Brian Pascus | Commercial Observer
A global commercial real estate firm is optimistic that the industry will have a healthier experience in 2024 after a miserable 2023.
Hines, a real estate investment manager headquartered in Houston with more than $94 billion in assets, wrote in the firm’s “2024 Global Investment Outlook” that U.S. commercial real estate is poised for a turnaround in the new year, particularly under the weight of a stronger domestic economy and increased interest rate stability. Still, the firm highlighted concerns around huge debt volumes CRE properties are struggling to service amid near-negative debt service coverage ratios.
“While the year-to-year result is bleak, there are signs of a turnaround,” wrote Alfonso Munk, Hines’ chief investment officer of the Americas. “The U.S. consumer hasn’t been having many concerns with employment or spending, and the economy itself has arguably been among the strongest performers in the developed world.”
Munk noted that, at 3.9 percent, unemployment in the U.S. is at its pre-pandemic rate, while consumption has increased by 2.4 percent annually through October. Both indicators point to a strengthening U.S. economy just as the Federal Reserve has signaled an extended pause in interest rates – music to the ears of CRE capital markets.
However, Munk and the rest of Hines leadership tempered their optimism by pointing to troubling CRE transaction volume and poor lending indicators.
Even though U.S. office, industrial and retail transaction volumes all rose in the third quarter of 2023, total U.S. CRE transaction volumes fell 53 percent during the 12 months through Sept. 30, 2023.
“Transaction activity remains muted globally as investors grapple with the new realities of higher rates. … However, Hines projections show it ramping up considerably next year and peaking in 2025,” wrote David Steinbach, Hines’ global chief investment officer and co-head of investment management, and an author of the report.
“Unlike during the Global Financial Crisis when all sectors crashed in unison, today’s distress (driven by higher rates and refinancing risk) is giving developers and investors time to prepare (and plan for sales if needed),” Steinbach added. “Ongoing repricing appears to have established an enticing investment landscape reminiscent of the early post-GFC years.”
Steinbach and the Hines team are particularly bullish on the opportunity for credit investments, due to a funding shortfall across the capital markets system caused by the commercial bank pullback in the last 12 months. The commercial mortgage market has fallen by 46 percent in the last year, just as CRE debt maturities are expected to reach $500 billion by 2024, according to Hines data.
“Risk-adjusted returns for credit generally exceed other asset classes and rival those of equity – with the only caveat being duration risk (which comes with an opportunity cost),” wrote Steinbach. “Credit is, in our opinion, a good play.”
But there’s no denying that the current market is still challenging for property owners and their investment partners.
Hines identifies several capital markets challenges that have played havoc on the balance sheets of investors and property owners alike — namely a drop in property values at the same time rent growth has finally subsided after years of upward movement, a pattern that has been especially problematic for those sponsors who took out floating-rate debt on their real estate deals during the heady times from 2019 to 2021.
Hines data shows that numerous loans were securitized using floating-rate debt and are now hampered by deteriorated debt service coverage ratios that are less than 1 percent. The value of sub-1 percent debt service coverage ratio properties has reached $45 billion, of which the apartment sector accounts for $20 billion, office properties nearly $14 billion, and industrial roughly $8 billion, according to Hines data.
“The unparalleled surge in apartment and industrial rents coinciding with the peak in transaction volume likely prompted many successful bidders to underwrite ambitious rent growth,” according to Hines. “With rent increases now moderating, especially in U.S. apartments and even in U.S. industrial markets, these assumptions may be failing to materialize as anticipated by buyers and lenders.”
As for specific asset classes and markets, Hines is bullish only on retail. The private equity firm said that the once-beleaguered retail sector “has now achieved a state of stability and has re-emerged as a favorable asset class. … Opportunities in grocery-anchored or open-air assets will abound.”
Hines is not nearly as bullish on office, industrial or multifamily. The firm noted that office vacancies in the 54 largest U.S. markets have hit levels not seen since 1992, and the market fundamentals in industrial “are softening,” largely due to increased vacancies due to speculative construction.
The report was critical of the U.S. rental market — noting that rental is “taking it on the chin,” and arguing that the fundamentals in Midwest, Southwest, Southwest and Eastern apartment markets are “deteriorating” because of increased supply.
“Apartment construction boomed in the Sun Belt in response to growing demand, but this now is undergoing a correction in vacancies, demand, and rent levels,” the report said.
