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The Office Dilemma: Hold or Fold?

Office owners and lenders have key decisions to make: restructure today or hold out for lower rates. Nationally, rents dipped 1% in May compared to last year—the steepest decline since 2020. Meanwhile, a new survey from DLA Piper says most commercial real estate executives have a pessimistic outlook on the industry in the coming year.

The Office Dilemma: Hold or Fold?

Office owners and lenders have key decisions to make: restructure today or hold out for lower rates. Nationally, rents dipped 1% in May compared to last year—the steepest decline since 2020. Meanwhile, a new survey from DLA Piper says most commercial real estate executives have a pessimistic outlook on the industry in the coming year.

Together with

Good morning. Critical decisions lie ahead for office owners and lenders. National rents experienced a 1% decline in May compared to last year—the largest drop since 2020. Furthermore, a recent survey by DLA Piper reveals a prevailing pessimistic outlook among commercial real estate executives.

What’s driving this bearish sentiment? Keep reading to uncover the details.

Today’s issue is brought to you by Juniper Square. The leading provider of partnership enablement for the private funds industry.

Market Snapshot

S&P 500
GSPC
4,339.00
Pct Chg:
0.9%
FTSE NAREIT
FNER
707.28
Pct Chg:
-0.6%
10Y Treasury
TNX
3.739%
Pct Chg:
-0.2%
SOFR
1-month
5.05%
Pct Chg:
0.0%

*Data as of 6/12/2023 market close.

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REALITY CHECK

As Office Buildings Lose Value, Distressed Asset Buyers Linger

Given the unfavorable economic climate in the CRE market, office owners and lenders are grappling with declining property values. The question arises: should owners sell at a loss or wait for better refinancing options in 2025?

Writing on the wall: Recent months saw a shift in attitude within the office market. There was a hopeful tone back in February, but things aren’t looking great. Officials predict a multiyear recovery with mass surrenders from rising vacancy and high ownership costs. Lenders are trying to restructure now rather than wait for rates to come down, but borrowers are more likely to walk away. The CMBS delinquency rate shot up in May, with the biggest one-month increase in missed debt service payments since June 2020, according to Trepp data.

Eroding brick and mortar: Remote work has all but ensured that most office buildings are worth less than they were when their loans originated. The loss of value impacts building owners and lenders alike as they cautiously decide whether to hold onto properties or give them back. Property management staff is one of the biggest variable costs that can cut into net operating income. Additionally, every block of space that comes vacant in an office building is one that takes millions in tenant improvements to make competitive with new construction.

Not your granddad’s office: Debt negotiations are carrying on with the assumption that long-term refinancing will again be possible in 2025. But interest rates are projected to stay sky-high until then, which means the office leasing market isn’t expected to meaningfully improve over the next year or two. With few workers pining after in-person work, the majority of companies have put hybrid work plans in place that require less square footage per employee, making quality the operative demand driver in most office markets.

➥ THE TAKEAWAY

Time to throw in the towel? Despite the eroding value of U.S. office buildings, owners and lenders alike are reluctant to give up quickly. Lenders don’t want office properties back from borrowers in the current environment. Meanwhile, borrowers face unprecedented costs of doing business, depending desperately on existing lender relationships to secure new loans. Smaller office owners can’t afford to burn any bridges, which gives lenders the slight upper hand right now.

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TOGETHER WITH JUNIPER SQUARE

6 questions to ask when outsourcing fund administration

Outsourcing to a third-party administrator has been the norm in hedge funds for a long time. It’s nearly universal in private equity and venture capital and is increasingly common in real estate. In a fast-moving landscape, GPs shouldn’t put themselves at a disadvantage by not doing something their peers have already figured out.

But choosing the right third-party administrator to take on this responsibility is critical to your long-term success. Your administrator powers many of your firm's interactions with the outside world—from investors to auditors—and their knowledge and efficiency reflect directly on your firm.

Any fund administrator should be able to deliver accurate financials and investor statements, but forward-thinking GPs know their administrators can be an ally—one who not only meets their needs today but enables them to survive and even thrive years into the future.

RENTAL MARKET

Apartment Rents Post Largest Annual Decline Since 2020

In May, nationwide rents took a plunge, experiencing a significant decline and marking the largest drop since 2020. Redfin suggests this decline results from a housing supply surge from a building boom, as well as demand taking a nosedive due to economic uncertainty.

Asking rents: In May, the median asking rent in the US experienced its largest annual decline since March 2020, falling by 0.6% to $1,995. This is in stark contrast to the near-record 16.5% increase observed a year earlier. Additionally, this marks the first annual decline since March 2020 on a revised basis. However, there were regional variations, with the West seeing a significant decline of 2.1% in asking rents compared to the national average. In contrast, the Northeast, Midwest, and South experienced increases of 5.4%, 4.9%, and 0.8%, respectively.

Rent trends in the US vary by region: The West is experiencing the steepest decline in rents, as it had seen significant increases during the pandemic. With supply catching up, rents now have more room to fall. The Midwest, known for its affordability, has steadier rent growth. The West's construction boom in multifamily housing has led to rising vacancies, while expensive tech hubs like Seattle and San Francisco may be seeing rent declines due to remote work and tech layoffs.

➥ THE TAKEAWAY

Growing supply: US rents have been on a rollercoaster ride. Rental prices are cooling down as more options flood the market, putting landlords in a tough spot to raise prices. Homeowners are jumping on board the rental train, opting to rent out their properties instead of selling, all while enjoying the benefits of high rents and building equity. However, it's important to note that rising mortgage rates also affect this trend, with monthly payments taking a $320 leap on average.

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Around the Web

📖 Read how lessons from past economic crises can help prevent a CRE crash this time around.

🖥️ Watch this segment from CNBC in which JLL CEO Christian Ulbrich claims that “The worst is behind us” already for office vacancies despite 50% of large companies stating they need fewer offices than ever.

🎧 Listen to Scott Everett, Founder & CEO of S2 Capital, talk about the multifamily outlook for 2023 as well as the Fed’s rate decisions, the regional banking crisis, and more on this episode of Fort.

BEARISH OUTLOOK

Majority of CRE Executives Pessimistic for 2023

According to DLA Piper's annual State of the Market Survey, 86% of CRE executive respondents reported holding a negative outlook for the near-term future for just the third time in the survey’s history. Back in 2022, 73% of respondents were bullish instead.

Interest rate imbroglio: Rising interest rates continue to be a thorn in everyone’s side, and 46% of respondents cited rates as the key reason for their bearish outlook. The survey also revealed concerns over reduced debt availability (20%), risk of recession (15%), and long-term impacts of work-from-home (9%). Rising or falling rates are expected to have the biggest impact on the CRE market, with 98% citing it as a top factor, up from 76% in 2022.

The silver lining: The good news is pent-up demand and record capital are still waiting to enter the market. Investors with war chests are patiently looking for low-hanging fruit. Logistics, warehousing, and cold storage (53%) were identified as top opportunities over the next 12 months, followed by multifamily (45%), affordable/workforce housing (38%), medical (37%), and life science/biotech (34%).

Attractive investment opportunities:

Refinancing restrictions: Refinancing CRE loans also appears to be a significant roadblock in 2023, with about $270M in CRE loans maturing this year, according to Trepp. Most of these loans will have to be refinanced at higher rates, which is why some office owners are deciding to call it quits and sell at a loss instead.

Offices officially out to lunch: Speaking of office owners, the survey respondents all believe the pandemic has fundamentally changed the nature of office work. Up to 72% of respondents believe office occupancy will not materially increase this year, while 43% believed U.S. office vacancies will never return to pre-pandemic levels. And for smaller office owners, office-to-resi conversions require navigating zoning changes and dealing with new regulatory frameworks before starting time-consuming and expensive construction.

➥ THE TAKEAWAY

Big picture: The commercial real estate industry has become more bearish due to rising interest rates and the changing dynamics of office spaces. Uncertainty around interest rates has led many investors to be cautious. Refinancing debt and repurposing office spaces are significant concerns. However, there are still attractive investment opportunities in logistics, warehousing, multifamily housing, and certain cities like Austin, Miami, and Nashville due to promising post-pandemic population shifts.

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📰 Daily Picks
  • San Dolores: San Francisco’s office market isn’t the only CRE sector to suffer—the city’s hotels are also getting pummelled through its worst stretch in the past 15 years.

  • Summer warning: Former Treasury Secretary Lawrence Summers believes the U.S. economy still faces 4.5–5% inflation and sees "pockets of distress" in CRE.

  • Changing of the guard: Charles Cadogan, the 8th Earl of Cadogan and a billionaire British real estate investor who owned much of Chelsea, passed away at the age of 86.

  • Inflation premium: Asking rents rose 5% throughout the Northeast and Midwest even as rents fell 0.6% nationally to just $1,995, according to Redfin.

  • Building back better: NYC launched the Manhattan Commercial Revitalization Program (M-Core) to incentivize transformative renovations of aging commercial buildings south of 59th St.

  • If you can make it there: Don Peebles, the most successful black real estate developer in the country, discusses the importance of DEI in real estate.

  • Ghostly skyscrapers: NYC's CRE market faces a crisis as the city's office vacancy rate of 21% leaves investors like Nightingale Group and Wafra Capital struggling to attract tenants.

  • Overallocated and uninterested: Private equity investors are hesitating to make new commitments to funds because they’re already overextended and have less capital than ever.

  • Barton's big bungle: Embattled Dallas developer Tim Barton lost control of the property where he planned to build a $395M luxury hotel/condo tower following fraud and conspiracy allegations.

  • Top Real Estate ETFs: Comparing the top 3 REIT ETFs in the US, Vanguard Real Estate has the highest AUM and expense ratio, Schwab US REIT has the lowest expense ratio, and Real Estate Select Sector SPDR Fund has the highest 5-year return.

  • Threatening to strike: 15K hotel workers in LA voted 96% in favor of a strike over pay, healthcare, and working conditions, affecting major hotel employers such as Marriott, Hyatt, and Hilton.

  • Sweden is sinking: If you think CRE is only bad in the U.S., think again—Swedish property companies have $41B in bond debt coming due over the next few years.

  • Rent fraud crackdown: Sen. Brian Kavanagh and Assembly member Linda Rosenthal are accused of attempting to pass a measure that seeks to punish property owners.

  • Facing foreclosure: $500B of office buildings are expected to be foreclosed on or returned in the next three years due to a flight to quality, higher borrowing costs, and a shrinking office market.

  • Mixing it up: Mixed-use cities are expected to have more appeal for companies seeking new office locations, according to a report by Moody's Analytics CRE.

  • Bad Math(rani): WeWork's embattled former CEO, Sandeep Mathrani, abruptly left in May due to frustrations with SoftBank. WeWork still struggles to build a profitable business and its stock is down over 95% since its IPO in October 2021.

  • Follow the lawyers: Nate Paul, CEO of World Class Holdings, may face up to 240 years in prison and $8M in penalties with the forfeiture of eight properties, after being indicted on eight counts of making false statements to lenders.

📈 Chart of the Day

Self-storage foot traffic got stronger every year into the pandemic, with the highest increase in monthly visitors coming in August 2022 (+54.9%), compared to a big dip in April 2020 (-25.2%).

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