Even with the recent roller coaster ride in a normally sedate Treasury market, it’s clear a time of reckoning is at hand for the years of abundant cheap debt we’ve enjoyed. Layoffs, a crypto crash, and a European recession, among other worries are dominating the headlines. As George Orwell wrote almost 90 years ago in his novel Down and Out in Paris & London: “It is a feeling of relief, almost of pleasure, at knowing yourself at last genuinely down and out.”

As we all know, another 75-basis point rate hike in November pushed segments of CRE into negative leverage territory. That’s the point at which the cost of debt to finance real estate deals exceeds the expected returns on those investments. This not only drives bid prices higher, but convinces many investors to rethink the wisdom of holding on to their properties whether in New York, LA, San Francisco, or any other metro area in the U.S. For instance, commercial property prices have dropped nearly 13% from their peak earlier this year, according to the Green Street Commercial Property Price Index in October, with prices down 7.3% during October alone.

As Orwell wrote, “You have talked so often of going to the dogs — and well, here are the dogs, and you have reached them, and you can stand it. It takes off a lot of anxiety.”

Inflection point for CRE

A new report by Moody’s Analytics showed that in Q3, nearly 30% of new commercial mortgage-backed securities ($5.5 billion worth) had negative leverage, up from 2% of similar loans in Q3 of 2021. Multifamily and industrial sectors are most likely to be wrestling with negative leverage, the report stated, as renters face affordability ceilings and warehouse demand has fallen since last year’s industrial push.

“The squeeze that’s being put on loan interest rates and CRE cap rates is driving a trend we haven’t seen to a significant degree since the 1980’s: negative leverage,” concluded Moody’s. The report added that negative leverage will translate to lower loan-to-value (LTV) ratios, a slowdown in lending and trading volume, and ultimately downward pressure on asset values, which we haven’t seen yet in the COVID era. As I’ve written in past articles, negative leverage ​ takes a whopping bite out of final cash on cash returns as higher rates and the effects of amortization can bring a 6 cap buy into a 4 cap return. That can turn even the simplest NNN transaction sour. Dueling buyers and sellers remain at least 10 paces apart, thus slowing down transactional volume to all but those who have plenty of cash, an opportunistic eye, and an iron stomach.

As Propmodo opined last week: “Now that interest rates have eclipsed acceptable yields for buyers, lending volume will most likely drop (at least in the short-term) as deals that were on the table get postponed until the Federal Reserve can finally get a wrangle on inflation.” I agree to a point, but while new deal flow is dammed up, balance sheet lenders still have an ample RE allocation to put to work at very competitive rates and terms. With the end of the year in sight, it’s clear some lenders have folded up their tents until Q1/2023 while others are purposely pricing themselves out to all but the most ignorant of borrowers. I experience this firsthand as we market our financing requests for our 1031 exchange buyers who must transact before year end.

Market resiliency

Multifamily housing is still in high demand since by all accounts, we’re still a vastly under-housed society. However, there are cracks in the foundation as rising vacancies accelerate due to exorbitantly high rents. Affordability is becoming a major concern to both the working class and younger professionals. Reduced rents and higher interest rates lead to an inevitable double whammy of lower asset prices.

Over in the office sector, I’ve been reading about employers inducing workers back to the office with luxe amenities as the LA Times recently reported. While employee pampering has its place, nothing beats the threat of layoffs to get workers hustling back to the office. More and more research indicates that telecommuters are often the first to go. It appears that as Covid lockdown memories fade, corporate America is taking the Musk-ian view that worker productivity is highest when conducted in a face-to-face communal setting.

Economist Richard McGahey wrote in Forbes last week that cities and urban experts are especially worried about the impact of the rate hike cycle on commercial real estate, which still hasn’t recovered from the pandemic. The work from home trend -- and a parallel drop in office occupancy -- could become permanent, he asserted. Case in point: the widely watched Kastle Office Occupancy barometer, measuring keycard swipes in ten major real estate markets, still hasn’t broken 50%. The Fed-induced slowdown has put downward pressure on office building rents and has also “thrown a shadow” over future office construction.

A new National Bureau of Economic Research (NBER) report entitled “Work from Home and the Office Real Estate Apocalypse” anticipates downward pressure on real estate values, plus cheaper and shorter-term leases, reflecting reduced demand as landlords scramble for tenants. NBER’s analysis for New York City predicts “long-run office valuations that are 39.18% below pre-pandemic levels,” which could lead to a “fiscal doom loop” for city budgets as well as for CRE office investors. No doubt about it, the office market at large is facing a serious storm surge.

And then there’s retail. Shopping mall prices have been hit the hardest since the recent peak, down 23%, Green Street reports. Industrial, a star performer during the pandemic, has dropped 17% since its May 2022 peak, making it the second worst performing property type. According to Bisnow, apartments, offices, strip centers and healthcare assets have each suffered double-digit drops as well. Hospitality, however, did relatively well with its prices down only 6% since the most recent peak. Self-storage was likewise down only 6%, Green Street noted.

Loan repayments are holding steady, but are defaults imminent?

We may be down but not out with respect to a CRE meltdown. On one hand, said McGahey, there’s downward pressure on property prices due to “buyers’ inability to access credit at the once-historically low interest rates, which is chilling the investment market.” But loan repayments aren’t collapsing. The Mortgage Bankers’ Association (MBA) reported that third-quarter delinquencies on commercial and multifamily lending actually fell slightly, part of a downward trend in 2022. Retail and lodging loans continued to be the worst, but even there, delinquencies are moving down, MBA noted.

Because tenant rent payments haven’t collapsed, delinquencies aren’t worsening, which allows landlords to service their debt. For instance, CommercialEdge reported that September average office rents were only down 2.4% year-over-year.

These statistics, while promising, are sadly backward looking. Here in Los Angeles County, landlords saw more space vacated than rented in the third quarter, a stark reversal after three previous quarters of net gains, according to CBRE. The report also said the amount of unleased space rose to 18.7% of the market, almost twice as high as the 10% benchmark considered a “healthy balance of power” between landlords and tenants.

According to CoStar, there is currently 232 million square feet of surplus commercial real estate up for sub-leasing -- twice the level of surplus from before the pandemic. As CNBC reported, with companies “still in the early days of their hybrid work experiments,” it’s not just economic uncertainty, but uncertainty about how in-office occupancy trends over time, that should make companies want to “hold off pulling the trigger on asset sales.”

Conclusion

In the current inflationary environment, common sense will again prevail as lofty acquisition proformas find their way into the trash bin. Again, there’s nothing like a layoff threat to jolt workers back to the office. A battered economy may just be the golden ticket if you buy into the office sector below replacement value. The writing is on the wall for CRE. As Orwell wrote: “The stars are a free show; it don’t cost anything to use your eyes”