Most predictions for the economy and real estate investment performance made at the beginning of 2023 were optimistic and proved wrong. We highlighted the lack of data to support expectations of a real estate rebound. Throughout last year, as real estate investors tried to dodge the impact of higher interest rates and slowing fundamentals, they searched desperately for clarity on the direction of the Fed policy, inflation, economic growth, and capital flows. While we now have some confidence that rates have peaked and inflation is under control, the timing and magnitude of declines in SOFR and the ten-year Treasury remain difficult to predict. Lack of confidence that property values have bottomed has kept investing powder dry.
Forecasting in this whirlwind of variables remains elusive. Yet cutting through all the noise, here are a few thoughts on the outlook for commercial and multifamily real estate in 2024:
Interest Rates: How Long Is Long?
Higher interest rates are the root of the industry’s problems. The realization that rates weren’t going back to their artificial pre-pandemic levels disappointed many who were betting on a recession. Instead, SOFR has been stuck at 5.3% since August, up from 4.3% in January and 0.5% two years ago. After reaching 5%, the ten-year Treasury has fallen to 4%, leading some to believe the “higher for longer” forecast was wrong. Yet the government’s deficit is rising, demand for long-term Treasuries is falling, and the Fed is unloading bonds from its portfolio, so no one should conclude that we can’t go back to 5% on the long end this year. But borrowers should get some relief as the Fed Funds rate drops during 2024, easing floating rate debt coverage ratios and lowering the cost of rate caps.
Property Values: Can You See the Bottom of a Well?
While we can say with some certainty that interest rates have peaked, no one can proclaim that valuations have stabilized, or pretend to know what they are. Lots of companies do a great job analyzing the market, but with fewer transactions the range of valuations estimates remains wide. According to the Greet Street CPPI: All-Property Index, year-end 2023 values were down an average of 22% since their recent peak, with office leading with a 35% decline and multifamily in second place with a 30% decline. While Green Street believes values will now stabilize, other analysts project another 10% drop in 2024. CBRE anticipates capitalization rates widening by another 25 to 50 basis points in 2024 bringing multifamily to around 6%, retail to about 7%, and office to almost 7.5%, on average.
Property values will remain elusive target for much of the year because most transactions will be between willing buyers and unwilling sellers. Once sellers are willing players, the market will have benchmarks and transaction volumes will quickly recover.
Equity Capital: Sprinters at the Starting Blocks
With economic variables still churning and without reasonably accurate valuations, equity investors still can’t price real estate risk with any accuracy. But they are ready and willing with over $200 billion in their pockets, according to CBRE. Most of that war chest is held by private equity firms who will act as short-term flippers between distressed sellers and longer-term holders. Ultimately, the real estate winners will be cash-rich, patient sovereign wealth funds and family offices who can buy low without debt and hold for years as values recover. Once the leaders make the first move investing will be contagious, accelerating the recovery as liquidity storms in.
Debt Capital: Shuffling the Deck Chairs
Some may look back at 2023 as the year when alternative lenders took center stage. However, debt funds have been more focused on high yielding bridge lending and rescue capital than traditional first mortgages. Mortgage REITs have been napping all year. Banks are dealing with a boatload of issues including an erosion of their deposit base, regulatory scrutiny, and possible higher capital requirements if the Basel Endgame rules are approved. According to a recent Morrison Foerster survey, 62% of respondents who were lenders have spent more than half their time on portfolio management and workouts, leaving little room for new lending.
According to the Mortgage Bankers Association, lending declined by about 43% in 2023. Through mid-December CMBS issuance dropped about 65% and CRE CLO issuance about 85%, per CREFC. A Trepp study recently showed bank lending had fallen 32% from 2019 to the third quarter of 2023. It’s critical to remember that banks provide the capital for over half of the almost $6 trillion of commercial mortgages.
Lending can’t support transaction volume without more concrete property valuations, and valuations are dependent on market-based transactions. This chicken and egg loop won’t be quickly resolved. Underwriting will remain strict and traditional lenders will remain reluctant to jump back in this year. That leaves debt funds to gain market share, charging small fortunes to real estate owners trying to hold on, and keeping average mortgage rates high, irrespective of any drop in SOFR or Treasury rates.
Distressed Debt: Blood, Toil, Tears and Sweat
In a real estate downturn, the real distress is centered in debt that cannot be fully repaid, potentially resulting in the loss of the property by the owner and the loss of capital by the lender. This cycle began in earnest in 2023 with a spike in delinquencies and a remarkable number of reputable owners turning the keys over to their lenders. Unfortunately, the process of working out distressed debt takes years. According to Trepp, CMBS delinquency reached its peak in July 2012, five years after a spread blow out that shut down the market in 2007.
While current CMBS market delinquencies are nowhere near the levels of the Great Financial Crisis, Trepp reports they are up over 50% from a year ago. And CMBS office loan delinquencies have skyrocketed from 1.58% a year ago to 5.82%. In October, almost $41 billion of CMBS loans were in special servicing and total losses for the year were $1.2 billion (a 54% loss severity rate on resolved loans). An unwelcome trend is the growing number of AAA CMBS bonds being downgraded by rating agencies. Delinquencies and charge-offs in the banking system are also climbing.
These statistics will continue to rise because over $500 billion of loans will mature in each of the next few years, including $327 billion in bank loans in 2024 alone, per Trepp and CREFC. That demand for capital will collide with a continued shortage of available and affordable financing. Several studies have recently quantified the approaching chaos. A sobering academic report from the National Bureau of Economic Research, “Monetary Tightening, Commercial Real Estate Distress, and US Bank Fragility,” concludes that about 14% of commercial mortgages held by banks, and 44% of the office loans, have valuation deficits, meaning that property is now worth less than the outstanding balance of the loans. A paper by Capital Economics expects the downturn to wipe out over $1 trillion in property value.
As an example of how much more difficult it is to refinance maturing loans, a recent Trepp study found that office loans originated by banks in the fourth quarter of 2021 had an average loan-to-value (LTV) ratio of 65%, but by the third quarter of 2023 that LTV requirement had fallen to 47%. At the same time the average mortgage rate rose from 2.70% to 7.57%. Even industrial LTV ratios have fallen from 54% to 45% during that time frame. Moody’s Analytics found that 69% of maturing office loans did not pay off in 2023 and believes 76% of office loans have a “high refi risk” in 2024.
Concern at the Top
Rising distress is making regulators nervous. In June the Fed, FDIC, OCC, and National Credit Union Association issued a joint Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts. The agencies typically issue a similar statement when they believe a storm is coming and lenders are overexposed to real estate. It provides a lesson to the current generation of bankers on how to work out real estate debt. In December, the FDIC issued Current Challenging Economic Environment and Real Estate Conditions, which states “CRE investment property capitalization rates have not kept pace with recent rapid increases in long-term interest rates, which leads to concerns about general over-valuation of underlying collateral.” The paper urges banks to maintain strong capital levels, carefully monitor the credits, and take appropriate credit loss allowances. The FDIC appears to agree, directionally, with the other reports cited that values will further decline, reducing collateral adequacy.
Taking the Licks till ‘26
While many are saying “stay alive till ’25,” it will likely take longer to clean up the mess. But by the end of 2024 investors will have a much clearer picture of where interest rates, capitalization rates, and property values will stabilize, providing the confidence to start pumping capital back into the sector. Until then the market will remain illiquid, and there will be both pain and opportunity.
2024 Winners:
- Investors with lots of cash and long investment horizons,
- Data center owners,
- Office tenants looking for better, cheaper space,
- Multifamily owners who have the liquidity to stay in it until new supply is absorbed,
- Providers of bridge loans and preferred equity at near 20% interest rates, and
- Lawyers specializing in loan workouts.
2024 Losers:
- Office owners,
- Value-add sponsors who couldn’t execute their business plans and won’t get a promote but must try to return capital to investors to save their reputations,
- Borrowers with loan maturities who don’t have the cash to rebalance the loan,
- Banks who can’t get back into real estate lending and lose the improving next margin,
- Brokers who will have another year with little to do.
While 2024 will likely be a bumpy road for many, every downturn is followed by a recovery. Those investors who have the liquidity to get through the next twelve-to-eighteen months will survive the storm. By the end of the year capital should begin to flow as the systematic and market risks become more measurable and credit spreads tighten. Transaction volume will gain momentum into 2025. Despite the short-term pain, the real estate industry has proven resilient after every downturn, achieving compelling long-term returns while providing great spaces for America’s families and businesses.
