Is the commercial Real estate market on the brink of collapse?
Is the commercial Real estate market on the brink of collapse?
These threats are occurring at different levels and different paces depending on the asset types and locations. Generally, capitalization rates are globally rising due to the interest rate pressure. Rental trends vary by asset class, with offices generally declining, multi‑family slowing and logistics assets still rising. Vacancy rates are highly dependent on local market dynamics and overall supply and demand; however, office properties are affected across the board, with certain market reaching new vacancy rate highs.
Due to the large increase in interest rates, some properties and projects are no longer financially viable, causing a further stress on the market.
The BDO Real Estate and Construction group has established a global Real Estate Valuation network to address the valuation challenges associated with these complex problems, that allow us to work on several different markets and maintain an overall market view of real estate. The BDO Real Estate and Construction group provides fair and market valuation analysis, impairment testing analysis, financial reporting and feasibility studies.
Investment factors
The pressure on interest rates has pushed cap rates up. While central banks took 12-18 months to raise interest rates to their peak, real estate market participants have taken longer to adjust.
In the U.S., interest rates peaked in August 2023 at a SOFR rate of approximately 5.33% from a low of nearly 0.00% in February 2022. SOFR rates have been flat since then. If we look at the historical data, sellers have stuck to the narrative that low rates will return soon, essentially assuming that the rate hikes are temporary. This was evidenced by the number of rate cuts the market was expecting, which by mid-2023 was expected to be of 6 cuts through 2024 for a total of 150 basis point rate cut. For perspective, as of the most recent date, the market has shifted narrative, with two cuts expected in 2024. There are even discussions about no cuts in 2024.
While cap rates have been pushed up across all asset types, sector-specific inertia has led to an erosion of the spread between risk-free rates, such as US Treasuries, and actual capitalization rates. Put another way, cap rates have risen more slowly than risk-free yields. For example, historically, spreads or premiums over risk-free rates for US office properties have been in the 3.00 to 4.00% range. Most recently, the spread has been in the 2.00 to 3.00% range.
This suggests that, on average and all things being equal, there is still room for an increase of up to 100 basis points for office properties. This view is also largely confirmed by various forecasts and market sentiment surveys in the US.
In addition, the refinancing of existing loans adds to the problem, with more than $900 billion of loans due to be refinanced through 2024, $117 billion of which is tied to office properties. In an environment where values are declining through cap rate increases, net operating income is suffering through occupancy and rent declines, interest rate increases are inflating debt service, and refinancing process will have to go through an equity infusion. While some market participants are strong enough to withstand equity injections, others are not prepared or are unwilling to do so, as evidenced by the recent increase in delinquent loans or foreclosed properties.
The situation in Europe is very similar. European prime rates have risen by 450 bps from pre-pandemic levels to September 2023, and a large amount of commercial real estate backed loans come due for refinancing in 2024. Spreads have also been largely eaten up by market optimism, with prime cap rates rising only about 130 bps on average over the same period. This points to potential overvaluation.
Operating factors
The operating landscape is different than investment factors. Rental performance needs to be differentiated by asset class, location, and property type. Office is the asset class that has suffered the most, with rents falling globally. Certain key U.S. office markets have been hit particularly hard, such as San Francisco, CA, where rents have fallen approximately 30.0% from their peak. At the other end of the spectrum, industrial logistics properties have, on average, performed better exceeding inflation in certain markets. (Several key markets in Florida have seen average 9.0+% rent growth for industrial logistics throughout 2023/2024.)
Vacancy rates are also highly dependent on local criteria and are mostly a byproduct of supply and demand. Office vacancy rates have generally increased in all locations, primarily due to the fundamental shift that has occurred with telecommuting and associated tenant footprint reduction. Certain markets have been severely impacted, such as San Francisco, CA (22.0% overall with a CBD vacancy of 35.6%, historically unprecedented - 6.2% overall vacancy pre-pandemic), Seattle, WA (15.4% - 5.7% pre-pandemic), New York, NY (14.2% - 8.0% pre-pandemic).
Growth in the major European office markets has been very uneven. Frankfurt, Germany, has seen a decline in rents, while London, UK, and Amsterdam, the Netherlands, have seen increases in line with the global average. On the other hand, European office markets have seen a slight increase in vacancy rates, albeit less than in the US.
Of all sectors, office is set for a supply rebalancing
The global office market has been affected by a clear downturn. Vacancy rates are generally rising, especially in the United States. Rents have mostly declined, while cap rates have risen due to debt service pressures. Sector inertia has meant that cap rates have room to rise further to fully adjust to the actual rise in interest rates. In the United States, many markets are poised for a supply rebalancing. New York has already indicated its willingness to convert its office stock into multifamily housing in response to the housing crisis. San Francisco has also passed a similar ordinance, although there have been few projects in the pipeline to date. Other asset classes have not seen the kind of rapid and sharp swings that would indicate a rebalancing of supply.
While values have already been impacted, with some markets down more than 20.00% from their peak, the refinancing wall that will occur in 2024 is likely to further impact the commercial real estate sector. Banking contagion is a risk to consider that could further escalate the value decline, as evidenced by US and European regulators pointing to this issue.
Opportunities
The commercial real estate landscape may be experiencing a correction, but there are still opportunities for investors and developers who take a discerning approach. While the traditional office space faces downward pressure, there's potential to unlock value through creative reuse of existing buildings. This could involve conversions to multi-family housing. The persistent housing shortage, coupled with population increases in many areas, creates a favorable environment for well-located multi-family properties to deliver stable returns.
Due to the large increase in interest rates, some properties and projects are no longer financially viable, causing a further stress on the market.
The BDO Real Estate and Construction group has established a global Real Estate Valuation network to address the valuation challenges associated with these complex problems, that allow us to work on several different markets and maintain an overall market view of real estate. The BDO Real Estate and Construction group provides fair and market valuation analysis, impairment testing analysis, financial reporting and feasibility studies.
Investment factors
The pressure on interest rates has pushed cap rates up. While central banks took 12-18 months to raise interest rates to their peak, real estate market participants have taken longer to adjust.
In the U.S., interest rates peaked in August 2023 at a SOFR rate of approximately 5.33% from a low of nearly 0.00% in February 2022. SOFR rates have been flat since then. If we look at the historical data, sellers have stuck to the narrative that low rates will return soon, essentially assuming that the rate hikes are temporary. This was evidenced by the number of rate cuts the market was expecting, which by mid-2023 was expected to be of 6 cuts through 2024 for a total of 150 basis point rate cut. For perspective, as of the most recent date, the market has shifted narrative, with two cuts expected in 2024. There are even discussions about no cuts in 2024.
While cap rates have been pushed up across all asset types, sector-specific inertia has led to an erosion of the spread between risk-free rates, such as US Treasuries, and actual capitalization rates. Put another way, cap rates have risen more slowly than risk-free yields. For example, historically, spreads or premiums over risk-free rates for US office properties have been in the 3.00 to 4.00% range. Most recently, the spread has been in the 2.00 to 3.00% range.
This suggests that, on average and all things being equal, there is still room for an increase of up to 100 basis points for office properties. This view is also largely confirmed by various forecasts and market sentiment surveys in the US.
In addition, the refinancing of existing loans adds to the problem, with more than $900 billion of loans due to be refinanced through 2024, $117 billion of which is tied to office properties. In an environment where values are declining through cap rate increases, net operating income is suffering through occupancy and rent declines, interest rate increases are inflating debt service, and refinancing process will have to go through an equity infusion. While some market participants are strong enough to withstand equity injections, others are not prepared or are unwilling to do so, as evidenced by the recent increase in delinquent loans or foreclosed properties.
The situation in Europe is very similar. European prime rates have risen by 450 bps from pre-pandemic levels to September 2023, and a large amount of commercial real estate backed loans come due for refinancing in 2024. Spreads have also been largely eaten up by market optimism, with prime cap rates rising only about 130 bps on average over the same period. This points to potential overvaluation.
Operating factors
The operating landscape is different than investment factors. Rental performance needs to be differentiated by asset class, location, and property type. Office is the asset class that has suffered the most, with rents falling globally. Certain key U.S. office markets have been hit particularly hard, such as San Francisco, CA, where rents have fallen approximately 30.0% from their peak. At the other end of the spectrum, industrial logistics properties have, on average, performed better exceeding inflation in certain markets. (Several key markets in Florida have seen average 9.0+% rent growth for industrial logistics throughout 2023/2024.)
Vacancy rates are also highly dependent on local criteria and are mostly a byproduct of supply and demand. Office vacancy rates have generally increased in all locations, primarily due to the fundamental shift that has occurred with telecommuting and associated tenant footprint reduction. Certain markets have been severely impacted, such as San Francisco, CA (22.0% overall with a CBD vacancy of 35.6%, historically unprecedented - 6.2% overall vacancy pre-pandemic), Seattle, WA (15.4% - 5.7% pre-pandemic), New York, NY (14.2% - 8.0% pre-pandemic).
Growth in the major European office markets has been very uneven. Frankfurt, Germany, has seen a decline in rents, while London, UK, and Amsterdam, the Netherlands, have seen increases in line with the global average. On the other hand, European office markets have seen a slight increase in vacancy rates, albeit less than in the US.
Of all sectors, office is set for a supply rebalancing
The global office market has been affected by a clear downturn. Vacancy rates are generally rising, especially in the United States. Rents have mostly declined, while cap rates have risen due to debt service pressures. Sector inertia has meant that cap rates have room to rise further to fully adjust to the actual rise in interest rates. In the United States, many markets are poised for a supply rebalancing. New York has already indicated its willingness to convert its office stock into multifamily housing in response to the housing crisis. San Francisco has also passed a similar ordinance, although there have been few projects in the pipeline to date. Other asset classes have not seen the kind of rapid and sharp swings that would indicate a rebalancing of supply.
While values have already been impacted, with some markets down more than 20.00% from their peak, the refinancing wall that will occur in 2024 is likely to further impact the commercial real estate sector. Banking contagion is a risk to consider that could further escalate the value decline, as evidenced by US and European regulators pointing to this issue.
Opportunities
The commercial real estate landscape may be experiencing a correction, but there are still opportunities for investors and developers who take a discerning approach. While the traditional office space faces downward pressure, there's potential to unlock value through creative reuse of existing buildings. This could involve conversions to multi-family housing. The persistent housing shortage, coupled with population increases in many areas, creates a favorable environment for well-located multi-family properties to deliver stable returns.