Key Takeaways
- This real estate correction has been drastically different than any in recent memory.
- Capital has remained available despite a pullback from banks, with alternative lenders playing a key role.
- The market rebound may be more gradual than some investors expect.
The current CRE correction has been of a different variety than those investors have experienced in the recent past. The mild recession of 2001 was not real estate–driven, but rather caused a modest deterioration in property fundamentals, resulting in multiple years of sluggish returns for the asset class. The 2008–2010 real estate crisis saw fundamentals weaken dramatically, but the original sin was a buildup of leverage that caused a breakage in the financial system and left the asset class completely bereft of available capital.
This correction has not been a fundamental shock (save for the office sector), nor is there a vacuum of capital availability. Rather, it is the cost of capital that is driving the dislocation in CRE. The U.S. economy has been remarkably resilient, growing at an annualized pace of 2.4% since the Fed began raising interest rates in early 2022. Just as critically, the CRE debt market has changed dramatically since the Global Financial Crisis (GFC) period, a time when banks and CMBS dominated the market.
This is especially important given the challenges faced by banks today. Regulation, an inverted yield curve and midsize institutions that are already heavily exposed to CRE have left the sector constrained in its ability to make new loans. Banks outside the top 25, which have sourced 90% of the growth in CRE bank lending since 2015, are on pace to grow their CRE businesses by the least in a year since 2012. Meanwhile, larger banks are outright reducing their holdings.
In a different time period, this pullback from banks may have been catastrophic. Today, however, the lending market is much more diversified, which has allowed for other institutions to fill the financing void left by banks. Alternative lenders—including debt funds, mortgage REITs, and other nonbank entities—have stepped up their activity, accounting for 40% of nonagency mortgage originations in 1H 2024 (compared to 23% in 1H 2023).
This is what makes the current cycle so unique—and the investment implications so different. Property values declined by more than fundamentals dictated during the GFC because properties—even those with strong cash flow profiles—simply could not acquire debt financing, and thus borrowers were forced to liquidate assets at fire sale prices. The improved resilience of the CRE debt market has helped avoid that scenario, and property values have seen a mostly modest correction; in fact, CRE risk premia remain rather tight.
Ultimately, this suggests that as market activity gradually improves, investors may be disappointed in the snapback (or lack thereof) in property values. Instead, the best opportunities will likely lie with alternative lenders who can take advantage of the air pocket left by banks and interest rates that will remain elevated despite Fed rate cuts.
