De-bunking commercial real estate’s doomsday delusion
- September 1, 2023: Vol. 10, Number 8

De-bunking commercial real estate’s doomsday delusion

by Todd Henderson

For months a rising chorus has proclaimed the death of U.S. commercial real estate — and the banks that lend on it. Naysayers fear a “doom loop” of falling prices and contracting credit, leading to further losses. The concern is understandable: Like most asset classes, real estate has suffered from higher interest rates. Bank failures — though not caused by real estate — have underscored the risks posed by longer-duration assets to liquidity and balance sheets. And high-profile defaults in Los Angeles, San Francisco and New York have raised the specter of mounting distress. Much of the recent anxiety stems from profound misconceptions, in my view. Consider the following:

CLAIM: Work-from-home is
killing commercial real estate.

COUNTERPOINT: CRE fundamentals are the strongest on record.

There is no denying the U.S. office market is challenged. Office utilization rates are mired at around 50 percent of pre-pandemic levels (albeit higher midweek and outside major coastal cities). Layoffs in the technology and financial industries have worsened the blow. But real estate is much larger than office buildings. The share of offices in the core real estate fund index is 21 percent and falling. Industrial (31 percent) and residential (29 percent) are much larger, and along with retail (10 percent), are in very good shape. Collectively, the vacancy rate for U.S. property is at its lowest on record, and net operating incomes (NOIs) are growing.

CLAIM: Bad real estate loans will cause a financial crisis.
COUNTERPOINT: Banks have considerable protection against real estate losses.

Higher interest rates and lower asset values may strain some borrowers’ ability to service and refinance existing debt. Yet, many loans have plenty of cushion to absorb these pressures. Over the past five years, core real estate NOI has increased 23 percent and prices 21 percent (after recent declines) overall — and much more for apartment and industrial properties. The Fed has observed that loan-to-value ratios average about 50 percent to 60 percent across lenders, and its 2023 stress tests concluded that even under draconian assumptions (prices falling 40 percent) loan losses at large banks were easily manageable. To be sure, smaller banks have more exposure, but they also sport near-record levels of capital.

CLAIM: Real estate faces a credit crunch.
COUNTERPOINT: Credit is tightening, but the effects are uneven.

It seems reasonable that banks could retrench amid heightened investor and regulatory scrutiny. A net 67 percent of senior bank loan officers reported a tightening of lending standards in second quarter 2023, on a par with global financial crisis and COVID peaks. Yet, there is little evidence of a credit crunch: Spreads on core real estate loans have barely moved, remaining in line with historical norms and well below COVID peaks. Why? Perhaps because insurance companies, government-sponsored entities (e.g., Fannie Mae and Freddie Mac), CMBS and private credit, which together account for half of the mortgage market, are filling the void.

In some ways, prospects for real estate are improving. Cooling inflation has seemingly capped long-term interest rates, providing relief to valuations. That is not to say that CRE is entirely out of the woods. A recession could hamper leasing and COVID-delayed construction will temporarily lift apartment and industrial supply. But lower prices and tighter financing are curtailing new projects, and any recession may be mild. If so, then real estate’s positive momentum will only slow, not stop, and then re-accelerate next year. Taking a longer view, chronic housing shortages, burgeoning Sun Belt migration, a nascent retail renaissance, ecommerce expansion and efforts to bolster supply chains are just a few of the forces that will drive demand for real estate for years to come.

The next 12 months might be somewhat choppy as improving capital markets collide with a soft patch in fundamentals. But conflicting signals are the hallmark of inflection points, where opportunities are often at their greatest. Fortune may favor the brave investor who can seize the moment and ride the next cycle.


Todd Henderson is co-global head of real estate at DWS Group.


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