CRE’s strains are contained

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Commercial real estate: contained, for now

Where are we in commercial real estate’s downward spiral? It’s hard to say. CRE is opaque. Transaction volumes are so depressed that it is hard to know with any certainty what buildings are worth. Higher interest rates take time to make an impact. Lease negotiations take place behind closed doors. Two recent Financial Times stories highlight the difficulty. The first, from Sunday, sounded dire:

One broker estimated that only the top 10 per cent of office buildings in New York were not distressed — either in terms of the level of debt or occupancy. “I think we are on the front edge of the forced sales,” this person said . . . 

Offices are not the only sector under pressure. Some rental apartment properties — viewed as a safe bet during the coronavirus pandemic — are also struggling.

In Houston, Applesway Investment Group bought four dated apartment complexes with nearly $230mn in floating rate debt beginning in 2021, hoping that it could raise rents. But it could not cover its payments after rates rose. Lender Arbor Realty Trust foreclosed on the properties in April.

The other, published on Monday, struck a hopeful note:

New York City’s largest office landlord has agreed to sell a stake in a prominent tower that gives [the building] a $2bn valuation, a modest markdown from its previous price that came as a relief to a commercial property market beset by vacancies.

SL Green will sell the 49.9 per cent stake in Manhattan’s 245 Park Avenue building to Japan’s Mori Trust . . . 

Harrison Sitomer, SL Green’s chief investment officer, said its Park Avenue properties were still commanding robust rents in spite of the broader market turmoil . . . 

“There’s been a notable momentum shift for groups wanting to find product in New York,” he said, citing growing inquiries from potential partners.

SL Green’s shares, which had lost two-thirds of their value since the start of the pandemic, have gained almost 30 per cent this week on the news. Other big-city office Reits such as Boston Properties and Vornado got a sympathetic boost, too. 

The sale of 245 Park may not be representative, though. The property, steps from Grand Central Station, is in a super-prime location. And the dispersion in performance — in asset prices, rents, vacancies and delinquencies — between the top of the market and the middle or bottom appears to be growing. For Class C offices, the worst kind, refurbishing is too expensive and rent cuts alone won’t stimulate demand, notes Kiran Raichura, property economist at Capital Economics. JLL, a broker, estimates that 30 per cent of office buildings account for 90 per cent of total vacancies in the US market, a sort of Pareto principle for cubicle warrens.

The bifurcation in the market is visible in commercial mortgage-backed securities, where triple-B (low investment grade) spreads have rocketed back near Covid highs, even as triple-A spreads remain tight. Investors want a big discount for holding in lower-quality assets: 

Fortunately, the slice of the market that is falling into trouble is small. Triple-A CMBS, which have not seen their spreads blow out, make up 87 per cent of the market, according to Ned Davis Research. In the wider CRE world, the number of properties in distress (in default or very close to it) is modest relative to the total market. Distressed CRE assets tracked by MSCI Real Assets rose 10 per cent in the first three months of 2023, to a cumulative $64bn. For scale, US banks hold $2.9tn in CRE loans (and non-banks hold a lot of CRE debt, too).

While the numbers are small now, they will rise, at least somewhat. MSCI categorises another $155bn in commercial properties as in “potential distress”, which includes assets delinquent on payment or in forbearance. 

For office buildings, the distress numbers are already rising quickly. While most delinquency rates for property debt packaged into CMBS are somewhat higher than they were pre-pandemic, they look broadly stable. In office buildings, by contrast, there is a clear rising trend. See the light blue line here: 

In summary: the CRE market is highly bifurcated. The best properties are still attracting good tenants and willing investors. In older, less desirable buildings, however, signs of distress are mounting. Happily, the trouble is so far contained to a small slice of the total market. 

Keep in mind, however, that the stress has remained contained in part because of a robust economic backdrop. The unemployment rate is a historically low 3.7 per cent, wage growth is strong, and corporate profits remain very high relative to history. If the labour market worsens, and incomes fall, rent revenue will decline and debt payments will become even harder to meet. This chart from Moody’s shows how sensitive CRE revenues are to labour market conditions. Notice the co-ordinated downswings between falling employment and rent revenue:

More distress is probably unavoidable, if only because the refinancing cycle continues and rates look set to stay high for a while. But a recession would turn a contained problem into a pervasive one, and a bifurcated market into a market in crisis. (Wu & Armstrong)

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