The Great Commercial Property Reboot Will Present Opportunities

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The writer is chief investment officer of asset and wealth management at Goldman Sachs.

About once in a decade, real estate values ​​experience a significant readjustment, usually driven by factors related to overconstruction, interest rate movements, dislocation in capital markets, or downturns in the most recent economic conditions. spacious.

The burst of the COVID-19 pandemic early 2020 felt like it could be the repricing catalyst for this cycle, after a long period of expansion following the global financial crisis. But during the highly unusual period that followed, the forgiving of the banks, the easing of monetary policy, and the injection of massive amounts of stimulus into the financial system helped avert disaster.

Instead of what might have been the characteristic correction of this decade, there was a spectacular rebound in global housing markets. With interest rates around the world close to zero, asset prices in 2021, in both public and private markets, have soared to all-time highs.

Then, after central banks were slow to react to rising inflation, an aggressive rate tightening cycle began. That led to a rapid decline in values ​​on the public real estate investment trust market in 2022. But private owners were slower to recognize a drop in values, due to muted trading volume. And property owners also expected continued rent increases in housing, logistics and life sciences to result in revenue growth sufficient to offset rising cap rates – the return buyers are willing to accept to purchase a property. , which is highly correlated with underlying interest rates.

But real estate markets are now facing multiple negative factors. Interest rates are significantly higher, leading buyers to demand higher returns when purchasing property and putting downward pressure on values. Financing for most properties (except for home loans backed by government agencies Fannie Mae and Freddie Mac) is tight, as a result of the US banking crisis and dislocation of debt markets.

The performance of the real estate sectors is uneven. Office space needs are evolving with more employees working from home, the migration of people and jobs, increasing sustainability requirements and general corporate contraction leading to diverging results on assets. Rental growth is also slowing in the healthier categories of housing, logistics and life sciences, but weaker demand in the oversupplied office market continues to present the most acute challenges.

These headwinds coincide with more than $1 trillion of loans for commercial and multi-family rental properties coming due in the next 18 months. In the absence of a clear path to replace these loans, which the banking, bond and insurance markets do not have the capacity or appetite to accommodate, prices can be expected to readjust as loans mature and assets appreciate. at levels that reflect economic conditions.

Seasoned real estate investors have seen this before. After a significant rise in values, prices reset, wiping out years of gains and leaving the credit markets as the battleground where ownership change plays out. Each story is different, but the plots always rhyme.

However, this time it feels a little different. Not so much from a capital markets perspective; Structural changes are taking place in the way tenants use space. A cyclical recovery is unlikely to follow its usual course. There is much higher residual value or risk of obsolescence. Lenders will find it harder to roll bad loans into a better day, pretending they are in better shape than they are, given the significantly higher maintenance costs and capital needs of most properties.

Prices will eventually reset in all sectors. New entry points will be established to yields that reflect risk premiums adjusted for this more normalized rate environment. The slowdown in new deliveries (as a result of inflationary pressures on the cost of construction) will allow owners to set prices in most sectors.

Sophisticated real estate investors will look to improve returns, over time, as markets recover and new buildings with modern technology, sustainability credentials, and great locations command higher rents.

However, the journey to that better day will require price discovery in a highly uncertain macro and geopolitical context and probably more than a little hand-to-hand combat between borrowers and creditors.

The near-term opportunity will benefit private market lenders, who can provide capital when the industry needs it most. Next will come opportunistic investors looking for “deals” on viable assets. Then the momentum investors will pile in and ride the waves of recovery and expansion, until the tide inevitably turns once more.