'The Most Chaos': More Downward Pressure On Values As Short-Term Loans Come Due

U.S. commercial property values are sliding, and they are going to slide more this year and in 2024, as loans come due that cannot easily be refinanced. In one way or another, properties will eventually change hands at lower valuations, and not only office assets will be affected.

“Debt funds are the lenders who made the most aggressive loans in 2021 and 2022, when interest rates were so low, and they were typically short-term loans with very few covenants,” MSCI Chief Economist Jim Costello said during a June 7 panel at the National Association of Real Estate Editors conference in Las Vegas.

“That's where we're probably going to see the most chaos,” Costello said.

Though the debt markets are sluggish, there is still some activity, especially as the government agencies have stepped up to fill some of the gaps in the multifamily sector.

“This downturn and the challenges we get out of this repricing won't be the same as what we saw after the financial crisis,” Costello said. “Investors will have to have different tool sets to access the distress and to make money from it.”

In the first quarter of 2023, deal volume in industrial, apartments and retail was higher than the long-term average, though retail was an outlier because of a single deal that moved the average upward. Without it, retail would be roughly at its long-term average, as is the hotel sector.

Unsurprisingly, office sales were far below their long-term averages during Q1 2023, with central business districts' offices hit particularly hard.

Though the second quarter isn't over yet, MSCI data for deal volumes in April 2023 show that every sector is down dramatically compared with the deal volume in April 2022.

Year-over-year, office deals were down 63%, but industrial, apartments and hotel deals were down even more, each in the low 70% range. Overall, commercial property deal volume is down 72% in April compared with a year earlier.

“April was striking, with double-digit drops across the sectors,” Costello said. “People are afraid to get bogged down in these [sales] situations today, unless it's at an exceptionally low price. The changing finance environments are impacting everyone.”

Currently, cap rates are still lower than the mortgage rates, Costello said, and that doesn't work trying to buy property.

“If I'm buying a property when mortgage rates are like high, there's no benefit from leverage,” Costello said. “If mortgage rates come back down, then the cap rates don't have to adjust. If I'm a current owner, that's what I'm hoping and that's why I'm not selling today.”

Regardless of short-term disruptions, there will be a continuing demand for apartments in the future, JLL Capital Markets Managing Director Annie Rice said.

During the era of low interest rates, apartment development was robust, especially in the warmer states. Higher rates have slowed things down, but because the agencies are still lending, development hasn't crashed to a halt in the sector.

“If we go back 18 months, anyone in my position was essentially working with banks, debt buyers, life insurance companies and every once in a while have an agency execution,” Rice said. “You could get 30% from Freddie and Fannie, or you can get 60% from a debt fund.

“Fast-forward to around this time last year, and we started to see that shift back in the agencies,” Rice said. “That has to do with the increase of overall rates, but on top of that, a lot of folks are converting from floating-rate to fixed-rate.”

The coming wall of maturing loans, so daunting for the office sector, will cause some problems in multifamily — unexpectedly, considering how fast rents have risen, though that momentum has cooled considerably in recent months.

“If you don't have the equity or a partner who's willing to put additional money into the deal, there could be some distress in some markets for properties whose operating income has also remained somewhat flat,” Rice said. “Borrowers who were expecting 10% growth in rents didn't necessarily see that.”