CRE Market Outlook — Fall 2023

At a Glance —

• The dramatic rise in interest rates over the last year has increased the cost of capital across all real estate classes
• Banks may continue to face tighter regulations such as reserve requirements, less leverage, and more oversight in general
• Experts believe that borrowers needing to recapitalize or sell their assets because of a pending renewal or refinance will bring high-quality assets to the market
• This displaced capital market opportunity will provide an excellent opportunity for non-bank investors

Rising Interest Rates

The dramatic rise in interest rates over the last year has increased the cost of capital across all real estate classes. Some of the ripple effects of the Fed’s rate increases are now starting to show themselves with the sharp decline in availability of debt becoming one of the most important factors the real estate market faces today. Because of the Silicon Valley Bank failure and the subsequent liquidity scare in the banking sector, many regional banks are on the sidelines and a tidal wave of real estate debt is coming due in the next few years.

The Fed monetary policy and secondary effects of banking liquidity have created a backdrop for one of the most interesting and potentially opportunistic times to be in the real estate business. Many experts believe that borrowers needing to recapitalize or sell their assets because of a pending renewal or refinance will likely bring high quality assets to a market where traditional buyers are on the sidelines.

The Effects of Failed Banks

In the second quarter of 2023, we saw Silicon Valley Bank, Signature Bank and then First Republic, all fail. Credit issues did not cause these bank failures, as was the case in the 2008 Great Financial Crisis. Instead, a duration mismatch between assets and liabilities caused all these banks to have a balance sheet crisis.

The long-dated assets and bond portfolios of these banks had a negative mark-to-market valuation as rates rose quickly. This caused all regional and non-money center banks to focus on loan to deposit ratios and forced a drastic pullback in available liquidity in the marketplace.

As a result, banks will face tighter regulation such as reserve requirements, less leverage, and more oversight in general. With this comes fewer new development projects to be financed in the coming years, which should support commercial real estate values as new supply becomes more limited.

The Office Space Sector

The number one area that everyone has been hearing about is the office sector and the high-profile defaults that have been happening across the country. The office space sector has faced an incredible headwind with low occupancy primarily because of the work from home trend resulting from Covid.

That trend is rapidly changing as many experts believe that companies are much more productive when they require their employees to return to the office. Additionally, experts emphasize that there is a strong delineation between the “Trophy Office” (newly built, well amenitized, and environmentally friendly buildings) versus the “Commodity Office” (which is everything else). The well performing Trophy Office segment represents just a small part of the office market, approximately 5-10% of the overall market. Many believe the Trophy Office assets will remain in high demand and can achieve high rental rates while the commodity office sector will undergo a tremendous amount of stress.

Basically, while the overall office market is very precarious today, there are certain types of office assets that are doing great. Many smart investors like Blackstone, KKR, Crescent, etc. are lining up to take advantage of this displacement in the Trophy Office space.

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The Opportunity — Loan Maturities are Creating Motivated Sellers

There are over $1 trillion of commercial real estate loans maturing in 2023-2024 and the financing requirements are expected to surpass the capabilities of the current commercial real estate debt markets. While some borrowers can restructure their capital stack with new loans, others might resort to equity, hybrid capital solutions, or be forced to sell prime assets. This need for liquidity and recapitalization will extend way beyond just the office sector.

Existing borrowers and sponsors with conservative capital structures and capital reserves to help de-lever any near term maturities will have a distinct advantage until real estate debt markets stabilize. Liquidity constrained borrowers with near-term loan maturities may be forced to recapitalize, seek equity infusions or sell attractive, healthy assets to support capital needs elsewhere in their portfolio.

While some loans may be refinanced or extended, many experts believe that a meaningful portion of upcoming loan maturities will result in assets coming to market across property types and under very different market conditions than in 2021 and earlier.

A final word from our Managing Director, Harris Junell —

Those who are in a unique position to be able to provide equity for great assets with great management teams will benefit at a time when equity may be needed the most. Our focus will not be on finding distressed assets but rather great assets that are displaced primarily because of the current market conditions.

As the real estate landscape continues to evolve, SageStreet’s approach centers on aligning with “best-in-class” managers to navigate these changes in the market. We are very excited about the opportunities over the next few years and feel this displaced capital market opportunity is going to provide an excellent chance to achieve above average yields for our investors.