U.S. Real Estate Debt Markets – Summer 2023

When Charles Dickens wrote in A Tale of Two Cities “it was the best of times, it was the worst of times…” he could have been writing about the current state of the real estate equity and debt markets in the U.S. The national office vacancy rate is approaching 20% and while the return to office (“RTO”) preference among the CEOs of major companies is steadily gaining momentum, the actual physical occupancy rate has yet to catch up to pre-Covid times. Nevertheless, the trend is a good one. Last week the White House Chief of Staff urged all federal workers to return to the office. In what may be the most ironic of positive RTO announcements, the founder of Zoom has asked the company’s employees to return to the office on a hybrid basis.

The Federal Reserve has raised short term interest rates by approximately 500 basis points in the past twelve months and property owners who borrowed funds when short rates were approximately 0% now are trying to negotiate loan extensions or forestall foreclosures because their assets are not able to cover today’s refinancing rates. Some U.S. cities that de-emphasized aggressive police work in their jurisdictions have experienced a surge in crime that has materially impaired the business environment in those markets. Major property owners have ‘handed back the keys’ to their lenders associated with prime office buildings located in downtown Los Angeles and hotels in what used to be prime submarkets such as Union Square in San Francisco. Tenants are abandoning markets such as Chicago and relocating to states such as Florida, Texas, Georgia, Arizona, and North Carolina. For investors who loaded up on Class B office buildings in secondary markets, or lenders who aggressively pursued higher loan-to-value mezzanine loans and/or transitional loans, the next 24-36 months are likely going to be very challenging.

Overall transactional activity is substantially below historical levels. Owners cannot/will not sell properties based on today’s implied cap rates, and on the retail investor side, large fund managers are facing long queues for redemptions. A similar trend is happening on the institutional side. We understand there are over $30 billion of outstandingredemption requests impacting the institutional open-end real estate equity fund market. Last year the major common stock indices (Dow Jones/S&P 500) declined by 10% to 20%, and the publicly traded REIT index lost almost 30% of its value, yet during the same period, private real estate funds reported total returns of 7% to 10%. Transactional activity cannot pick up until the bid/offer spread compresses, which, in our opinion, means that property values are likely to be declining in the next 12-24 months. This phenomenon will hold most true for office properties. The trend likely will not apply to industrial assets and life science properties and probably only modestly for multifamily assets. Retail property values already have begun to rise. The sector that will be most acutely impacted will be office buildings, particularly older properties, with mid-block locations, in less economically diversified locations and ones that do not have more up-todate sustainability features.

The positive side of the real estate finance ledger is that with distress growing across the markets in an economy that is likely to become more challenging as the Fed contemplates additional interest rate increases, those with capital to invest have a terrific environment with which to deploy new funds. AAA rated SASB (single asset/single borrower) CMBS can be acquired with yields of 6+% and their BBB rated SASB counterparts can be purchased in the secondary market with yields of 8+%. While the secondary CMBS market remains very active, there is virtually no bid for bonds secured by most office buildings. The very best buildings may command a bid, but the price/yield available is indicative of the market’s fears. Unleveraged yields in the 9% to 12+% range are readily available for the office bond buyer. The new issue market has been, and is likely to remain, quite slow. If real estate equities are not trading and loans are difficult to refinance (for the reasons noted above), then there is a much lower volume of new loans that can be fed into Wall Street’s origination machine.

Through the first six months of this year, total new issue volume was approximately $16 billion. This sum represents approximately 30% of last year’s total volume. Conduit issuance this year, for the first time in more than two years, has exceeded SASB issuance ($9+ billion vs. $6+ billion). The forward calendar for new securitizations is likely to remain relatively muted. Accordingly, the ‘technicals’ for CMBS trading are relatively good because of limited supply and modest demand.

The loan side of the business substantially parallels the securities component of the market. The largest life insurance companies remain active, albeit with smaller portfolio targets, as the rating agencies are carefully scrutinizing insurance company balance sheets. The largest banks also remain active, but they are subject to increasing pressure from their regulators and so their origination targets are materially lower than last year. The private debt funds are in mixed positions. Some funds, particularly those that focused on mezzanine loans, transitional loans, and construction loans, have materially curtailed their new business activities as they become more focused on loan extensions and workouts. The more prudent debt funds have been gathering capital to take advantage of today’s excellent lending environment with less competition and higher yields.

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