The rise in extra yield (spreads) that investors are demanding to buy commercial mortgage-backed securities instead of risk-free Treasuries, the large amount of debt that will mature in the coming years, and their expectations for losses and distress.
The commercial real estate market, especially office buildings, is facing a period of transition. As interest rates continue to climb, the sector is grappling with the demand for newer, more sustainable architecture in different regions of the country. However, this challenging landscape also presents unique opportunities for investors looking to hedge against inflation and geopolitical turmoil.
According to Miriam Wheeler, head of Goldman Sachs' Global Real Estate Financing Group in Investment Banking, there is an obsolescence issue in commercial real estate, particularly in the office segment. This is mainly due to a significant amount of outdated legacy properties. On the other hand, Neil Wolitzer, a managing director in Real Estate Investment Banking at GS, highlights that the sector is attracting global capital seeking assets with better insulation against economic uncertainties.
Credit Valuations and Market Volatility
Miriam Wheeler sheds light on the credit valuations in the commercial real estate market, specifically in the commercial mortgage-backed securities (CMBS) market. The spread widening and credit contraction in the first quarter of 2022, coupled with rate volatility and concerns about future credit performance, have led to investor apprehension. Regional banks, which constitute a significant portion of commercial real estate lending, are also under scrutiny. As these banks face regulatory changes, it may become more expensive for borrowers, especially those in the construction market.
Conversely, Neil Wolitzer notes that the current environment presents attractive opportunities for debt funds and private capital. With traditional banks pulling back, these alternative sources of capital can fill the gaps and take advantage of the dislocation in the CMBS market.
The Wall of Maturing Debt
The industry is closely watching the wall of maturing commercial real estate debt. While there is concern, the distress is expected to be more pronounced in the office sector. A significant percentage of maturities are office assets, and some borrowers no longer have positive equity in these properties, which may result in limited incentives to contribute additional capital.
However, other segments, such as multi-family, industrial, storage, and hotel properties, are attracting considerable capital and witnessing strong revenue performance. The availability of private capital further supports these asset classes, contributing to increased demand.
The State of Office Real Estate
Neil Wolitzer points out that the challenges in the office sector primarily pertain to older buildings with inadequate amenities. High-quality office buildings with desirable features continue to command attractive rent growth. However, the sector faces a volatile macro backdrop, and the cash flow characteristics can be quite unpredictable in periods of diminished tenant demand. The memories of the regional mall sector's struggles contribute to cautious sentiments among institutional investors, which may delay a return of office real estate as a preferred asset class.
Miriam Wheeler adds that banks and institutional capital already express concern about their existing office exposure. This cautiousness makes it difficult for borrowers to secure new loans for office assets. Consequently, investor demand has led to a reduction in office concentrations in CMBS deals.
Shifting Trends and Timing of Losses
Miriam Wheeler highlights a notable shift towards newer, higher-quality assets that align with the preferences of today's tenants. This shift is evident across various segments, with office assets being the most affected. Neil Wolitzer emphasizes that market participants are being selective about deploying capital in the office sector. They focus on higher-quality assets and markets experiencing population and job growth.
Regarding the timing of losses, historical data indicates that peak losses in commercial real estate took about four years after the financial crisis to materialize. However, Miriam Wheeler believes that this time, losses may occur sooner. She attributes this to a substantial increase in floating-rate debt and borrowers' decisions around supporting distressed assets in a higher rate environment.
The Future of Commercial Real Estate
Neil Wolitzer remains bullish on North American commercial real estate over the medium term. He points out that as the world undergoes greater geopolitical uncertainty, investors will seek stable and safe places to park their capital. North America, with its natural resources, infrastructure, protective oceans, and reasonably stable demography, is a favorable long-term geopolitical hedge. While the current credit contraction poses challenges, he believes that commercial real estate will weather this period of volatility.
It's essential to remember that this article is for educational purposes only. The information provided does not constitute a recommendation from Goldman Sachs, and readers should seek professional advice before making any financial decisions.
*Disclaimer: This article is being provided for educational purposes only. The information contained in this article does not constitute a recommendation from any Goldman Sachs entity to the recipient, and Goldman Sachs is not providing any financial, economic, legal, investment, accounting, or tax advice through this article or to its recipient.
