The Conversation: Understanding the Current Landscape of Commercial Real Estate Distress; Insights from America’s Commercial Real Estate Show
The commercial real estate market has been under the microscope lately, especially with the specter of distress looming large across various sectors. This topic took center stage in a recent episode of America’s Commercial Real Estate Show featuring Jim Costello, Chief Economist at MSCI Real Assets. The discussion provided critical insights into the state of distressed assets in the commercial real estate sector, exploring the nuances and differences from past downturns, particularly the financial crisis of 2008.
Note that this discussion is national in scope. Miami, at least so far, has seen few signs of stress in commercial real estate that are being experienced in other markets. Thus, many aspects of this conversation don’t apply much, if at all, to the local South Florida markets.
A Different Kind of Downturn
One of the key takeaways from the conversation was the contrast between the current market distress and what was observed during the 2008 financial crisis. Costello emphasized that while distress levels are rising, the pace and nature of this increase are different. Unlike the previous crisis, which saw nearly 20% of the market in distress within a couple of years, today’s market distress sits at a modest 2.5% of total sales. This discrepancy is attributed to the fundamentally different drivers behind the distress.
During the financial crisis, the distress was largely due to overleveraged assets that needed refinancing. However, today’s distress is more structural, driven by changes in demand, especially in sectors like office space. The shift towards remote work and the subsequent reduction in demand for large office spaces have left many buildings vacant, with no clear path to recovery. This kind of “fundamental distress,” as Costello describes it, is harder to address because it isn’t just about restructuring debt; it’s about reimagining the use of these properties.
The Geographic and Sectoral Breakdown
Geographically, the distress is concentrated in large, expensive coastal markets such as Manhattan, San Francisco, Los Angeles, and Chicago. These areas have been hit hardest by the shift to remote work, leading to a significant reduction in demand for office space. As a result, these markets are seeing the highest levels of distressed assets, particularly in the office sector.
The office sector, especially in central business districts (CBDs), is experiencing the most significant price corrections. Costello noted that while prices have dropped sharply, particularly for CBD offices in major coastal cities, the rate of decline has started to moderate. Despite this, the future remains uncertain, with much depending on how demand for office space evolves in these markets.
Liquidity and the Role of Lenders
Another critical aspect discussed was the role of liquidity in the current market. Unlike the financial crisis, where liquidity was scarce, there is still considerable “dry powder” available today, meaning that investors have capital ready to deploy. However, the challenge lies in finding opportunities that offer a good return, given the changes in market fundamentals.
Costello also highlighted that the type of lender involved can significantly impact how distress is handled. For instance, Commercial Mortgage-Backed Securities (CMBS) lenders, with their more rigid structures, are seeing higher levels of distress compared to local banks, which might have more flexibility in working with borrowers. The “vintage” of loans—when they were issued—also plays a crucial role, with loans from 2022 being particularly problematic due to their origination at peak market conditions with record-low interest rates.
Looking Ahead: A Localized Recovery?
The conversation concluded with a discussion on the potential paths forward. Costello suggested that unlike the last downturn, which saw large institutional players swoop in to capitalize on distressed assets, this recovery might be more localized. Smaller, local investors who understand the intricacies of their markets and can navigate the complexities of local zoning and permitting processes may be better positioned to capitalize on the current distress.
For lenders, this period presents an opportunity to build strong relationships with borrowers and to be selective about where to extend new loans, focusing on assets with solid fundamentals that are less likely to experience severe distress.
Conclusion
The commercial real estate market is facing a unique set of challenges, with distress levels rising but not mirroring the severity of the 2008 financial crisis. As the market continues to navigate these turbulent waters, understanding the fundamental shifts in demand and the role of liquidity and lender behavior will be crucial. Local investors and lenders with deep market knowledge may find opportunities where others see only risk, paving the way for a more nuanced and localized recovery.