Tightening Credit and Rising Rates: The CRE Crunch

After a good run for over a couple of decades with low interest rates and easy credit, the $20 trillion commercial real estate (CRE) industry in the US now faces a headwind due to market volatility. Many of the major investors in the industry are hurrying to encash their investments before the property value plunges further, affecting both asset liquidity and overall investment strategy. In fact, withdrawal requests from a group of property funds for institutional investors last year seem to be the biggest since the Great Recession, signifying a credit crunch.

The pulling out of capital is adding pressure on the fund managers, who are already dealing with the spiral dive of the commercial real estate industry due to increased interest rates. High-net-worth retail investors, too, are cutting their exposure to the current volatile real estate market, prompting companies to put a cap on the amount of money that investors can withdraw. Many core funds are also inclined to sell their most liquid assets, such as multifamily and industrial assets, which have demonstrated relatively greater resilience in the face of market dynamics.

While the queue for exiting investments is extensive, the perceived outflow of capital may seem substantial due to investors’ inflated requests. This may be a sign of the industry's risk assessment and the problems that the CRE industry may face in the future. On a contrary note, one may say that things can change with a wink. The current scenario may be completely reversed when investors start reinvesting. A similar case happened in 2009 when a 15% exit queue turned into a 14% entry line in 2010. Hence, even though the current scenario may seem bleak, there's always a chance of things turning positive in the future. As of now, we can only wait and watch.

Meanwhile, the values of office and retail properties have been seeing a constant fall since the pandemic because of how it changed the way people worked and shopped. Also, the rise in interest rates isn’t doing much to help the industry, which relies heavily on credit.

The CRE market has been facing several challenges, including declining demand for office space caused by remote working during the pandemic, exacerbated by the climbing cost of maintenance and interest rates. Many office owners are choosing to default on loans than refinance their debts because of the lack of demand for office space. To add to the woes are the recent banking crisis.

Greater percentages of loans are made by the small and medium-sized banks to the commercial real estate sector than any other player in the market. This could potentially lead to a situation similar to the 2008 financial crisis, where the prices of commercial properties go down dramatically. These impacts are not limited only to the real estate industry itself due to inclining fears of possible bank failures among lenders, underscoring the importance of regulatory changes.

Broadly speaking, commercial real estates like multifamily apartments, data centers, and hotels seem to be doing better than office and retail properties. The office sector has gone through a huge transformation as a result of COVID-19 lockdowns, flexibility in work culture, and changes in laws. Consequent to the pandemic, some jobs have relocated to other markets, and work locations have gained more importance in terms of working flexibility and its impact on demand and lease economics.

Real estate companies are now predicting a sharp fall in volume for the year 2023. The decline would likely come from higher interest rates and a smaller number of deals that the financial institutions are willing to finance. That being said, many employees have now gone back to the pre-pandemic routine of working from the office, which is a glimmer of hope for the sector in the times to come.

So, how bad is it right now?

Although the growth in prices is evidently slowing down, certain asset classes are experiencing a decline, with office properties being one of them. Even before the collapse of Silicon Valley Bank, banks had already decreased lending to the industry. At present, private lending is also becoming scarce.

Smaller banks will face additional regulations that could make obtaining loans from them increasingly challenging. With credit becoming scarcer, evaluating the value of buildings becomes far more difficult. While sellers ask for a price based on past valuations, buyers may present a lower offer based on current market conditions. As a result, the number of successful deals is decreasing.

Real estate is known to be the most shorted industry in the world, and the shorts have recently hiked their stakes against the CRE industry, portending a further decline of the industry.

What does the future of the commercial real estate market look like?

In terms of national commercial real estate markets, multifamily and industrial assets are apparently more fundamentally stable in the US. Meanwhile, the change in the way people use office space has brought about a change in its demand and supply equation. In the years to come, there is a possibility that office owners might have to refinance their assets at higher rates even when only half of their building space will be in actual use. Currently, the conversion of office spaces into residential properties seems to be at the top of the list of possible solutions. This can be achieved if the state and local authorities can facilitate the quick zoning reforms that are required for these conversions. Consequently, this can help CRE developers offload their stuck inventories and simultaneously address the existing challenges in the housing sector, paving the way for sustainable investment.

Overall, it will be some time before we see a trend reversal in the commercial real estate market, but the foundations for future market recovery and sustainable investment are being laid.

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