Navigating headwinds: a pulse on the CRE market

Despite the anticipated economic downturn and increased interest rates in the first half of this year, the real estate industry continues to offer prospects for investment, especially in property types that continue to show resilient fundamentals, according to the experts at KeyBank Real Estate Capital. It remains to be seen what the overall ripple effect will be on the financial industry resulting from the recent failed banking institutions, and the impact on commercial real estate.

The KeyBank real estate team of John Hofmann, regional team leader, Commercial Mortgage Group/Capital Markets, Andrew Lucca, head of the Income Property Group, and Al Beaumariage, SVP and program manager of affordable housing, share their insights for the discerning investor.

With the potential for steady and enduring income streams and capital appreciation, investors in commercial real estate have historically seen strong returns. In recent years, significant technological advancements have emerged, providing valuable insights and more informed decision-making. Nevertheless, in the current dislocated market, each asset class has its own distinct characteristics, risks, and potential rewards, all of which must be carefully evaluated before investing.

For example, retail and industrial have made swift recoveries from the pandemic downturn and are now maintaining a robust level of demand. By contrast, outlook in the office sector is complicated by the impact of remote work and reduced tenant demand. Meanwhile, the underlying fundamentals of the multifamily sector remain robust despite experiencing a deceleration in rental growth. At the same time, demand for multifamily affordable housing remains stronger than ever.

A valuation discovery period

According to John Hofmann, regional team leader, Commercial Mortgage Group/Capital Markets, the current period is focused on discovering – or rediscovering – the value of real estate. “Despite office complexes showing a different trend, most major property types exhibit solid fundamentals.”

Rising interest rates have had adverse effects on borrowers’ ability to access debt due to stricter debt service coverage requirements and potential valuation uncertainties, he added. “This has led to a decrease in transaction activity and created a significant expectations gap between buyers and sellers.”

The current volatile rate environment has led to most buyers and sellers hitting the pause button. “While this has caused a temporary pullback in activity, it also indicates that there is still discipline in the market as parties wait for the right price for deals to make sense,” Hofmann explains. “Looking ahead, a period of stabilized rates should lead to an increase in transactions as people become more confident in the market.”

A shift in debt, equity and opportunities

During the current environment, there has been a noticeable shift in borrower debt activity as borrowers are moving from floating rate debt to fixed rate debt. According to Hofmann, many CRE players – Fannie Mae, Freddie Mac, life insurance companies, and even the CMBS market – are getting aggressive on five-year fixed-rate borrowing to fill the void with shorter term debt. The goal is to provide prepayment flexibility and meet the changing needs of borrowers.

In this challenging environment with a muted acquisition market, investors have a unique opportunity. “Those who have floating rates can switch to fixed and benefit from refinancing at a lower, more permanent rate,” says Hofmann. “Additionally, many sponsors and strong multifamily operators are exploring the preferred equity space to deploy their dry powder.”

Multifamily eases back into a normal cycle

According to Andrew Lucca, head of the Income Property Group, the multifamily market has entered a new phase where landlords can no longer increase rents without renovating or upgrading units, as was possible during the high demand post-COVID period. Lucca explains, “The multifamily market now is returning to a more normal cycle, where there is still a significant shortage of housing in the US and single-family housing is still expensive, especially when considering current mortgage rates and pricing.”

Lucca adds that the fundamentals of the multifamily market remain strong. However, he notes that new supply entering certain submarkets can create pressure on rents. Lucca also points out the impact of increasing government involvement in multifamily projects, which can introduce eviction moratoriums and rent control. “This phenomenon is starting to manifest beyond the states that already had rent control.”

Affordability’s rising costs

The shortage of affordable housing in the country is a significant challenge, adds Al Beaumariage, SVP and program manager of affordable housing. “Waitlists for affordable units can extend up to 18 months in some cases.” He further comments that “the COVID-19 pandemic only worsened the problem.”

According to Beaumariage, those investing in affordable housing must contend with various obstacles, such as increasing construction expenses, fluctuations in low-income housing tax credit rates, and disruptions in the supply chain. “All of those factors can create pressure on the capital required for new constructions or the re-syndication of tax credit properties, resulting in greater difficulty in financing affordable housing projects.” 

He continues that investors in the affordable housing industry are becoming increasingly discerning about where and with whom they invest their capital. “If a project is outside of a major Community Reinvestment Act (CRA) market, it usually receives lower pricing proposals than those in strong CRA markets,” he says. “This can have a detrimental effect on the project’s overall feasibility.” Beaumariage adds, “These are situations where developers can benefit from Key’s integrated affordable platform. By working together across disciplines, we are able to maximize proceeds for our clients and in some cases completely close the capital gap. In other cases, we are able to structure financing so that developers are able to take advantage of future increases in area median income with an earn-out structure. It’s all about maximizing the options.”

Office’s fight against fundamentals

The office sector is currently encountering various challenges that are significantly impacting its fundamentals. The COVID-19 pandemic has accelerated remote and hybrid work – and while occupancies are trending back up as employers welcome more employees back to the office in a hybrid or full schedule, there’s still much uncertainty about the future demand for office space.

Hofmann explains that companies are currently assessing their cost structures and may be reconsidering leases, leading to a decrease in tenant demand. Consequently, office landlords are experiencing more rollover valuations and fewer lease renewals, which can adversely affect their cash flows. “Higher interest rates increase the cost of financing for prospective office building buyers, causing a significant impact on valuations,” he says.

The sector is also experiencing a flight to quality. “We are seeing a significant difference in valuations/cap rates between Class A and Class B with more liquidity for Class A assets,“ says Hofmann. Considering these hurdles, the office real estate sector is anticipated to face a challenging environment for the next few years. “We expect the disparity in valuations to be more evident in this sector,” Hofmann continues. “Investors must carefully evaluate the potential risks and rewards of these properties and be ready to face challenges that arise.”

Retail’s rebound

The retail market has experienced a remarkable rebound from the COVID-19 pandemic, presenting ample opportunities for investors who are willing to adapt and evolve. Although there may be challenges in the mall space or older power centers, the overall market is not oversaturated. Moreover, new constructions in the retail space can offer several benefits to investors.

Hofmann notes that grocery-anchored retail centers have demonstrated exceptional performance, and having high-quality tenants remains crucial for the center’s success. “Longer-term leases can still be viable for tenants, especially when the space is tailored to meet their specific requirements,” he explains. “Moreover, consumers have exhibited resilience, and the retail market has undergone a restructuring of sorts, with COVID-19 clearing up some corporate bankruptcies and uncertainties that previously made lending more challenging.”

The retail market presents ample opportunities for investors who are willing to thoroughly evaluate the potential risks and rewards of these properties. Lucca adds, “Pre-leasing can also be a useful tool in driving the success of a center, and construction opportunities may be available for those who are willing to take advantage of them.”

What does the future hold?

While economic uncertainty and rising interest rates may cause some commercial real estate lenders and investors to reduce their activity in 2023, a majority of those surveyed by CBRE, for example, indicated that they will largely maintain their capital allocations to the commercial real estate sector. This suggests a strong end-of-year expectation for increased investment activity and abundant capital.

“Overall, the commercial real estate market remains strong, with opportunities for investors who are willing to carefully assess the potential risks and rewards of different property types and to adapt to changing market conditions,” says Hofmann. “While there may be challenges in some sectors, such as office properties, other sectors such as multifamily, retail and industrial properties continue to have strong fundamentals, and therefore it’s incredibly important for the owners to have the appropriate debt structure.”

To discuss your options in navigating the current headwinds, connect with KeyBank Real Estate experts:

• John Hofmann, Regional Team Leader, Commercial Mortgage Group/Capital Markets
• Andrew Lucca, Head of the Income Property Group
• Al Beaumariage, SVP and Program Manager of Affordable Housing