3 Commercial Real Estate Challenges You Can Also Profit From
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Here’s how to outsmart the biggest challenges the CRE market throws at you.
CRE investors have faced strong headwinds in recent years, from pandemic lockdowns to liquidity crunches. These commercial real estate challenges have made landing good deals and keeping a healthy portfolio difficult.
Unfortunately, this year did not bring much good news to lighten the investor’s financial burden. Instead:
- Continued higher interest rates keep the cost of capital for commercial properties high and put pressure on investors’ debt profiles.
- A potential economic slowdown weighs on the commercial real estate (CRE) market with declining property values affecting investment.
- Tight lending standards make financing CRE deals more difficult than a few years ago.
Yet rather than just thinking of problems in the real estate industry, smart CRE investors see opportunities in turbulent times.
Equipped with the right knowledge and strategy, you can face the current market challenges head-on and capitalize on evolving market conditions.
In this guide, we cover the 3 biggest commercial real estate challenges that should inform your CRE investment strategies, including:
- The looming maturity wall
- Hybrid work and low office space occupancy
- Decelerating rent growth
Read on to find out how to turn these real estate challenges into CRE opportunities.
[Missing out on great real estate is a challenge you shouldn’t have to deal with. Duckfund's soft deposit financing helps you quickly secure the funds you need when rare CRE opportunities arise.]
1. The looming maturity wall
As economists show little hope for rate cuts from the Fed, the commercial real estate market continues to rack up debt to new heights.
CRE loans at small regional banks surpassed $2 trillion in total value in April having reached $1.9 trillion in Q1 of last year.
Together with outstanding loans at large banks, the CRE market’s total debt is steadily creeping up to $3 trillion.
Source: National Association of REALTOR (NAR REALTOR)
What’s worse, $1.5 trillion of that debt is set to mature by the end of 2025, according to CPA firm PBMares. The Financial Times estimates it to reach $2 trillion over the next three years.
This looming maturity wall is at the heart of the challenges in commercial real estate, spelling problems in the form of bank failures, defaults, declining commercial property values, and more market malaise.
But the debt bubble isn’t just one insurmountable challenge. Instead, it’s an indicator of a combination of factors that each present unique challenges to CRE investors.
Here’s a look at the positive and negative consequences of the debt wall.
The negative: a bursting debt bubble
Commercial mortgages typically have short maturities and balloon payments where borrowers refinance the remaining debt. Before the current rate cycle of rising interest rates, this structure benefited borrowers with lower refinancing costs – but after interest rate hikes this is no longer the case.
Borrowers looking to refinance CRE debt that matures soon will face higher debt payments. These debt payments alone impact the profitability and viability of real estate investments. To make matters worse, the market’s weak underlying fundamentals compound the issue.
The maturity wall is bad news for commercial real estate as CRE debt relies heavily on refinancing.
U.S. banks hold roughly half of all CRE debt, the St. Louis Federal Reserve reports. This not only puts the CRE market at risk but the US economy as a whole.
The positive: return to fair market prices
While many CRE businesses will seek to refinance at higher interest rates, many others will be forced to sell at a loss to service debt. While lenders will try to delay losses, accounting regulations will ultimately force the disclosure of definitive losses.
This will trigger a significant mark-to-market adjustment, news outlet CRE Daily predicts, and reduce the valuation of numerous, if not all, commercial real estate loans.
The ensuing cascade of delinquencies and defaults will almost certainly lead to a decrease in property prices, presenting a golden opportunity for CRE investors with a diversified portfolio and cash at hand – especially those who do proper commercial real estate analysis to find the right properties.
The commercial real estate sector was sitting on $300 billion of unallocated capital at the end of 2023, according to PBMares. That capital reserve is likely to be put to good use once the market resets.
Paul Cattin, Senior Agent and Managing Partner at Platinum CRE, agrees. "It's definitely a tricky market at the moment with interest rates continuing to creep up, creating a disparity between what buyers are able to pay and what the seller expectations are or the debt payoff amounts remaining," commented Cattin. “We are seeing some early moves and cracks in the market. However, my crystal ball predicts that, post-election, in the second half of 2024 and into 2025, we will start to see a meaningful market reset.”
2. Hybrid work and low office space occupancy
Office properties have been hit hardest out of all asset classes in recent years. The pandemic pushed people out of offices and into a hybrid or remote work culture. The demand for traditional office spaces has continued to decline since.
The negative: Class-A exodus
Premium class-A office spaces weathered the storm of this trend to begin with. Yet since last year, these spaces have suffered the most from an exodus of workers.
Premium office spaces now account for 49% of all vacated space, according to NAR REALTOR.
More specifically, there has been an exodus from tech hubs like San Francisco, Houston, and Dallas-Fort Worth, where office space is expensive and vacancy rates are peaking.
Source: NAR REALTOR
Premium office buildings are also increasingly empty in Silicon Valley, the heart of the global tech industry. Vacancy rates are up 450 BPS from one year ago, reaching all-time highs at 22.7%, according to CRE company Cushman & Wakefield.
The positive: Office spaces can be repurposed
While the US housing shortage worsens, the pandemic dream of creating housing out of unused office buildings remains unrealized. Why is that?
Tough zoning laws and restrictive bureaucracy on urban buildings are one factor but, more importantly, offices just don’t seem fit for residential living. They’re hard to convert, lacking natural light and amenities, and have awkward layouts and ceiling heights.
Plus, office buildings often aren’t located where people want to live and where’s the opportunity in that?
Yet with the US housing market short somewhere between 4 to 7 million houses, according to a survey by Pew Charitable Trusts, any solution is a good one.
From 2021 to 2024, the number of old office spaces scheduled to be converted into residential apartments increased from 12,100 to 55,300.
Source: RentCafe
The housing crisis forces both CRE businesses and architects to be creative. More and more architecture firms are coming up with smart solutions for conversions that turn unused office space into attractive residential real estate.
Repurposing old office properties might be tough, but fortune favors the brave – and creative. As office property valuations decrease and property owners service negative equity debt, creative CRE investors can start looking into conversion options more seriously.
Successfully converting an office building into housing requires finding the “Goldilocks zone”, according to architect Charles F. Bloszies, who was interviewed by the media outlet Fast Company.
Blosznies argues that areas like San Francisco are primed for an office conversion trend and that now is the time to get started.
With rising office vacancies, growing demand for housing, and relatively low real estate costs, office-to-housing conversions are more feasible than ever. “We’re at what you might call a critical storm of opportunity for converting offices to residential,” Blosznies commented.
3. Changing rental rates
A shift in rental rates is a feature of the US real estate market this year and they’re set to bring both opportunities and challenges to investors.
First, office property value is decreasing – and rental rates are down in the office space sector, too.
Rates are decelerating across all sectors, according to the above NAR REALTOR report, compounding investors’ commercial real estate challenges.
On the other hand, areas like multifamily are performing well.
The negative: Decreasing profitability amid debt increases
CRE investors depend on rental income for financial stability and to service debt, yet current conditions threaten that vital revenue stream.
Paul Cattin sees rental rates drop as the market adjusts to a new economic reality. “Ultimately, the market reset will come in the form of reduced rental rates to help fill vacancies and, therefore, reduced property prices adjusting for the returns on the net operating income from those lower rates,” he comments. “We'll see a reduction in the pricing both for buyers and for tenants.”
Cattin acknowledges the commercial real estate challenge of reduced rental rates. “There was so much inflation in the rental rates over a short period of demand and shortage of property. Now we are overbuilt with lower demand. The reduced rental rates work against owners to achieve the NOI (Net Operating Income) they need to be positively leveraged. i.e. earning profit above the costs of operation and any bank loan. ”
The positive: Some property types continue to perform well
While asset classes like office buildings suffer, other commercial real estate sectors are continuing to perform. Multifamily is property management’s darling, CBRE's latest research indicates that US multifamily rent growth is expected to accelerate in the second half of 2024 due to slowing new construction completions and continued positive net absorption. Rent growth in student housing was up 6% from last year, according to market research firm Yardi Matrix.
The industrial asset class is also continuing to perform well – even in tech hubs where office rent is down.
While Silicon Valley’s office vacancy rate is 20.2%, the area’s industrial vacancy rate is only 5.8%. This percentage reflects nationwide vacancy rates. Meanwhile, the asking rent for industrial property types has steadily increased at around 8% annually, Cushman & Wakefield report.
Source: Cushman & Wakefield
CRE investors should diversify their portfolios with assets that continue to give good rental returns This enhances financial stability and helps investors weather the brewing real estate storm.
Securing deals while facing lower capital availability
While the challenges in commercial real estate are daunting, certain CRE investors can profit from current economic developments.
Buyers, especially, are set to benefit from discounts.
“We're starting to see more and more properties come up for sale at lower prices immediately versus trying to hit the higher strike price. That's an indicator that the seller market is softening,” Paul Cattin remarks. “For those buyers that are active, there will be some deals to go buy.”
The one caveat is finding the liquidity to finance these deals. Lending standards are tightening in a CRE market with a looming debt wall and high interest rates.
According to Paul Cattin, that’s where financial creativity comes into play.“I think there are opportunities for both buyers and sellers if they can be creative. We like to be problem solvers and help people think through more non-traditional ways to close a deal.”
Cattin mentions some examples: “It could be a seller leaseback. It could be owner financing or loan assumptions. Those are just a few ways that we're seeing buyers and sellers being able to bridge the gap in pricing and rental rates.”
Soft deposit funding is a way to close deals faster
Another way to stay agile in today’s CRE market - and weather the storm of unforeseen challenges - is to keep your reserve capital free.
Stumping up the money for soft deposits (or earnest money) is a common problem for busy investors. However, not doing so means they risk missing out on important CRE deals.
That's where Duckfund comes in. Duckfund’s Sign-Now-Pay-Later model provides fast and affordable financing that saves you from dipping into your own capital. You can apply for funding in two minutes and secure your property in 48 hours.
With funding at the ready and CRE deals lined up, you can capitalize on the opportunities that today’s biggest commercial real estate challenges present.
[Cash reserves are key to capitalizing on the unfolding CRE downturn. Let Duckfund cover soft deposits for you. Secure the funds you need with our soft deposit financing to nail down your dream property without dipping into your capital.]
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