From office distress to opportunity

The continued struggle in the capital markets to resolve middle market commercial real estate (CRE) debt has necessitated new ideas for investment strategies, capital sources and debt stack solutions. The higher interest rate environment and inflationary pressures have led to increased demand for creative financing to help bridge the funding gap. Meanwhile, unprecedented discounts in the office market have opened the door to urban adaptive reuse strategies never before considered (or even thought possible), which may hold the key to revitalizing the CRE sector.

Urban adaptive reuse strategies take hold

While office values continue to plunge, urban adaptive reuse strategies to remake obsolete office space have taken hold as deals begin to make financial sense. Public subsidies to support affordable housing developers are spurring creativity around transforming vacant office space across the United States and Canada.

CBRE research for Q1 2024 showed nearly 70 million square feet of office space was undergoing conversion to other uses, with multifamily conversions accounting for nearly 63% and life sciences conversions 12%. Canada saw 870,000 square feet of competitive inventory leave the office market and enter conversion.

Urban cores with older office buildings have been hurt the most by the post-pandemic market shift around office demand, and we are now only starting to see the true impact on CRE values. The RCA commercial property price indexes, as reported by CBRE, measured a year-over-year decline of 16.6% for office space. While this is the national average, some markets flooded with supply and poor occupancy have seen discounts as high as 50% on commercial property values. A high-profile example is the Aon Center in downtown Los Angeles, which recently sold for 45% less than its last purchase price.

These discounts underscore the challenges facing the CRE market. The need for (and move toward) urban adaptive reuse can no longer be ignored, and innovation will be critical for commercial property owners and developers in pursuit of risk-adjusted returns that meet investor and tenant needs.

An evolving debt market

The regional bank stress resulting from plunging property values and held-to-maturity unrealized losses wreaked havoc on balance sheets and tightened lending for all commercial real estate. However, pending maturity wall concerns have waned somewhat as banks deploy the “extend and pretend” practice of modifying loans to avoid recognizing a loss. Mortgage REIT Q1 2024 earnings calls revealed how lenders are providing relief to borrowers, and included Arbor Realty Trust’s announcement that it successfully modified 40 loans totaling $1.9 billion with fresh capital.

In response to the CRE financing gap, new entrants to the private credit market have taken the industry by storm with historic amounts of capital sourced through private equity, family offices and life insurance companies. These private credit lenders understand the market and have capitalized on opportunities to lend to high-profile properties affected by the floating-rate debt service—e.g., by offering higher-rate but shorter-term loans in preferred positions with protections. For real estate borrowers, calculating one’s true cost of capital in this extended high-rate operating environment will make the difference between surviving versus thriving in this new real economy.

Dislocated-market opportunities

The market correction many have been waiting for has yet to materialize, as the market fundamentals for the sector remain strong. Property sales in this dislocated market have been a struggle due to pricing disparities resulting from historically low sales volumes and value uncertainty, which have slowed activity in the debt and capital markets.

Recent data from the RCA commercial property price indexes provides a good snapshot of the state of the CRE sector, including year-over-year changes and market peaks from 2022 and 2007. The data illustrates how the multifamily and industrial sectors have thrived in the last few years, powered by market dynamics, including the housing market shift from buying to renting and an increase in online shopping. 

Many commercial property owners continue to operate in a net cash flow position and have chosen to hold on to their assets rather than sell them at a 20% discount. The market opportunities around distressed debt have not materialized as expected, but we have seen deals happen off-market, with lenders and sponsors engaging in strategic acquisitions in the last 12 months.

Deal sourcing has primarily resulted from long-term relationships within the real estate network and has focused on cash-flowing assets that minimize downside risk. The players tend to be those that acquired properties in the last three years with floating rate debt and then were hit by inflating operating costs and the inability to capture higher rents. Time will tell if deal flow increases following Blackstone’s acquisition of Apartment Income REIT Corp., which could signal the bottom of the cycle as more big players see value in CRE’s long-term returns. 

The takeaway

While CRE owners and funds face multiple headwinds, from high interest rates to rising insurance costs, many industry players see an opportunity in the second half of 2024 to make investments. A historic level of dry powder remains on reserve as investors wait for creative strategies to provide risk-adjusted returns; understanding capital optimization through diversification will be key to success for the sector.