As CRE Continues To Recalibrate, 5 Themes From ’23 May Remain Relevant in ‘24
History shows that when real estate prices decline — because capital costs have risen, net operating income has fallen or both — owners do all they can to hold on to assets until conditions improve and prices begin to rise. Over three previous economic periods when pricing declined, this recalibration took about 24 months, on average.
Pricing began to fall steadily in March of 2022, when the U.S. Federal Open Market Committee began its drum beat of rate hikes. Twenty months later, with interest rates appearing to have settled, this leveling may begin to give some investors the confidence to set pricing and slowly turn on the spigot of CRE sales.
With this scenario as a backdrop, below are five topics that garnered the attention of CRE professionals in 2023 that will likely stay on their radar in 2024. In the current cycle, most of the distress in the system relates to office assets but the dynamics below can apply to all CRE asset classes.
As the market waits for conditions to improve, lenders and borrowers engage in “pretend and extend” tactics that essentially extend terms on maturing loans, giving borrowers more time to refinance. By waiting for aspects of the market to improve — demand to strengthen, rents to rise, inflation to decline or operating and capital costs to fall — some borrowers may prevent foreclosure and some banks may avoid turning into an owner-of-last-resort, thereby saving the market from becoming flooded with devalued assets.
Numerous headlines in 2023 warned of systemic bank failures that never materialized. At a recent Goldman Sachs conference, Brookfield Asset Management CEO Bruce Flatt said that numerous CRE buildings will be available at bargain prices, but they won’t all appear in one day or as part of one event. Instead, he said, they will be brought to the market over the next 24 to 36 months. A spread like this, over two to three years, is not likely to overwhelm the entire banking system. Additionally, data compiled by Marcus and Millichap shows that in 2024, fewer office loans will come due than in 2023 and that most CRE loans are well dispersed across numerous banks and lenders, diversifying the potential pain across the system.
Through 2023, numerous owners of office buildings turned the keys over to lenders — and this transfer, or deed-in-lieu-of-foreclosure, is expected to continue in the coming year. Planning in advance for this scenario — whether for office or other assets — may help a borrower hold on to asset management fees or avoid reputational dings. Proactive borrowers can prepare packages for lenders that outline the pros and cons of a property and illustrate how they can recoup as much of their debt as possible.
With fewer office buildings serving as fortress investments in real estate portfolios, there is more pressure on niche CRE alternatives to fill the void. As investors shed office buildings to recalibrate their portfolios, not only are they on the hunt for new property types to stabilize their holdings, they are also rethinking the definition of a core asset.
Owners of class A office building wrestling with price declines from cap rate compression are doing what they typically do when CRE assets are challenged: focusing on old-fashioned management and client service. By prioritizing client satisfaction, they can attract and retain tenants and be better positioned for growth. This extra care is especially necessary for top-tier investment-grade buildings because the number of ESG compliant buildings, especially in the U.S., is dwindling, making it harder for international investors to deploy funds in the States.
