Three key themes are dealmaking, bank distress and repositioning office workplaces.
- Deals are difficult to complete because of a variety of market conditions, and many investors are waiting for the Fed to stop raising rates before they re-enter the market.
- Regional banks will continue to struggle—some are likely to fail, and others will merge to avoid that.
- Companies are shrinking their footprints because of post-Covid work trends, prompting landlords to repurpose office buildings.
LightBox recently hosted a webinar with industry experts to discuss the LightBox 2023 Mid-Year Sentiment Report, which summarizes professional perspectives on the CRE market. Moderated by Dianne Crocker, principal analyst at LightBox, the panel included Jeff Garvin, director of appraisal services and chief appraiser for Bank OZK; Erik Binkowski, a principal in the Washington, D.C., office of Lee & Associates; and Marc Perusse, the president and chief executive officer of E2M Ventures.
“The slowdown continues at mid-year as the market braces for distress over the next 12 to 18 months,” said Dianne Crocker in her introductory remarks. Recessionary concerns, property pricing uncertainty, and the wave of loan maturities are top of mind for our clients who took the survey, as were unknowns about where interest rates will ultimately land. Deals are very difficult to complete given the lack of clarity on rents and property values and general market conditions, and the above market challenges are limiting access to debt capital. The survey results show lenders are tightening the reins on debt capital, asking more questions, and shying away from loans on property types with high-risk profiles.
Jeff Garvin added, “A lack of data requires appraisers to make judgement calls for market transactions and makes it hard to see where things are going.” Cap rates are a bit more of a mystery and appraisers have to do more due diligence in their reports to support their conclusions. Until the Fed slows down and stops threatening to raise rates, I don’t see much activity happening.
The webinar brough to light three essential themes:
- The state of dealmaking in the commercial real estate market: how and where are transactions happening?
“The market is bipolar,” noted Marc Perusse. We’re seeing some deals which are still getting done but pricing is off – a minimum of 15 percent plus and closer to 25 percent on average from peak highs. In terms of getting transactions done, you have to be creative. We’re seeing sellers providing financing, lenders trying to carry back loans to get transactions done, and for new capital to be invested in a lot of these assets. Some investors are underwriting three percent growth as if it’s 2020 again. In a few areas we’re seeing rent growth – in retail, for example, some shop and big box leases are being signed at higher rents. I think investors who aren’t doing deals are waiting for the Fed to indicate it’s done hiking rates, and potentially even cutting them, before they reenter the market.
Deals that are getting through committee are those from banks’ largest borrowers, who have existing relationships with these lending institutions. I would say most lenders aren’t really looking to form new relationships. They’re looking to maintain and keep existing ones.
“This is the longest cycle in our industry, and many younger professionals who have only seen low interest rates during their careers are not attuned to the correction coming,” said Erik Binkowski. We will get through it, but those who haven’t experienced it have a lot to learn. There is still debt capital for rational investors who had adjusted to the cost of debt and the amount of equity that’s needed. However, just like we saw in the late 2000s, high leverage will be the death spiral for some investors.
2. We know distress is still trending – how are banks responding?
“Regional banks are under tremendous stress, and some will likely fail,” suggested Binkowski. Part of the reason is the government asked them to deal with many of the Paycheck Protection Program (PPP) accounts during Covid, and not everybody who applied for them has had their loans forgiven. Also, after 2010, regional banks were lenders of choice for construction projects across the country, and they face a challenge as interest rates move so rapidly. It’s not just the PPP hangover, they’re not getting paid off as par, and their capital is under pressure. I believe as many as 15-20 percent will need help or assistance or be taken over, and it will happen before Thanksgiving. Stress is definitely here, but I don’t believe the transaction timeline is immediate. Between lender and borrower, it requires two quarters before the lender admits distress. We’re in that grey period right now.
“Some banks are going to struggle, especially as they start going through more renewals as rates stay high,” said Garvin. Three- and five-year notes are going to roll 300 basis points higher than where they were. That’s not just in CRE lending, it’s going to affect commercial bank C&I lending prospects as well. Everyone is in cost-cutting mode because they believe things aren’t going to bounce back. Some are considering staff cuts, a possible reflection of negative market confidence. I don’t see failures happening, I see more banks reacting quickly and merging rather than going into failure.
3. Office tenants are downsizing and repositioning workplaces
“Coming out of Covid, most tenants were kicking the can down the road and renewing their leases in place,” said Perusse. As the pandemic continued, some tenants gave back a fair amount of space. It started off at 30 percent, but it has since moved to 50 percent, and in some cases more than that. I believe that’s the knee-jerk reaction which doesn’t consider the long term, but right now capital is king, and space is necessary. In the short term, there’s going to be an overreaction and we’re going to continue to see a tremendous amount of reduction, to the point where the level of square footage per employee will be as low as it’s ever been in the U.S. But, if we have a recession in 2024 or 2025, I think there will be a reversal and employers, who will have the upper hand, are going to require their employees to come back to the office.
“In order for lenders to get active in the office market again, they need to get rid of their bad loans,” said Binkowski. Some of those are from non-cash flowing assets and construction and some are from assets which were performing well before the downsizing of office and industrial. The too-big-to-fail banks will be much more active on the construction side of on the non-cash flow side than they were in the last decade. And, in a sign of the troubles the office sector faces, the National Labor Relations Board announced it will decrease its footprint by 44 percent, after earlier cuts of 20 and 15 percent.
Opportunities can be found in specific CRE markets and asset classes across the country
Despite the challenges facing the CRE industry, there are numerous opportunities. Perusse believes there is potential in secondary real estate markets such as Kansas City, Louisville, and Columbus, each of which is well-positioned, and California and New York will return to their previous highs. The office market may be down, but there are signs of buyer appetite and investors have capital to invest. Binkowski sees a “green shoot” opportunity in grocery anchored retailed and in locations big box retailers are downsizing or vacating. He also likes multifamily and assisted living. “Cash is king,” he said in an earlier LightBox interview. If you don’t need a loan or if you have an equity partner, there are plenty of opportunities to buy assets at a discount and look for long-term gain.
To hear all the panelists’ comments, watch the full Diverse CRE Voices in 2023: Mid-Year Pulse Report and Looking Ahead webinar.
For a more in-depth understanding of their viewpoints, read the LightBox 2023 Mid-Year Sentiment Report – you’ll gain insights from commercial real estate industry experts on the critical role of technology in solving business challenges, the use of new AI applications like ChatGPT, and the growing importance of climate risk in dealmaking.
Dianne Crocker, principal analyst, LightBox
Jeff Garvin, director of appraisal services and chief appraiser, Bank OZK
Erik Binkowski, principal, Lee & Associates
Marc Perusse, president and chief executive officer, E2M Ventures