to have an actual impact on the economy's function, estimated at 9-12 months from the point of hike, the first hike was in March of 2022. Property empires that require excessive leverage and ever-rising values/rents are starting to show signs of weakness and potential collapse. Property owners risk defaulting if they cannot generate sufficient income to repay loans, particularly those with high loan-to-value ratios and/or floating-rate loans (debt that adjusts automatically). This problem may worsen if rates continue to rise. Per the Wall Street Journal, in late 2021, an investor group in Houston took out a highly leveraged (~80% loan-to-value) floating-rate loan to purchase a large number of rental units only to see their rates jump from 3.4% initially to ~8% now. These properties are now in foreclosure.
Multifamily properties, also known as apartments, are technically categorized as CRE even though they serve residential purposes. The impact of COVID-19 work-from-home policies has resulted in remote working lifestyles for some industries, causing concern for another category of commercial property, office space. Currently, office space occupancy remains at approximately half its pre-COVID level as shown below.
Due to low office occupancy, available spaces are increasing in most cities, particularly those with more technology companies that have a greater capacity for remote work than manufacturing for example. Availability refers not only to empty offices but also occupied space where tenants have given notice they will not renew but still pay rent. As a result, the full financial impact of increased availability may be delayed. Nonetheless, West Coast tech hubs have experienced the largest surge in available office space while the national figure is approximately 16%, surpassing even levels seen during the 2008 Great Financial Crisis.
Stating again, office space availability is high, and rents are dropping, especially in major tech hubs. However, this trend does not apply uniformly across all areas due to the varying industries present locally.
Based on the above, it is not too shocking that in the CRE space, office properties are leading the valuation losses, having given up all valuation gains since 2006, with only shopping malls faring worse.
An additional problem for CRE is competition from now higher yielding assets that are traditionally safer investments, thanks again to Fed rate hikes. The current real estate capitalization rate over the 10-year treasury yield (cap rate spread) is at its lowest since just before the 2008 Great Financial Crisis. This means that compared to other safer income-producing assets, real estate provides less income benefit than it has in approximately 16 years. Consequently, there may be less investor demand and upward price pressure on CRE property valuations.
Financial institutions are tightening lending standards in response to tighter Fed policy, a declining economic outlook, and the early 2023 regional banking crisis. This makes credit less available to would-be borrowers as seen before past recessions (grey bars in the chart below).
The CRE market, specifically office space, is experiencing a decline in demand and an increase in available space. Additionally, credit conditions are becoming stricter while interest rates rise. If that were not enough, as seen in the below chart, a significant number of existing CRE debt requires refinancing within the next two years with even fixed-rate loans facing potentially high-interest costs upon maturity if rates remain unchanged.
Adding fuel to this economic fire, small regional banks, the same group that saw some historically big blow-ups earlier this year, are the largest holders of commercial mortgages. Banks that are already experiencing a historic runoff in their deposits are also facing a further strain on their loan portfolios which is creating a feedback loop into even tighter lending conditions.
The data is fairly grim, but compared to the past, there are some bright spots. While high loan-to-value ratios exist among some bad actors (as mentioned at the beginning of this article), overall, the sector's loan-to-value health has improved significantly in recent times. Lower loan-to-value levels make it more difficult for borrowers to default and give up their property as properties have more equity. Therefore, most borrowers now face less risk of default than during the early 2000s when LTV was higher. Additionally, any defaults that do occur will not hit lenders as hard due to the likely higher recovery of value in those instances.
Another potential support may occur if the economy worsens as the Federal Reserve would likely reverse its recent hiking policy and implement rate cuts. Market forecasts show that this could happen by the end of 2023, resulting in lower rates on all forms of debt and alleviating some of the refinancing burden. However, while market participants predict these cuts, the Fed itself suggests that rates will remain higher until year-end. Whether cuts happen or not in the relatively near future could be meaningful for economic outcomes, especially in the CRE space, over the coming years.
The CRE market is experiencing challenges due to high vacancy rates causing an oversupply of commercial property and downward pressure on rent prices. Stricter credit conditions and rising interest rates are also creating difficulties for borrowers seeking refinancing options. Additionally, small regional banks, who hold the majority of commercial mortgages, face solvency issues unrelated to the CRE problems which may further tighten credit availability. Historically low loan-to-value levels offer some support but uncertainties regarding future economic outcomes suggest caution in this space, which is another red flag for the American economy as a whole. The CWM investment team continues to recommend defensive investing in this current market environment.
CWM Risk-Adjusted Models: It should be expected that markets will continue to be volatile as the world combats 40-year high inflationary pressures and major geopolitical events go unresolved. Based on established disciplines, your CWM team believes that maintaining defensive positioning while awaiting a potentially more favorable future risk-taking investment environment is still the most prudent course. Future allocation changes will be made as relevant datapoints change.
CWM Accumulator Models: Your CWM team believes there is a high potential for continued market volatility and perhaps even further sharp market valuation drops in the near-term (0 – 2 years). A significant benefit of choosing this more passive investment style is the strategy’s longer-term focus (5+ years) and the ability to ignore day-to-day news, so long as discipline is maintained.
A key component of investment discipline is the responsibility of investors to continue to make portfolio contributions in line with their financial plans (assuming they are able). New contributions are particularly important in scary market environments, where often the best future return (buy low) opportunities exist.
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