We’ve been following the business news even closer than usual these days because concern over the health of the “commercial” real estate market has hit the front pages of major media outlets again.
We will get into the reasons why in a moment, but we want to first make clear that commercial real estate is a general term, and there are many types of properties that fall under it including industrial, office, retail, hospitality, multi-family and public storage properties.
Unfortunately, journalists tend not to make these distinctions in their writings, which is a pretty basic mistake given the fact that all these types of real estate are distinctly different from one another in many ways. Often we see a headline signaling an oncoming storm for commercial real estate, only to find three paragraphs in that the article is actually about a single downtown office market that is struggling to recover from the pandemic. While any market in distress is worthy of our attention, it is also important not to be misled by clickbait headlines. That said, it’s just as important not to ignore warning signs that are right in front of us, either.
So, why is it that commercial real estate is getting more attention these days? Lately, it’s been the banking crisis. Before that it was the low return rate of employees to office buildings. Now it’s both. When Silicon Valley Bank (SVB) went under, its over-focus on the struggling tech sector and its interest rate risk on a pile of US Treasurys and mortgage-backed securities it invested in was laid bare. Like most banks, they borrowed short and invested long, but ignored the rate risk associated with the Fed’s push to get inflation under control. Once the light was shined on the SVB’s position, a run ensued and, well, you know the rest of the story. Then Signature Bank went down due to its own narrow customer focus and interest rate risk exposure.
Next, all the other regional banks came under scrutiny and that’s when commercial real estate was dragged into the drama. Why? Because it’s the regional banks that make a big chunk of the loans on commercial real estate across all product types. Some of those loans are secured by large office buildings with declining occupancy and falling rental rates. Since it has been widely reported that over a trillion dollars of that debt is maturing in the next year that will have to be refinanced at interest rates that have doubled, many experts believe the regional banks are going to soon become the not-so-proud owners of some of that real estate. Not good.
Could this happen? Yes, it could and it probably will to some degree. However, here’s where the journalists’ failure to make the product type distinction clear, which causes a perception problem for those us on the industrial side of the equation. While office building vacancy has been rising and lease rates have been weakening across the country, industrial property vacancy remains near an all-time low and rents have skyrocketed to record levels. Since loans for investment property are underwritten on the quantity and quality of their income streams, it’s safe to say that refinancing an office building right now presents a much bigger challenge. We wish the business writers would get better at making that clear in their reports.
This is not to say that there isn’t an increased risk in owning any real estate that needs to be refinanced during the current interest rate environment. We concede that there may be properties in all asset classes out there that may be negatively impacted by the current underwriting profile. But, we believe the trouble will be primarily in the office property type.
If you own industrial property that needs to be refinanced soon, either as an investor or owner/user, there is still money out there to get the deal done. To be sure, the cost of that debt will be much higher, but your property is probably worth 2 to 4 times what you paid for it. So, refinancing your current loan balance at that low an LTV should be achievable.
If you need to refinance maturing debt soon, this is also a good time to take a good look at all your options, including a sale or tax-deferred exchange. Demand for quality industrial real estate is still running ahead of supply and pricing is holding up surprisingly well even though the market peak is in the rearview mirror. With the economy showing further signs of weakness, it is possible that we will suffer a significant correction, and we are seeing more industrial owners move up the time frame on their exit strategies in response to that threat. Most of them have highly appreciated assets they have held for a long time and whose properties figure significantly into their retirement plans.
Whatever your current strategy is, these are “head-on-a-swivel” times. The economy is showing several danger signs and even the most optimistic economists are predicting some level of recession in the near term. It is important for you to consider how you and your property would likely fare in the case of a significant downturn. Could you tolerate higher vacancy in your industrial investment property, or if you are an owner user, will your business likely remain healthy enough to meet current obligations?
It costs nothing to ask the questions, but it could cost a fortune if you don’t. We are here to keep you up to speed on industrial market conditions that will help you develop a strategy that fits your unique circumstances.