Investors navigate real estate industry disruption

ARTICLE | February 29, 2024

Authored by RSM US LLP

While a soft landing might be expected for the macro economy, the real estate industry is navigating unfamiliar territory. Elevated rates sparked by the Federal Reserve’s relentless battle with inflation have caused concern felt across investment sectors.

The industry benefited from an effective federal funds rate near zero from early 2020 to the beginning of 2022. Deals with favorable returns, coupled with low interest rates, sparked the opportunity for new capital to enter the market. According to Preqin, nearly $250 billion of fund capital was raised in 2021. With the strategy to leverage equity raised and short-term low-interest floating financing offered at over 70%, market demand soured. Through a variety of strategies and across sectors, investors acquired real estate assets with the intention to flip them within the life of the short-term investment vehicle or to refinance with long-term-hold investors. The market was not anticipating a 500 basis point rate hike.

Without consideration of historic fluctuations in interest rates, unsophisticated investors failed to deploy derivative strategies to hedge short-term financing, which has created tremendous exposure. Even investors who deployed interest rate caps may not have accounted for the elevated costs associated with renewals. This oversight has been exacerbated by inflationary operating costs and the federal funds rate reaching levels not observed in over 15 years. As a result, capital fundraising in 2023 hit a six-year low.

In addition to interest rates, final demand pricing—essentially, the price of labor—is elevated. According to the U.S. Bureau of Labor Statistics, average hourly earnings of all employees within the real estate industry have increased by approximately 20% since 2019. Additionally, property insurance premiums have risen across sectors. According to CoStar, premiums were 35% higher for multifamily properties, 27% higher for office properties, and 25% higher for retail properties in 2022 compared to the average prices of the previous five years. Marcus & Millichap’s Rising Insurance Costs Special Report from August 2023 highlighted that multifamily insurance is most expensive in the coastal metros due to climate change risk. The culmination has created instability within the real estate industry.

Market instability calls for creative investment strategies

We are operating in a period in which the fundamentals of the investment unwritten, no longer work. Higher interest rates, tighter financing and inflated operating costs have created a stagnant deal market, which has placed downward pressure on real estate valuations. According to NAREIT data, in comparison to the near-zero interest rate period, today’s implied capitalization rates for all equity REITs are up nearly 200 basis points, with the average debt-to-market value of assets up nearly 10%. Deal count in 2023 was the lowest we have seen in 11 years.

With market instability comes heightened risk of financial covenant noncompliance. Many investors had been able to avoid default interest rates by extending their loans in 2023, often with an influx of capital or a softening in obligation terms. The “extend and pretend” strategy, also popular during the global financial crisis, allows lenders to avoid foreclosure by negotiating extension terms to avoid recognizing significant losses or taking over asset management responsibilities. Unfortunately, with the high volume of distressed debt approaching maturity and investors operating in loss positions, lenders are currently getting keys handed back. According to Trepp, approximately $2.81 trillion of debt is coming due by 2028, an indication that workouts will be ongoing.

The mezzanine loans that became popular after the global financial crisis as an alternative source of financing to conservative lenders have been difficult to track. These loans are typically originated by debt funds or nonbank lenders to provide short-term financing at high yields with the intent to cover shortfalls, and typically sit above senior lending in the debt stack. Unlike mortgages, mezzanine loans do not appear on property records, which makes them difficult to capture the underlying data, and are typically secured by the limited liability company owning the asset and not the real estate, which creates a faster path to foreclosure. The difficulty in measuring total exposure, taking into account higher interest rates and a faster path to foreclosure, highlights another degree of distress in the industry.

Anticipation builds as investors wait eagerly on the sidelines

Not all bad news! According to Preqin, funds’ dry powder ended the year at an all-time high of over $300 billion. Interest rate stabilization has allowed market participants to price the market, suggesting an increase in transaction volume. Further, U.S. Federal Reserve Chairman Jerome Powell has indicated that interest rates will drop in 2024. Although the rate cuts will offer a lifeline to many market participants, many holders of distressed investments will be forced to transact, enabling a more accurate picture of real estate market valuation and creating greater equilibrium between buyer and seller demand.

In the current environment, market participants will have to consider the globalization of capital, a shifting regulatory environment, emerging technologies and evolving customer sentiment. Investors will deploy creative strategies to offset disruption, including making creative use of underutilized spaces, initiating conversions of what cannot be saved, and seeking out alternative asset investments that have more favorable demand characteristics.

Consistent with the current administration’s 2023 guide to conversions, we anticipate government enticement for adaptive reuse of distressed real property. According to data from CoStar and CBRE, approximately 100 office conversion projects are currently underway across major cities in the United States, which is a significant spike in comparison to the annual average of 40 conversions between 2016 and 2022. Further, in a recent study, Avison Young examined over 26,000 office buildings across 10 U.S. cities and four Canadian cities and identified 8,996 properties that are ripe for multifamily conversions.

Alternative investment and creative collaboration will continue to attract market participants. Data centers have emerged as a core asset class. A McKinsey & Co. article from early 2023 forecasted that demand in the U.S. will grow by 10% per year until 2030. Key drivers of data center growth include the increase in cloud computing and market demand for artificial intelligence. Strategic partnerships between the private sector and municipalities have supported master community developments, which have benefited all parties by establishing real estate tax revenues, improving project margins and fostering community.

The takeaway

Continued uncertainty in the real estate industry will be felt differently across geographies and investment sectors. The inability to move properties in distressed financial positions will be painful for investors not vertically integrated to manage investments or improve margins through operational efficiency. It will remain critical to embrace digital transformation and invest in organizational infrastructure. Sophistication among market participants will be essential, and investors will engage in strategic partnerships to mitigate risk and create a competitive advantage.