Survive or Thrive? Understanding – and Misunderstanding – the State of Commercial Real Estate

Much has been written about the state of commercial real estate. From CBS’s 60 Minutes to the New York Times to the Wall Street Journal and just about every other publication you can think of, experts have been writing for the past twelve to eighteen months about the impending catastrophe of commercial real estate prices across the United States. For example, just this week, Barings listed its 100 Wall Street office tower for $125 million, less than half of the $270 million it paid for it in 2015. And this is not unusual by any means. A combination of the “new normal” of work from home, the state of inner cities, rising interest rates, mismanagement of existing assets, and the timing of existing property debt maturities coming to term has led to rapidly decreasing Commercial Real Estate (CRE) values across the United States.

However, while correct on average, much of what has been written misses the important nuances of the commercial real estate environment over the next 12-to-24 months in particular. There is a danger of treating all commercial real estate with the same broad strokes assessment, reminding us of the old adage, it’s kind of like putting your right foot in an ice-cold bucket of water and the other in boiling hot water and saying that, on average, you’re just right. This tale of extremes is not unlike what we see today in commercial real estate in the US – those encumbered by existing asset portfolios needing to stay afloat through 2025 into 2026 and those without legacy debt who now may have a once in decades opportunity.

Given the timing of the commercial real estate maturity profile in the United Sates over the next 12 – 24 months, the time to take advantage of this opportunity is now. Thinking ahead to these next 12 – 24 months, it is instructive to separate out the acquisition side from the execution side: making smart acquisition decisions in today’s market is not enough – it is necessary, but not sufficient. Long run success also entails efficient, productive, and lean operational excellence. Accordingly, we look at each here in turn.

1. Acquisition
Scott Goodwin, Co-Founder and Managing Partner of Diameter Capital Partners, notes that “Real estate is something people seem afraid of right now, that might be the best lending opportunity over the next 10 years or so … there are going to be bankruptcies and there is going to be new money needed and if you can lend at the top of the capital structure on a new capital structure … that’s a really interesting opportunity.” (FII Institute Conference, 2/22/24).

The last decade has seen an unprecedented level of nearly free capital not only in the United States, but through much of the globe. Add to this an unpresented level of fiscal stimulus over the pandemic, historic quantitative easing of the Federal Reserve’s balance sheet, and an over exuberance of existing CRE entities, and you can quickly understand much of commercial real estate’s remarkable investment performance over the last decade. For example, according to Forbes, the average annual rate of return of commercial real estate over the last 20 years is approximately 9.5%, higher than the S&P’s annual return of almost 8.6% over the same period. However, underpriced and free-flowing capital has led to economic distortion in investment and lowered the entry barriers for inexperienced operators. As a direct result, a large number of deals that never should have happened, did.

Hence, it’s time to pay the piper, as the old saying goes. With interest rates returning to more historic norms, the problem for companies that have existing portfolios is that many of these maturities are coming due in the next 12 to 24 months. Consequently, a number of existing firms will need to unload part of their existing portfolio just to stay afloat as these loans come to maturity at significantly higher interest rates.

For example, according to the Mortgage Bankers Association:

• Out of approximately $4.4 trillion of outstanding commercial/multifamily mortgages, $659 billion (15%) are maturing in 2024 alone.
• Among capital sources, 26 percent of the outstanding balance of loans maturing in 2024 are held by credit companies, 23 percent are held by depositories and 22 percent held in CMBS.
• Approximately $250 billion in multifamily maturities alone will be due in 2024 and again in 2025.

This maturity profile across multifamily, office, retail, and industrial is ominous for mature CRE companies holding onto existing debt across these asset classes. Many of these loans were underwritten during operational “loose” times when interest rates were at unprecedented decade-long low levels. Given the interest environment at the time, a large number of deals were placed with inexperienced operators who lacked the operational expertise to manage portfolios efficiently, but who could survive and even do well in an artificially low capital rate environment.

Now, they need to be refinanced at considerably higher rates, rates that are likely to remain in place for the foreseeable future, into an environment where operational excellence is materially required for long-term financial success. Many of these assets that will need to be unloaded at pre-distress levels of valuation are actually cash flow positive when managed efficiently. The opportunities for lean, well-run, experienced operators, clean or relatively clean of encumbered debt, is significant. Indeed, one of Warren Buffet’s most famous quotes is, “”A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”

Fred Cordova, CEO of Corion Enterprises, believes that “There will be a bifurcation … the product in a good location, safe environment will recover. Then you have another group … that will get reset in pricing. And then you have the others that are basically worth nothing – the D class. They just have to be torn down.” (Fortune, 2/25/2024).

Frederick Knapp, Founder and CEO of Knapp Capital Management, known for its operational experience and expertise, equates the current environment to that of a lifeboat, “It’s a lifeboat market: you have provisions for 5, but 10 are on board, something has to give.  The entire lifeboat goes down or you right size the number on board to the provisions available.”  A firm may have 10 good properties, but given the maturity timing, inability to execute, and/or an inherent incapacity to change, have demanded the need to right size each portfolio to keep it afloat (pun intended).

2. Execution

When you combine ignorance and leverage, you get some pretty interesting results. … Warren Buffet

In general, tight capital necessitates and instills financial and management discipline; by contrast, a great deal of mismanagement gets swept under the rug when you have nearly free capital for a decade. Today, with real interest rates closer to historic norms, that is no longer the case. Further, market fundamentals have shifted dramatically: labor cost growth has exceeded the CPI/PPI, elevated material costs have dampened ROIC, insurance premiums have risen dramatically, and city and local governments face increasing pressure to raise tax rates due to the impact that falling property values have on tax revenues. If the entirety of any investment strategy is based on interest rate compression, favored cap rates and high market occupancy / rate stability, 2025 will be no different.

But as Einstein once famously said, “You cannot solve a problem with the same mind that created it.” Could the real risk in Commercial Real Estate today be execution risk?  Frederick Knapp suggests just this, “Organizational change management, nimbleness and execution are real seeds of success – and failure – in commercial real estate today.” And therein lies the opportunity for lean, well-run CRE ventures to acquire, run, service and turn good, cash flow positive properties at per square foot prices that have not been seen in a decade or more.

To summarize for investors, the keys will be the following:

• The combination of work from home, Federal Reserve quantitative tightening and interest rate policy, the ending of decades long near zero interest rate policies, and overall mismanagement of existing service organizations have led to a near historic decline in commercial real estate property values across the country, across asset classes, and across the entire maturity profile.
• For those heavily invested or overweight in commercial real estate, the saying “Survive to ‘25” may simply be a rationalization or an excuse, not a solution. Clearly many organizations will need to unload assets in order to survive long-term.
• Be wary of commercial real estate development and management organizations that have a large portfolio of existing properties and existing debt. Look very closely at the timing of their maturity profile and their need to refinance existing properties before investing in any entity.
• However, as Warren Buffett has often said, these times provide opportunity. In this case, it provides opportunities for organizations that have the dry powder to take advantage of both lower prices in the market and the lower interest rate environment. Look for organizations that can do just that.
• That said, acquisition is only part of what a good company should be able to do in order to make your investment accretive. Not only do they need to be able to acquire assets at significantly deflated prices, but they also need to be able to run assets post-acquisition in ways to maximize value and the return on capital. Hence, look for organization that are able to both be clean on debt and have a track record of service on existing organizations because that will be an integral part of the longer run profitability.
• Hence, it is a time for organizations with industry-leading operational and executional expertise and experience with a track record to prove it. This may indeed be the key to long run success coming out of today’s commercial real estate market.

Wrapping up:

All commercial real estate is not the same. For those interested in diversifying existing portfolios and who have been looking for commercial real estate investment opportunities to invest in an asset class that has been underweight or missing in their portfolio, there may not be a better time to do just that in our lifetime. However, as you think to investing, look for organizations that are clean of debt, have a track record of performing on existing assets and can manage for success, both in the long run in the short run. For organizations with integrity, transparency, and a proven track record of operational success, taking advantage of a once-in-a-decade, perhaps lifetime, opportunity, no time has been better in the last 15 years.

With this said, there is an urgency – the window is now. The opportunity is now.

However, the timing for a bad deal thesis based on unsound fundamentals is never right. Further, perhaps the greatest risk is a sound acquisition strategy combined with inefficient or poorly run operational execution post-acquisition. Given the sea change in labor, material, insurance, tax, and overall costs, not to mention occupancy and overall rates, the margin for error is small. Focus on executional excellence when planning a deal – the acquisition business case is a necessary, but not sufficient condition for success today and the number of truly good, efficient operators is relatively small.

Just remember that all CRE Is not the same. Invest in clean, debt-free, service organizations that can profit in today’s environment and then manage for success in the long run.

Written by Dr. William Putsis.

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