FireSide: Anatomy of a CRE correction

Andrew Korz and Lara Rhame discuss the commercial real estate market, troubling headlines around the office sector in the financial news, and what lies ahead for the CRE market.

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May 11, 2023 | 30 minute read

About this episode:
The CRE market is undergoing a painful correction today, as demonstrated by declining property values and tepid investment activity. In this episode of FireSide, Chief U.S. Economist Lara Rhame and Investment Research Director Andrew Korz analyze the causes, address concerns around debt financing and examine what comes next in the CRE market.

Transcript excerpt
Lara Rhame (00:03):
Welcome back to Fireside, a podcast from FS Investments. I’m Lara Rhame, Chief U.S. Economist. Today’s episode of Fireside is gonna focus on the commercial real estate market, and lately there have been a lot of troubling headlines in the financial news, including defaults on office buildings, and combined with recent bank failures. Suddenly it feels alarmingly similar to conditions ahead of the financial crisis. Spoiler alert, so that we don’t all get too negative going into this podcast: My guest’s view is that we are not likely to get a repeat of the late 2000s, but I want to know why and what is in store for the CRE market in the coming year. So I am joined today by Andrew Korz, a director in our research team, and an expert on all things real estate. Welcome, Andrew.

Andrew Korz (00:56):
Thank you, Lara. I am excited to be here with you.

Lara Rhame (00:57):
This is going to be a great episode. I want everyone to know that today we’re recording May 2nd, 2023. Markets are expecting the FOMC to raise rates 25 basis points tomorrow, and that would mean 500 basis points of rate hikes in about a year. That is a huge number in just 14 months and we’ve seen interest rates rise across the curve. We’ve seen mortgage rates jump higher and there is probably no sector of our economy that is more interest rate sensitive than the real estate market. So knowing that this fast and furious rate hike cycle has kicked real estate markets in the teeth, let’s talk about where we are right now in the cycle. And I want to just take a step back and remind everyone that when the Fed raises rates, when interest rates, mortgage rates all spike, we expect some correction and price, but it doesn’t happen right away. What we get initially is this freeze because we get buyers expecting prices to come down a lot and sellers not wanting to meet them there. That’s a tough thing. We do see it correcting a little bit faster, but it’s already a slow process. In residential real estate, it’s extremely slow in commercial real estate. So we get this frozen market transactions and then we get a thaw. Buyers and sellers slowly start to feel each other out and transactions very slowly pick up with prices at a lower level. Where are we right now?

Andrew Korz (02:40):
Yeah, Lara, that’s a great place to start and I think you framed it perfectly. I mean, when you think about the equity market and matching of buyers and sellers, it happens in real time. There’s an order book on an exchange there, there’s bids, there’s asks, and you know, the exchange just kind of matches the bids and asks. The other thing is that every share of Apple is the same. If I’m gonna go buy a share of Apple today, you’re gonna go buy a share of Apple tomorrow. It’s the same exact financial asset. Real estate, we’re inherently dealing with real physical assets here. And the reality of them living in the physical world is that they’re all different. So they’re all going to have different fundamentals based on the age of the asset, the tenants, you know, what metro area it’s located in.

So real estate is just inherently going to be a much slower, more bespoke type of market than what we’re used to in a lot of financial markets. So, it makes pricing difficult because, you know, what a property trades for in California might be very different than what it trades for in New York. So, it’s sometimes challenging to really make broad generalizations about the market. But I think one generalization we can make today, as you pointed out, is that as the Fed has raised interest rates by 5% in a 14 month period, the market has dropped everything and is in the process of just reassessing. What are the economics of deal making today? Clearly they’re extremely different than they were really over the past 15 years. So we’re, in this period, I think of, as you mentioned, buyers and sellers trying to figure out where the value is.

What is that equilibrium? You have, on one hand, and I’ve mentioned this before, but sellers or potential sellers of property saying, “Hey, I got this office building, or I got this retail property that I own, you know, appraised 12 months ago I was told it was worth a hundred million dollars and now you’re telling me I should be selling it for 75 or 80 million. There’s just no way that I’ve lost 20 or 25% in just a year.” You have prospective buyers saying, “well, what do you mean the financing costs for me to acquire this property have gone up by three, 400 basis points and over that time, rent growth has slowed.” So you have this sort of dance going on between buyers and sellers and to answer your question, it’s hard to say exactly where we are in this cycle. Every cycle is different. Sometimes it takes over a year for a new equilibrium to form, and sometimes it takes a shorter amount of time. A lot of that’s gonna depend on what the Fed does over the next six months or so, what interest rates do, what the economy does. But I think right now we’re really in the thick of that feeling each other out. We’re sort of in the thick of figuring out where that new equilibrium is.

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Andrew Korz, CFA

Executive Director, Investment Research

Lara Rhame

Chief U.S. Economist + Managing Director

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