Don't Panic, but Commercial Real Estate Already Crashed

The two things I get asked most frequently are “Where are interest rates going?” and “Is commercial real estate going to crash?” We’ll talk about rates another time, but try not to take anyone too seriously who has short-term, high-conviction opinions about where rates are or aren’t going. If they break out charts and a PowerPoint, run.

As to commercial real estate, it has crashed.

What is commercial real estate? (I promise not to be too patronizing)

I just want to be crystal clear about what CRE is, because what it isn’t is just office buildings.

“Commercial real estate” is a super broad term. It encompasses office, industrial, self-storage, multifamily, retail, hospitality, healthcare and then all the subcategories within those. Even those terms are, themselves, quite broad.

Multifamily, for example, encompasses student housing, affordable housing, high rises, low rises, military housing, and senior housing (which itself breaks down into assisted living and independent living, but can be further disaggregated into memory care, hospice and so on).

Industrial then? That’s anything from cold storage to a warehouse facility; from a manufacturing plant to last-mile, logistical infrastructure. Office means everything Class A, B, or C; everything urban, suburban, or rural — any kind of office, anywhere. Coworking, single tenant, multi-tenant, whatever.

So, “commercial” means a lot.

But it crashed? I walked outside today, and there was very little blood in the street. Virtually none.

So like I was saying, people ask me: Will commercial real estate crash? I tell them, it has. Done. But also, everything is kind of fine, right? I mean, it’s not fine, but last I checked, the stock market was ripping, employment was full, inflation was kinda-sorta contained (probably, maybe), and nothing looks like 2008. Sure, the odd bank or two blew up, and real estate CLOs are running near 10% default rates, but everything is, like, pretty OK. All things considered. Right?

But what do I mean when I say it’s crashed? You likely already know this math, but to be safe, let’s just take a quick look.

If you have a property and it’s running a $100,000 net operating income and 24 months ago your cap rate was 4%, today it’s 6%. Your property value has tanked 50%. You actually didn’t need to know anything about the NOI; just that 6% is 50% higher than 4%, which means your property value is 50% lower, all things equal.

Cap rates differ based on a million things. Things generally fall in a range, and the first two standard deviations (I suppose in all statistical cases) cover most of it.

If it’s retail: When do rents reset? Is it owner-user? If it’s multifamily: Is there an affordability component? What’s the tax abatement? Which market is it in? What’s happening in that market? What are the trends there? Are jobs being created or destroyed? Is Amazon building a next-gen warehouse that will employ nobody or are we building a coal mine that needs lots of humans and canaries?

It’s complicated.

Let’s say you bought a property 20 years ago. It might have been an eight cap, then a three cap, now a 10…whatever. Two years ago, it was a four cap, today it’s a six cap. Your property is down 50% from peak to trough; except for the stuff that happened in between, because your NOI (net operating income) probably hopefully materially benefited from inflation, so you’re fine; except two years ago you were 100% richer than you are today (except if you don’t sell, you don’t have to admit it, so don’t lower your price, and if your loan isn’t maturing and your fund life isn’t coming to an end, then whatever, keep clipping coupons). It’s a bond, anyway. It’s a bond with…some interesting tax and appreciation elements that traditional fixed income instruments don’t have, but also interesting risks, like operational ones. Elements of senior housing have struggled recently in some markets because it’s highly operational. You buy a 30-year Treasury and then watch its value get destroyed in a year, but you’ll get your coupon and money back on the last day. This could introduce a segway into junk bonds, Milkin, and the 80s, but I won’t take the bait.

By the way (and this isn’t investment advice), if you own stocks and you own real estate, you don’t really need to own bonds because real estate is kind of your fixed-income exposure that’s arguably super correlated to treasury yields (I know people that will argue that with graphs and data so I’ll say right now, this isn’t a hill I’m willing to die on). If you own income-producing commercial property, you basically already have bonds. Nothing in macroeconomics is a straight line, and correlation isn’t always causation, but income-producing commercial real estate? That’s basically your bond exposure.

We have meandered wildly from wherever we were headed.

The market’s already crashed. What does this mean? Your real question might be: “How does the crash that has happened manifest itself in the broader tapestry of the global and domestic economy and, order of magnitude more importantly, in my own pocket? And how long does this crash last, because most certainly the extent of the contagion in financial markets will be derivative of how long, long-term income instruments like commercial real estate (and corporate and government bonds) and their relevant counterparties (banks, sovereign states) stay under pressure?” That’s a very thoughtful question, you cheeky armchair economist. But I’ll dodge that bullet and jump in front of a different one.

Is Office Dead?

Nope. Yes. Maybe?

The most asked question in America after “How many times have you been divorced?” or “How do you identify?” is “Is office dead? What will happen to office!?”

Some corners of the office market are more screwed sensitive than others. What’s a “corner” of the market? Think of it like a Venn diagram (you don’t have to pretend like you know what one is; there’s a picture below).

So just kind of think about these overlays and you may be short a couple dozen circles. There’s location; like urban, urban core, suburban, rural (and of course every little market has its own vibe/economic conditions that can be its own set of Venn diagrams); Class A, B, and C; tenancy, whether it’s single tenant (is it Microsoft or a corporate HQ for a mail-order smoke shop?) or multi-tenant; and so on. Think about how complex each individual office is, and understand, that applies to all real estate (and multiply it by thousands and millions to understand an actual economy), and it doesn't matter because the office market has gotten whacked on the capital markets side of things (both debt and equity providers are fundamentally disinterested) and buildings are sometimes being sold for less than what the furniture is worth.

Banks don’t want to lend on it, tenants are leaving, and valuations are lower because nobody wants to buy it. You could have an office property that’s fully leased in a tough market, and it might not sell for a 10 or a 12 or 15 cap. I’ve seen crazy things.

But is office gone? Is it screwed? No. I mean, I really don’t know, but probably not, right? Nothing is ever as good or bad as it seems. Except meme stocks and the velocity at which our deficit is growing. In the words of Jay-Z, “that shit cray.”

Remember when Amazon took off, and everyone said “retail’s gone”? They said it was the end of retail. And then there was a period where it was the end of malls. I was at the mall a few weeks ago with my wife and two kids — the place was slammed…with young people. After COVID, they said retail is gone. But retail is okay. It’s here. It’s fine.

I think office is probably okay, too.

I run a tech company, and I can tell you: Being in the office is powerful. I’d like my rent to be lower, but there’s power and utility in being together as humans. I feel like an old man saying it, but that water cooler talk does add real value.

The point is, commercial real estate has crashed. Those valuation swings in office have happened. And we’re still here. Maybe because LPs haven’t been wiped out on 2021/2022 vintage transitional product, because banks are extending and pretending, because…well, it’s kind of hard to say. But I think the underlying fundamentals of the properties are still pretty favorable, and markets are complicated. What’s propping things up? Is it inflows to America? Are we still the best of less good and bad options? Lots of unknowns here.

Manifesting and Risk

The way the aforementioned crash manifests itself may be through loan defaults, LPs getting creamed (not in a good way), GPs getting wiped out, lenders failing, some life companies that hold billions of dollars in derivative risk suddenly realizing there’s a very hot potato in their hands. It takes time to bleed through the system. But it’s not everybody getting wiped out. Everything is broadly, generally okay. And remember there’s all that capital “on the sidelines” (probably earning a 5% return in money market while paying a management fee of 2%).

Where else is there risk? There’s vintage risk. I’m not talking about fancy French wine or your 2023 Manischewitz. When I say vintage, I mean the time the property was purchased, not the age of the property. Odds are, if you’re a GP and you raised money from LPs and purchased property in 2021 or 2022, you’re having a tough time. Common strategies are construction or value-add where you can create a ton of value in a short period of time by doing hard work. Hopefully, you’re doing more than just painting the walls and counting on cap rate compression. Hopefully, you modeled for cap rate expansion.

Even with all that, hopefully, you bought a rate cap. But even then, you’re still in a tough spot. You could perform according to plan. You could be the best operator in the world. It doesn’t matter. If you have a two-year loan, you’re in a tough spot. I feel for the GPs and LPs out there. Even if you modeled for the risk, it’s been tough: Interest rates soared. Your loan payments skyrocketed. Insurance premiums in Florida, Texas — up 50%, 100%, even 200%. It’s crazy. Even if you knew it was all coming, it’s still tough. Those rate caps have limits, but expenses don’t, and rents don’t rise in straight lines forever nor do cap rates drop like bricks off freshly painted buildings.

Coming back, some folks that purchased property during that time have much more exposure. No interest rate cap, unrealistic “sensitivity analyses”. I’ve seen sensitivity analyses for buying a property at a four cap with a worst-case scenario of selling at a three. That’s not a sensitivity analysis: That’s delusion.

Is it delusion, though? It’s actually quite reasonable when you look at the last 10 years. It worked! Over and over. But we can’t look at things from a 10-year lens. A decade is a piece of ceramic in an Egyptian archaeological site in the context of financial history. We need to look through 50-year, 100-year, 1,000-year lenses and debt cycles to get an idea of what is happening and will likely happen. Even then; history is riddled with “firsts” and we can expect the future to be similar.

What’s Next?

Valuations have collapsed. Will they collapse further? You’ll have to consult inflation, interest rates, geopolitics, consumer sentiment, regulators, and all the other things that create the environment influencing valuations of a variety of assets (including commercial property) and in turn or simultaneously, each other. You’d save time reading tarot cards and arrive at a similarly useless destination.

There’s not enough liquidity in the commercial real estate transaction market to prove the massive repricing has happened because such a wide bid-ask spread exists between buyers and sellers that sales simply aren’t happening. Lenders are kicking the can; so not only does nobody want to realize the loss (as an aside,GPs are likely, generally, doing just fine from earlier vintages), they also have no incentive to. There is no catalyst except maturities (of debt, funds, etc.) or rate cap expirations and debt defaults. The place where the catalysts will and are starting to rear their heads are in the 2021-2022 vintage construction and bridge loans (probably mostly in multifamily) where debt is coming due or the combination of floating rates and soaring insurance costs have caught up with the NOI.

Transactions will happen. And when they do; the market will find its equilibrium and you’ll think back to this “piece” and say to yourself, “Thanks, Blake.” A lot of folks are having a tough time, but it’s not all doom and gloom. Most properties are performing as well as ever, sitting happily on 3% to 5% fixed-rate debt with plenty of cashflow. Opportunities are out there, and as we move through and beyond this crash, time will alleviate sellers of their stubborn asks (and perhaps buyers of their stubborn bids). The market will normalize at whatever levels that new normal becomes and we will find new things to worry about.