The commercial real estate sector is experiencing a period of declining property values and no asset class has been spared. From retail, to office, to industrial, it’s the same story but with different chapters in each sector.
When will values stabilise, or have they already? Each asset class, and more specifically, each sub-asset class, has their own profile of risk and reward. Right now, the office market is making the news. While the office sector has some specific challenges of its own, there is a broader challenge for commercial real estate, and that is one of economics.
Changing expectations around long-term interest and bond rates
The most wide-ranging issue is the change in expectation around long-term interest rates and the corresponding impact on the cost of borrowing. In Australia the 10-year bond rate has risen from a pre-covid low of less than 1%, to now being close to 4%. The backdrop being the Reserve Bank raising short-term interest rates to fight inflation. But long-term rates have moved upwards too. It’s hard to look through such a rapid change in long-term rates as being temporary. Changes in interest rates impact all financial investments including equities and bonds. With so much liquidity, the value of the equity and bond markets react quickly to these changes. For commercial real rstate, the changes in value have been happening but it’s been slower and harder to see due to the illiquid and long-term nature of Real Estate investments.
Typically, the value of a commercial property is related to its rental income and the financial value of that income over time. The leases behind these rents are often long in duration, sometimes much longer than the economic cycle. Unless rents are softening, usually associated with a supply and demand issue, the underlying income stream of the asset remains strong. However, if the cost of money goes up then the income stream becomes less valuable than it was before. The result being a direct financial impact. Commercial Real Estate investors tend to look through short-term financial market volatility as being temporary because they are taking long-term positions. However, the sudden movement upwards in the 10-year bond rates is making investors more concerned about the long-term financial value of those income streams.
Fewer transactions make market evidence harder to find
Given the illiquid nature of commercial real rstate, experts are required to make on-paper estimates of value on a regular basis. Sometimes as regularly as every three to six months. What makes this exercise tricky is the evidence required to determine if the market participants are looking through the current interest rate changes as temporary or more permanent. Remember these are long-term assets, so it makes a big difference calling a permanent change in borrowing costs even if the bond market is saying so. But transactions have slowed so market evidence at the top end of town is not as bountiful as it was pre-pandemic, or even last year.
Buyers are struggling to make deals work as additional equity is required in the deal to cover the increased borrowing costs. More equity makes it harder for the buyer to meet the investment return required, so deals die on basic economics. Rinse and repeat. Transaction volume falls, hello 2023!
The long-term nature and illiquidity of commercial real rtate, dislocation in financial markets and changes in social behaviour as a result of the pandemic coupled with the lack of transactions make assessing value in this market incredibly difficult. Only time will tell which of these changes are temporary or permanent. Owners are waiting for the interest rate cycle to peak, economic growth to return, and the market to find a new normal. So maybe doing nothing is just fine for now. When will rates peak and when will the economy revert to higher activity levels? Everyone is guessing, no one has a crystal ball, but one thing is true; if you have to sell now, it’s hard work.
While all this is going on, the wonderful world of the economic magic is unfolding hidden from us. Individual decisions by millions of people change the path, sometimes in unpredictable ways. Soon people will start doing things, we are a restless bunch. Tourism and immigration slowly pick up, demand rises, interest rates peak, rents rise, new businesses are born, existing businesses reinvent themselves, space gets repurposed, surplus work from home space is absorbed and before we know it, it’s a new normal.
So, in a way, while economics is the problem, it is also the solution. Ironically this could all happen before the lease on the building is even up for renewal, and maybe this whole chapter gets skipped for some. The question is, how long is this chapter? It could get worse before it gets better, but it will get better.