Commercial Real Estate Is Due For A Correction

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The word “recovery” is used a lot these days to describe everything from recent job gains to resurgent lending and transaction volumes in commercial real estate. Before investors get too carried away by the good news, however, they should pause and ask themselves, “What are we recovering from?”

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It is safe to say that the nation is on its way to recovering from the pandemic. According to tracktherecovery.org, just over half, or 51.4%, of US citizens had completed a series of vaccinations against COVID-19 by August 26. Consumers are returning to seated restaurants and brick-and-mortar retailers, and businesses are navigating the return to the office. Employment has rebounded in many sectors, although bottom quartile jobs have declined 20% or more since January 2020 and have changed little over the past 12 months.

Commercial real estate does not recover from a correction

What we are not recovering from is a correction in commercial real estate or the overall economy. To the surprise of many seasoned commercial real estate finance professionals – myself included – real estate markets were barely able to recover. At least for now, it seems that the federal government’s measures to support the economy during the pandemic have averted a disaster of payment defaults that threatened to devour tenants, landlords and lenders alike.

This performance is all the more remarkable given that commercial property is corrected roughly every 10 years, suggesting that a correction would be due before the coronavirus hit. The pandemic seemed destined to trigger this market restart, but instead the pandemic became a pause in the economic cycle. More than a year later, market participants are combing mixed economic indicators for signs of a correction that never occurred.

On the one hand, the around 3,000 US assets in the Trimont portfolio show a solid return, measured against the on-time capital and interest payments. On the other hand, COVID-19 infection rates are rising and low-wage jobs have shrunk. Given the broad risks to the economy, it would take little to plunge us back into recession.

And there are evolving conditions that deserve surveillance. These include capital inflows into the real estate sector and an increase in mutual funds, evoking the excitement leading up to the global financial crisis (GFC) of 2008.

Competition in capital placement increases the temptation to relax underwriting, which can lead to riskier investments and fuel inflated property prices. The pressure to downplay risk is particularly strong for some closed-end funds whose managers have limited time to invest tied capital but have lost most of a year that left few investment opportunities to match their internal risk / return could correspond to thresholds.

Uncomfortably aware of the increasing risk, lenders and investors are wrapping themselves in layers of financial structures designed to mitigate risk. Indeed, the unprecedented level of structured lending today is itself a cautionary indicator of unsustainable market conditions that will eventually have to realign.

Setting up for storage lines

The recent multi-year decline in interest rates has put pressure on fund managers to deliver the promised returns for investors. To increase marginal returns, many lenders today grant mortgage loans by supplementing their own funds with low-interest capital raised through a storage line of credit. In just two to three weeks, the originator sells a newly created mortgage to a standing investor or through a securitization, repays the storage lender, and uses his restored storage credit to create more credit.

Using a stock line can help an originator offer more competitive prices by lowering their cost of capital. One drawback, however, is that leverage means that the originator uses less equity with each funding, requiring them to speed up their loan count and / or increase the average loan size to maintain their capital placement rate.

Similarly, the number of storage lines, bonded notes, secured loan obligations, and other debt structures also grow as the funds strive to deliver promised returns in today’s low interest rate environment. While the above structured debt transactions and the like can help lenders generate the required returns for their investors, these strategies require high volumes to meet placement goals.

Notice the writing on the wall

Since a correction to commercial real estate is not only possible, but is increasingly likely in the medium term, market participants should be prepared for all possible scenarios. Asset managers should understand where their wealth compares to expectations. Maintain good relationships with investment partners and understand the demands they can make in the event of a crisis. Originators should stick to their underwriting standards and avoid overusing complacency, as so many did before the GFC.

This cycle still has a few more stages and many more profitable opportunities on the market. But commercial real estate industry veterans know that their industry tends to overheat and then correct itself roughly every 10 years. That’s why many sought a fix in the last few years before the pandemic, a decade after the GFC. However, this corrective event could still be ahead because COVID-19 was not.

About the author

As Managing Director of Client Services for Trimont, Beau Jones is responsible for building and strengthening customer relationships for greater business performance and profitability.

Updated on September 8th, 2021, 11:57 pm