The CRE market is undergoing a painful correction today, as demonstrated by declining property values and tepid investment activity. In this chartbook, we analyze the causes, address concerns around debt financing and examine what comes next.
There is no use in sugarcoating the issues facing U.S. commercial real estate—the asset class is in the midst of a meaningful correction. Property values, which soared for almost two years consecutively through mid-2022, have begun to decline rapidly. A price index from Green Street that is based on appraised property values has fallen -15.2% from its all-time high while a transaction-based index from Real Capital Analytics shows values down -10.0% from their peak. Of course, the ultimate determinant of value is the level at which transactions occur, and sales have been in short supply. Total transaction volumes were just $85 billion during Q1, a number that pales in comparison to the nearly $200 billion in sales from Q1 2022.
It is clear to us that the sharp rise in interest rates, alongside a slowing economy and secular doubts around certain property types, has driven a wedge between CRE buyers and sellers. The dearth of sales illustrates the uncertainty surrounding the asset class and the likelihood that, despite property values having fallen from their peak at a faster pace than in the early months of the Global Financial Crisis (GFC), these price declines have further to go to draw buyers in. These dynamics invite challenging questions: how similar is today to the GFC? Will debt markets be able to provide enough liquidity? What will become of the office sector? We attempt to provide answers to the many questions facing the CRE market in this chartbook.
In our view, the proximate cause for the correction in CRE is the significant and rapid rise in interest rates, which has pushed financing costs from all-time lows to 13-year highs in the span of one year. The Fed’s belated response to above-trend inflation forced it to hike its policy rate by 500 bps between March 2022 and today, the most aggressive hiking cycle in four decades. Despite significant yield curve inversion, this has still managed to push the 10-year Treasury to around 3.5% today after it averaged 1.4% during 2021. The shock to CRE financing has been profound; for an asset class in which 50%–80% of financing is in the form of debt, the rise in mortgage rates from 3.5% in 2021 to north of 6% today has had profound and negative impacts on returns for property owners.
One way to consider the impact of higher interest rates is expressed in the right chart above. In its simplest form, the business model of CRE equity investors is to leverage the spread between a property’s yield (cap rate) and its cost of debt (mortgage rate). When that spread is wide, as it was for most of 2020–2021, return expectations are robust. As we can see, that spread has quickly narrowed to zero, meaning today’s cap rates and mortgage rates are roughly equal on average—a very rare occurrence historically. Absent some ability to drive incredibly strong rent growth, equity investors will not see these levels as attractive—hence today’s muted sales volume. Ultimately, if mortgage rates remain elevated, the path to a more normalized market likely involves higher cap rates, implying lower property values.
The failure of Silicon Valley Bank (SVB) and Signature Bank, and the corresponding flight of bank deposits, has market participants considering the role of banks in CRE debt markets. Banks hold roughly 55% of outstanding CRE mortgages and were responsible for half of CRE lending activity in 2022. While total assets in the banking system are quite concentrated in the largest banks, CRE loan assets skew toward mid-size and regional banks, which are better equipped to understand local real estate markets. In all, we can estimate that small and mid-size banks—those outside the top 25 in total assets—hold around 35% of U.S. commercial mortgages. This makes them a key source of capital for the asset class and makes their response to financial stresses critical for the space.
Even prior to recent events, banks were signaling they would be paring back growth in all manner of business credit, commercial mortgages included. Lenders, which opened the credit taps in 2021 and early 2022 to fund robust growth in investment and capital expenditures, have turned decidedly more cautious as rate hikes threaten to send the economy into recession. On the whole, it is reasonable to expect bank lenders to continue tightening their credit standards, but banks are not a monolith. There are more than 4,000 U.S. banks, not to mention foreign banks that are active in the market, with a wide range of financial positions and loan portfolio compositions. We believe regional and midsize banks will remain crucial players in the CRE debt markets but expect them to be more restrained in the near future.