There has been no shortage of captivating commercial real estate headlines this month. Bloomberg alone issued headlines like “Distressed US Commercial Property Assets Rise to $64B” and “Commercial Real Estate Reset Is Causing Distress From San Francisco to Hong Kong” – and that is one news outlet. The lingering effects of the March banking crisis combined with the rapid interest rate rise has kept pundits busy, and investors uneasy.
Unfortunately, there is some truth to the concerns being raised in the commercial real estate industry as a whole.
As debt servicing has become more costly, we are starting to see who was swimming naked under the tides.
This market is presenting opportunities, though against a tough economic backdrop, a deal needs to have special factors in its favor to warrant a closer look. To give you a look behind the curtain, we are seeing about forty deals for every one that gets serious consideration.
Today, we dive into each asset class to discuss what we see happening moving forward–and what that means for you as an investor.
Office:
The office asset class is struggling, no surprises there. From high-profile defaults by Brookfield and PIMCO-owned Columbia Property Trust to the highest vacancy rate recorded in Manhattan since 1984, office properties have taken a large hit to their valuations. Of the $64B in distressed assets reported by MSCI Real Assets, office represents around $18B (28%) of distressed US commercial real estate. The same index reports a potential $43B in additional office assets that could become equally troubled in the near future.
The reasons for distress are clear. The pandemic-induced hybrid work model seems to be here to stay. Despite efforts by firms to bring back employees, overall demand for office space has decreased. While trophy assets in key markets have held their ground with healthy occupancy rates, anything below a AAA-rating is suffering under the weight of empty space and soon-to-be-renewed debt.
Our team has been presented with a few office deals with reduced vacancy as opportunities for value-add, where operators are betting that the trend will reverse and companies will need the space again. We have also seen operators repurposing offices into industrial and residential properties. While we are keeping our eyes out for deals of this sort, we are cautious as this strategy requires significant expertise to identify the right properties that can indeed be cost-effectively refurbished and brought up to market rate standards.
The bottom line: A significant amount of commercial real estate distress at the moment is found in office due to a significant shift in market demand coupled with costlier debt. Expect more properties changing hands at vastly different valuations, especially in Secondary and Tertiary markets and those assets in sub-optimal locations. Refurbishing and value-add in this space has strong potential but requires significant expertise, capital, and risk tolerances.
Retail:
Despite some bright spots, retail is still bleeding from the effects of the pandemic. Online shopping trends have shifted consumer behavior such that many retail spaces have become obsolete, and higher debt costs have led to the shuttering of under-performing assets. MSCI reports that retail properties in the U.S. make up $23B, or 36%, of the $64B in distressed real estate.
This is not to say that retail is dead; far from it. There is one particular type of retail property that has remained resilient and is performing well in the current rate environment. These are properties anchored by businesses that are essential to communities. Think grocery stores, liquor stores, and pharmacies, or as one local Vancouver developer likes to put it: “food, booze, and drugs” retail. Many of these properties are also becoming more integrated into developments that allow for better store-front traffic due to the residential component of projects (such as the Vancouver master-planned development in Oakridge).
The bottom line: retail properties are likely the most distressed asset class at the moment in most markets, though the “food, booze, and drugs” sector is likely going to continue to do well. Knowledgeable operators that can capitalize on the negative sentiment for retail properties can likely acquire cash-flowing assets at attractive prices.
Multi-Family
The multi-family story continues to be driven by demand outpacing supply.
On the demand side, North America is seeing strong population growth, led by high immigration numbers. Canada alone estimates that a new immigrant arrives in the country every minute. We anticipate that higher interest rates will also push more individuals towards renting due to unaffordable house prices, which should put further upward pressure on rents.
On the supply side, developers are reporting significantly longer build times vs. 2019, due to slow regulatory processes, and supply and labour shortages. With governments beginning to offer incentives for purpose-built rentals (such as faster rezoning and attractive lending rates), many developers will likely focus on this strategy for the time being. That means more potential for deals, but also raises the potential for over-supply depending on the market.
Moving forward, we expect that well-capitalized properties will continue to benefit from higher demand. However, strong fundamentals are not enough to offset additional debt costs for operators that employed high-leverage strategies on assets purchased near the market peak. As we have noted recently, there has been a rise in the use of preferred equity to recapitalize distressed properties. We expect this trend to continue, presenting both challenges and opportunities depending on which side an investor finds themselves. Hawkeye Wealth is connecting with as many operators in the space as possible to find those managers that have been able to keep their properties afloat despite the adverse market conditions.
Given the rate environment, those that can secure the best financing and have the expertise to deliver on the development will stand to create significant value on their properties. Institutional demand for this type of asset is not going away (see concluding note below), so there should be plenty of opportunities for successful exits.
The bottom line: Multi-family will likely see continued demand growth that will outstrip supply for the time being, which bodes well for the rent growth of many properties (whether existing or currently being built). Despite all the strong fundamentals, interest rates still pose a risk, especially in areas where rent control will further squeeze landlords’ cash-flows. Expect many properties to change hands as some asset managers are forced to sell.
Industrial
If office is still trying to recover from the pandemic hangover, industrial as an asset class is still having drinks at the bar. Shoppers continue to move online, logistics needs continue to grow, and on-shoring of manufacturing due to geopolitics has pushed up the need for industrial properties. A 3.3% vacancy rate for North American big-box industrial facilities (over 200,000sqft in size) and record-breaking rent increases are showing the resilience of industrial properties in this current market.
Vancouver, one of the markets that Hawkeye Wealth has been particularly active in on the industrial side, continues to maintain its status as having one of the lowest vacancy rates for all industrial space at 1%. Since industrial properties require significant amounts of land and present challenges when developing multi-story properties, we expect the tightness in key markets to continue.
Consequently, we expect an increase in demand for industrial in gateway markets, due to affordability. As urban areas have an increased need for last-mile logistics, that will continue to push manufacturing to the outskirts where industrial lands can be purchased and developed more cheaply.
The bottom line: The demand trend is likely to continue as manufacturing-heavy industries continue to move back to the U.S. and Canada while logistics’ needs also push rents and prices higher. As competition ramps up our team is focused on identifying the operators that can indeed find and acquire the right assets at the right price. The current market environment does impact existing assets on cash-flow and construction costs, though the long-term fundamentals might provide upside at the exit.
Conclusion
While some asset classes are faring better than others, there is certainly a level of distress in the commercial real estate space due to higher debt servicing costs and operational expenses. While this will present new opportunities to invest with the right operator, it brings up a key question we are asking ourselves: is this level of distress signaling something systematic or are only a few segments of the market impacted? Or, to put it in a different way, are we going to have a soft landing or a full-blown recession?
We don’t have a crystal ball. The Canadian and American Central Banks seem to believe that inflation is yet to be tamed. Many local lenders remain tight, investors are getting capital calls, and the unease is causing liquidity to dry up.
The flip side of this is to consider that despite such large defaults from groups like Brookfield reported earlier, Blackstone has raised $30.4B for the largest real estate fund ever while Brookfield partnered with Fidelity to offer additional real estate exposure to their clients. While it is impossible to know whether the level of available capital for real estate is sufficient to hold off this wave of distress, it does signal that the demand for real estate has not gone away (at least at the institutional level).
As assets continue to reshuffle and reprice, we are monitoring the strategies and assets that we feel will likely offer the highest risk-adjusted returns. We anticipate that there will be some excellent deals over the coming year, but there is nothing wrong with making sure you have cash in the bank in the event that there is an economic downturn that leads to generational buying opportunities. Whatever you choose, just make sure you are wearing something when going swimming in the ocean.
