After the chaos and uncertainty of the last year, commercial real estate experts are finally getting a clearer idea of what the real value of real estate should be. That starts with a growing consensus that interest rates are not likely to return to the rock-bottom lows that persisted for much of the last 15 years.
“Deals are starting to happen,” says Arthur Margon, partner with real estate market research firm Rosen Consulting Group. “The biggest set of deals will come from people who realize that the prices aren’t going to go back up supported by super-low interest rates—so that they stop trying to get 2019 prices.”
Margon spoke at the 30th ULI McCoy Symposium on Real Estate Finance, a gathering of real estate leaders held December 8, 2023, in New York City, and named after real estate legend and longtime ULI leader Bowen “Buzz” McCoy.
The mood at this year’s symposium was “realistic,” according to Margon. “They may not like it, but people are getting used to interest rates that have normalized.”
Interest rates move towards “normal”
At the end of 2023, the benchmark yield on 10-year Treasury bonds had settled around 4 percent. That’s down from over 5 percent last fall. The current level is also about where long-term interest rates were in the years before the Global Financial Crisis—before the Federal Reserve cut its own benchmark interest rates to effectively zero.
Short-term interest rates are also likely to moderate in 2024. Fed officials now indicate they would be open to cutting their short-term rate 75 basis points from the current peak of more than 5 percent, if economic data continues to show relatively weak inflation. Judging by the 4 percent yield on 10-year Treasuries, bond investors expect the Fed to continue to cut rates towards roughly 3 percent—though nowhere near the lows of the last decade.
“The very, very low interest rates of the 2010s were an anomaly,” says Margon. Today’s real estate investors are gradually re-learning how to make money at today’s long-term interest rates. It is possible, Margon said. Many of real estate’s family offices built their wealth in times when long-term interest rates were much higher than they are now.
When interest rates rose in 2022 and 2023, many real estate dealmakers were suddenly unable to make new investments as the cost of their financing grew. Many sellers refused to accept lower prices and hoped that interest rates would soon come back down to the low levels they had gotten used to.
The volume of properties bought and sold dropped sharply. Ken Rosen, chairman of Rosen Consulting Group, called it “a capital markets recession for real estate” in his presentation for the attendees a year ago, at the 2022 McCoy Symposium.
For troubled property types like office and life science properties, there is still a big difference between the sale prices sellers have been willing to accept and the valuation implied by the prices of stock in real estate investment trusts (REITs). The prices of REIT stocks adjust quickly to changing realities and the mood of the market.
The wide disparity implies the market price of these troubled properties is still lower than sellers have been able to accept.
“Part of what I’ll call the healing process is when those things get closer to one another,” says Roy March, chief executive at real estate investment bank Eastdil Secured. “Then transactions can occur.” Much of that healing may have already occurred for property types like multifamily and industrial properties.
Properties under pressure
Potential sellers can’t hold out forever. In particular, many real estate owners are likely to struggle to refinance loans that expire in 2024.
A gap has opened up between the larger loans that their properties could support when interest rates were lower and the smaller loans those properties can support at today’s higher interest rates. Other owners will struggle to renew expiring interest rate caps for floating-rate loans, which have become much more expensive, says March.
Some owners will be pressed to sell properties that are too expensive to recapitalize. “The office sector in particular—that’s where the bulk of the capitulation in our opinion is going to occur,” says March.
Other property types have a brighter outlook. The U.S. economy performed better than expected in 2023. Many economists predicted a recession as interest rates rose, followed by a quick recovered. Instead, employers steadily added jobs and consumers continued to spend, creating steady—if undramatic—demand for real estate.
“You’re not going to see the kind of explosive growth in rents you had in 2022,” says Margon. “The leasing markets for all of the different property types have become relatively stable -- the exception for that is a lot of the office properties.”
More capital is available than many expectedA growing number of owners are finding ways to recapitalize overleveraged properties. Some are putting in their own equity. “There’s more acceptance that interest rates and cap rates are not going back to what they were,” says Margon. “There’s also the fact that the building is sort of stuck until you get this stuff worked out.”
Others are finding a new mix of debt and equity capital—despite high interest rates and the fact that many regional banks are still unwilling to lend.
“There’s a tremendous non-banking capital market out there in the private credit arena,” says Sheridan “Schecky” Schechner, vice chairman Barclays Investment Banking, based in New York. “That changes the dynamic dramatically.”
In the last months of 2023, Roy March’s firm Eastdil Secured was involved in six deals to finance large properties with single-asset, single-borrower issuances of commercial mortgage-backed securities (CMBS). The six deals total $4.1 billion. The properties financed include resort hotels, data centers in addition to retail and industrial property.
Attendees at the symposium were “a little surprised” to hear that the debt markets were able to provide that kind of financing, said March.
Other lenders making commercial real estate loans include large insurance companies like Athene, often backed by private equity firms like Apollo, KKR and Blackstone. “It is no longer a question of if there is money—it is more question of at what cost?” says Schechner.
Private equity provides preferred equity “rescue capital”
Property owners can also find “rescue capital” to help bring new equity to overleveraged real estate properties. Preferred equity from private equity funds can help pay for new interest rate caps. It can also help fill the gap between large, expiring loans and the smaller, new loans available to replace them. Multifamily and industrial properties show the strongest demand are attracting most of this private equity rescue capital, says March.
The yield property owners pay to receive this preferred equity is typically a percentage rate in the mid-to-high teens. “These structures, they’re not cheap,” says March. “This is value-added capital.”
Private equity funds still have hundreds of billions of dollars available, according to data from Preqin. That includes funds focused on real estate globally and in North America, which are largely targeted at high-yielding opportunistic and value-added investments. “Most of that capital is seeking 13 percent to 20 percent levered internal rates of return,” says March.
Private equity funds might be especially interested in providing this rescue capital. High interest rates have it much more difficult to earn a high rate of return by simply buying a property and improving its income.
“Private equity is having some difficulty coming up with a high-teens return in a straight equity investment,” says Margon. “If you have to pay 7.5 percent in interest, you need a whopping increase in rents to make that work.”
Other capital is piling up to potentially acquire properties. A rally in the stock markets has provided cash to REITs. High energy prices have provided capital in international investors from places like the Middle East. “There is a lot of capital in particular coming out of the Middle East,” says March.
Political uncertainty in late 2024
Chaotic events may still scramble tentative plans to invest in real estate in 2024.
“It’s very tenuous—it still could all fall apart,” says Margon.
Armed conflict overseas could once again disrupt supply chains and push commodity prices higher—for just one risk. Closer to home, political dysfunction in Washington, D.C., could cause economic instability, especially as the Presidential election this year gets closer. A prolonged shutdown of the federal government is just one scenario.
“Getting things done in the first half of the year is probably prudent,” says March. “The last half of the year may be caught up in political issues.”
This year, the McCoy Symposium was especially well-attended, according to people in the room.
“It was almost double the size it has been in the past,” says Schechner. People who’ve been attending the Symposium for years are now bringing a next generation of dealmakers to the annual conversation, he said. “It’s a really good way to get a lot of information.”
