CONTRIBUTORS
Richard Byrne
President,
Benefit Street Partners
In the classic 1994 film, “Forrest Gump,” Forrest bought an old shrimping boat and began his venture in the hypercompetitive shrimping scene of Bayou La Batre, Alabama. Things were tough for Forrest until his fellow shrimpers’ boats were wiped out while they were anchored in the harbor trying to avoid Hurricane Carmen. Unfortunately, these boats suffered a direct hit and the entire fleet was wiped out, except for Forrest and his boat, Jenny, who were not in the harbor that day. After that with little competition on the water Forrest’s catch exploded. In our view this is the current story of commercial real estate debt (shrimp), firms with large existing allocations to office commercial real estate debt (fleet in harbor), and firms with fresh capital to deploy in commercial real estate debt (Forrest).
Commercial real estate (CRE) debt is currently navigating a challenging environment, due to a combination of steeply rising interest rates, falling property valuations, and severe issues in the office sector. This situation is exacerbated by a looming maturity wall of low-interest loans due to refinance in 2024 and 2025, potentially causing significant distress for highly leveraged lenders. However, this crisis also presents a unique investment opportunity, particularly for investors with fresh capital ready to deploy.
The swift increase in interest rates, as the Federal Reserve responded to 40-year high inflation rates by raising rates from near-zero to over 5% in just 17 months, has significantly impacted the CRE debt market. This rapid rise is the fastest since the early 1980s and has led to a net interest margin windfall for lenders, as borrowing costs have increased. However, this has also doubled or even tripled debt service payments for borrowers, leading to increased loan-to-value ratios and potentially leaving borrowers exposed when interest rate caps expire at loan maturity.
Exhibit 1: Federal Fund Rate Rises at the Fastest Pace Since the 1980s
Source: Federal Reserve Bank of St. Louis, Economic Research Division.
The office sector has been hit particularly hard. The shift towards remote work and the integration of artificial intelligence have led to a surplus of office spaces, significantly impacting asset values and leading to surging vacancy rates. By the fourth quarter of 2023, nearly 20% of office space in major U.S. cities was unleased. The recovery of this sector is expected to be slow, with a bifurcation in the market between still-viable properties in sectors like retail and industrial, and the struggling office properties.
Exhibit 2: Office Vacancies Rapidly Rising
Source: Cushman & Wakefield U.S. National Office MarketBeat Reports, Q1 2019 through Q4 2023.
Amid these challenges, the CRE lending landscape has dried up, with many lenders halting new loans and building up liquidity instead. This has created a significant funding gap, particularly as $1.2 trillion in CRE loans are set to mature in 2024-25. This scenario is described as a maturity wall, with a substantial amount of debt coming due in a challenging market environment.
Exhibit 3: Wall of Maturities
Source: Trepp, Q4 2023. *Other: Primarily comprised of multifamily lending by Fannie Mae and Freddie Mac. This could also include finance companies (private debt funds, REITs, CLOs, etc.), pension funds, government or other sources.
Despite these challenges, there are opportunities for investment, particularly in CRE debt rather than equity. The current environment for CRE debt offers potential for equity-like returns with lower risk and better downside mitigation. Debt investments provide immediate cash flow and a quantifiable gain at repayment, which is particularly attractive given the high interest rates. Additionally, the lack of competition in the lending space, brought about by self-preservation responses from regional banks and other investors with large allocations to office property loans on the books, allows for selective investment in high-quality properties at lower valuations and better terms.
Exhibit 4: Regional Banks Account for Majority of Outstanding CRE Debt
Source: Federal Reserve H.8 reported U.S. bank CRE holdings. Data is non-seasonally adjusted and as of October 29, 2023.
Multifamily properties are highlighted as a particularly promising sector within CRE debt. These properties are seen as having the best credit quality and risk-adjusted returns, with a history of recession resiliency and a built-in hedge against inflation. The sector is expected to recover quickly from any recent downturns, supported by high demand for rentals due to rising home prices and mortgage rates and a low inventory of single family homes.
In conclusion, while the CRE market is currently facing significant challenges, particularly in the office sector, there are substantial opportunities for investors willing to navigate this complex landscape. The ability to invest in high-quality loans at attractive terms presents a potential for strong returns, especially in less competitive areas of the market like multifamily properties. And to quote Forrest, “After that shrimpin’ was easy.”
WHAT ARE THE RISKS?
Past performance does not guarantee future results. All investments involve risks, including possible loss of principal.
Risks of investing in real estate investments include but are not limited to fluctuations in lease occupancy rates and operating expenses, variations in rental schedules, which in turn may be adversely affected by local, state, national or international economic conditions. Such conditions may be impacted by the supply and demand for real estate properties, zoning laws, rent control laws, real property taxes, the availability and costs of financing, and environmental laws. Furthermore, investments in real estate are also impacted by market disruptions caused by regional concerns, political upheaval, sovereign debt crises, and uninsured losses (generally from catastrophic events such as earthquakes, floods and wars). Investments in real estate related securities, such as asset-backed or mortgage-backed securities are subject to prepayment and extension risks.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Equity securities are subject to price fluctuation and possible loss of principal.
An investment in private securities (such as private equity or private credit) or vehicles which invest in them, should be viewed as illiquid and may require a long-term commitment with no certainty of return. The value of and return on such investments will vary due to, among other things, changes in market rates of interest, general economic conditions, economic conditions in particular industries, the condition of financial markets and the financial condition of the issuers of the investments. There also can be no assurance that companies will list their securities on a securities exchange, as such, the lack of an established, liquid secondary market for some investments may have an adverse effect on the market value of those investments and on an investor’s ability to dispose of them at a favorable time or price.
Diversification does not guarantee a profit or protect against a loss.