Artificial intelligence and commercial real estate are probably the two most-discussed industries in America right now – and the loudest talk about both tends to be apocalyptic. But in commercial real estate, the current storm of uncertainty and illiquidity might be sowing the seeds for once-in-a-generation investment opportunities.
There are certainly commercial real estate segments in significant distress. Earlier this month the Boston Consulting Group published a report on what it called “the curse of Zombie Buildings.” The report argued that a host of structural changes— including the inevitable aggressive deployment of AI technologies — will mean that only 60% to 65% of current U.S. office space is needed in the future.
Nevertheless, it is important to note that office space represents less than a fifth of the vast commercial real estate universe, which also includes retail, industrial, and multifamily properties. While urban downtown office space demand has been adversely impacted by the shift to work-from-home, the other commercial segments are in no way facing a long-term structural crisis.
Commercial real estate transactions are way down, but that’s as much about the Federal Reserve’s interest rate increases as it is about demand. Recent bank failures and concerns about regional banks have temporarily throttled the availability of debt to finance commercial property acquisitions, which in turn dampens potential investor returns – making equity capital harder to get, too.
That’s causing a repricing of commercial real estate assets. Shorter-term investors in particular are steering clear of acquisitions, as the “cap rates” used to value commercial properties– a property’s net operating income divided by its value – remain hard to forecast.
Investors without deep experience in the commercial real estate market can be forgiven for thinking this situation is unprecedented and ought to be completely avoided. But professionals who have been in the asset class for several decades see the current freeze-up as a new twist on an old, recurring story of market dislocations that create outsized return opportunities.
The U.S. saw just such a reset in residential real estate following the global financial crisis of 2008. Another arose some twenty years before that in the commercial property that was cast off during the savings and loan crisis of the late 80’s.
Meanwhile the commercial real estate market has certain characteristics that make it uniquely attractive for investors willing to step into the breach.
Unlike residential mortgages, the vast majority of commercial loans are assumable, meaning they can be transferred to new owners with lenders tacking on only a modest fee. This is true for both longer-duration loans issued by institutions like life insurers—which can run to 25 years—to mortgage-backed securities and other shorter-dated loans, which might run as short as five years.
There is an oversupply of properties with assumable loans with healthy duration – most of which carry much lower interest rates than are available today. Judging from the forward US treasury yield curve and economists’ predictions, it seems rates are likely to trend back down in the next few years, making these assumable loans even more valuable.
At the same time, the banks’ hesitation is leading to more seller carrybacks, in which the current owner of a property provides a portion of the financing for the sale. In such a transaction, a building that is being sold for, say, $100 million with an existing assumable loan of $55 million would normally require the buyer to come up with $45 million in cash.
But in less liquid markets, sellers often offer to finance a significant portion of the total price. $20 million in seller financing on the $100 million transaction would mean a required down payment of just $25 million. Structures like this offer sellers cash flow on an asset they know well, with the expectation that the buyer will refinance within a certain time.
It’s a type of creative financing that might seem unlikely to those unfamiliar with commercial real estate, but in practice the structure is quite common. With banks on the sidelines, investors on both sides of a transaction need to be creative, but that creates further opportunities for each.
As for when the current commercial real estate turmoil will end, that of course is anyone’s guess. But if economy-wide recessions average around 18 months, such periods in real estate tend to last twice as long, as buyers and sellers need to bridge a naturally sticky gap between bid and ask.
With most large commercial investors legally committed to turning over their portfolios within three to seven years, the window of opportunity is likely to be soon opened widest. And it will be opened across a range of assets, from central business district office to industrial and distribution properties, apartment buildings and data centers.
That doesn’t mean there won’t be further volatility – and its attendant risks – in the immediate future. But a few last turns of the interest rate screws aren’t likely to matter much to investors over a three to five year time horizon.
Instead, what will matter most is a property’s location, quality and price — just as it did before the current period of turmoil began, and will after it inevitably ends and repeats itself sometime in the future.
