Commercial Real Estate Is Due For A Correction

The word “recovery” comes up a lot these days, describing everything from recent job gains to resurgent lending and transaction volume in commercial real estate. But before investors get too carried away by the good news, they should pause to ask themselves, “what are we recovering from?”

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It may be safe to say the nation is on its way to recovering from the pandemic. Just over half or 51.4% of U.S. residents had completed a vaccine series for COVID-19 as of Aug. 26, according to tracktherecovery.org. Consumers are frequenting sit-down restaurants and brick-and-mortar retailers again, and businesses are navigating returns to the office. Employment has rebounded in many sectors, although jobs in the lowest quartile are down 20% or more since January 2020 and have moved little in the past 12 months.

Commercial Real Estate Is Not Recovering From A Correction

What we are not recovering from is a correction in commercial real estate or the larger economy. To the surprise of many experienced professionals in commercial real estate finance – myself included – the real estate markets have had little from which to recover. For now, at least, it appears the federal government’s measures to prop up the economy during the pandemic averted a disaster of defaults that threatened to swallow occupiers, landlords and lenders alike.

This feat is even more remarkable because commercial real estate tends to experience a correction about every 10 years, which would suggest it was coming due for a correction before the arrival of the coronavirus. The pandemic seemed fated to trigger that market reset, but instead, the pandemic became a pause in the economic cycle. More than a year later, market participants are combing through mixed economic indicators for signs of a correction that never arrived.

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On the one hand, the roughly 3,000 U.S. assets across Trimont’s portfolio are showing a solid return to performance as measured by on-time principal and interest payments. On the other hand, COVID-19 infection rates are increasing and low-wage jobs have contracted. Amid broad-based risks to the economy, it would take little to tip us back into a recession.

And there are developing conditions that deserve monitoring. These include capital pouring into the real estate sector and a proliferation of investment funds reminiscent of the flurry of activity that preceded the 2008 global financial crisis (GFC).

Competition to place capital increases the temptation to relax underwriting, which can lead to riskier investments and support inflated pricing on financed properties. Pressure to downplay risk is especially keen for some closed-end funds, whose managers only have a certain amount of time to invest committed capital, but have lost the better part of a year that offered few investment opportunities that could meet their internal risk/return thresholds.

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

Lining Up For Warehouse Lines

The recent, multiyear decline in interest rates has ramped up pressure on fund managers to deliver promised investor returns. To increase marginal returns, many lenders now originate mortgage loans by supplementing their own funds with low-interest capital borrowed through a warehouse credit line. In as little as two to three weeks, the originator will sell a newly created mortgage to a permanent investor or through a securitization, repay the warehouse lender and use its restored warehouse credit to create more loans.

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Using a warehouse line can help an originator offer more competitive rates by lowering its cost of capital. A drawback, however, is that leveraging means the originator is placing less of its own capital in each financing, so it must accelerate its loan count and/or increase average loan size to maintain its rate of capital placement.

Similarly, the number of warehouse lines, note-on-note investments, collateralized loan obligations and other debt structures is also increasing as funds scramble to deliver promised returns in today’s low-interest-rate environment. While the aforementioned structured debt transactions and the like can help lenders generate needed returns for their investors, those strategies require high volumes to meet placement goals.

Heed The Writing On The Wall

Recognizing that a commercial real estate correction is not only a possibility but increasingly likely in the middle term, market participants should be preparing for all possible scenarios. Asset managers should understand where their assets stand in relation to expectations. Maintain good relationships with investment partners and understand what demands they may make in the event of a crisis. Originators should stick to their underwriting standards and avoid complacency becoming overextended, as so many did before the GFC.

There are still legs to this cycle and plenty of worthwhile opportunities remaining in the market. But commercial real estate veterans know that their industry tends to overheat and then correct itself about every 10 years. That is why many were on the lookout for a correction during the last few years prior to the pandemic, a decade after the GFC. That correction event may well be ahead of us still, however, because COVID-19 wasn’t it.

About the Author

As Managing Director of Client Services for Trimont, Beau Jones is responsible for expanding and strengthening client relationships to deliver greater business performance and profitability.

Updated on Sep 13, 2021, 10:23 am

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