Despite Negative Sentiment, Lenders Are Still Lending

If you’re concerned about how to navigate the current CRE industry, you may want to let John Chang be your guiding light. Compared to the pessimistic outlook being voiced by so many, the view of the market held by Chang, senior vice president and national director of research services at Marcus & Millichap, is energetic and optimistic.

In an earlier article, he shared his thoughts on why the CRE industry alone will not cause banks to fail. In this second installment, he discusses why he believes the CRE industry is not in a recession, why there is not a capital crunch and how the transaction market could reignite later this year if the Federal Reserve does not raise rates at its Federal Open Market Committee meeting in June.

There are many ways to measure the health of CRE sales activity, Chang said, indicating that he typically measures transaction count in addition to dollar volume. Right now, he said, there is a decline in the sale of institutional office towers that trade for billions of dollars and those mega transactions “can really swing how much the market moves.” So, if just a few of those large institutional deals are absent, the dollar volume figure can decline significantly.

When one measures the number of buildings traded, the decline is not as steep as it is for dollar volume, Chang said. For example, CoStar data shows that in the first quarter of 2023, U.S. dollar volume declined by 64.3% year-over-year for office, multifamily, retail and industrial properties combined, while the number of sales contracted by 41.4%.

Despite the decline in the sale of CRE assets, Chang said the underlying drivers of commercial real estate such as vacancies, rents, and the general performance of assets “are doing fine, except for office.”

But even with office you can’t paint all markets with the same brush. In San Francisco, the office sector is “getting murdered,” he said. But at the other end of the spectrum, places like Palm Beach, Florida, Miami and Las Vegas all have lower office vacancy rates today than they did before the pandemic. According to CoStar data, between the first quarter of 2021 and 2023, Palm Beach vacancy declined by roughly 300 basis points to 7.7%; Miami vacancy went from 10.0% to 9.2%; and Las Vegas moved from 11.5% to 10.1%.

“It's not a one-size-fits-all conversation, but in general, commercial real estate is performing well ahead of where it was in 2019 across almost every property type,” Chang said.

“For example, multi-tenant retail vacancy rates are on par with where they were in 2019 [and] rents are 10% higher on retail right now than they were prior to the pandemic. So, that's a sector that fell in the pandemic and recovered.” Chang added that the multifamily sector is ahead of where it was, and the same is true with industrial, especially self-storage.

“So, I would not characterize commercial real estate as being in a, quote unquote, recession, because operationally it is performing — for most property types — very well.”

“There is a slowdown in the market. We have seen vacancies for multifamily rise, for example,” Chang said, but part of that is due to a wave of construction. Another contributor to that is “a decline in household formation last year, when everybody was worried about what was happening with inflation in the economy.” He believes the slowdown in household formation “was tied more to consumer sentiment than it was to a structural weakness in the economy.”

The unemployment rate is 3.7% and there are over three million more jobs today than there were before the pandemic, Chang said. Many structural factors of the economy are “doing pretty well, but there is a broad-based perception that we're already in a recession, or we're going into a recession or we're facing huge hurdles that we can't surmount,” Chang said.

But, he emphasized, if you look at the hard numbers — setting aside all speculation about the future — the economy's doing very well. And in real estate — again, setting aside speculation about the sector being the next shoe to drop or that we are moving toward a liquidity crunch — “the actual performance of the assets themselves is generally pretty good.”

“So, I would not characterize this as a commercial real estate recession,” Chang said.

The CRE industry does have a liquidity challenge, he added, but it is not as restrictive as it was during the global financial crisis, when you couldn't borrow money. “There was nothing to borrow, nobody would lend. That's not the case today. The banks and other lenders are still active in the market for most property types,” Chang said.

Contributing to the frozen market is the Federal Reserve, Chang added. The Fed raised the federal funds overnight lending rate by another quarter of a point in May and if they flatten it or “take a pause in their rate increases, which I hope they do, then we could see the market stabilize and balance out,” Chang noted.

He said that roughly between June and November 2022, the Fed raised the overnight rate by 300 basis points in the span of 140 days. “That's less time than they give you for a 1031 exchange,” Chang said incredulously. “How do you underwrite to that?”

For example, if someone made an offer on a building in the beginning of June, and their rate moved 200 or 300 basis points over the roughly 120 days it took to close, “how does that deal still work?” Chang asked. “It doesn't, and that's the problem.” If the Fed were to take a pause and stop raising rates, he said, it would allow investors to have more certainty about capital costs and therefore pricing.

In the meantime, “the banks have widened their spread and tightened their underwriting. I don’t think they're going to loosen their underwriting. But if there's a little bit more clarity on where we're going in the future, those spreads will start to come down,” Chang projected.

Yet despite challenges like these, Chang said “the lending is still there.”

“I check with our finance company every day to hear what they're hearing from lenders,” Chang said. He added that his lending company works with more than 500 different lenders. There's always a venue for debt placement “but it's cautious,” he said. Accordingly, it takes extra work from their capital company to find the right lenders.

When the capital group goes out to work on a deal, “they're getting three loans committed by three different banks, because the number one [offer] may pull out. And we've been running into that.” So, Chang said they are setting up transactions with multiple banks in order to “have a plan B and a plan C, just in case.”

“It's not easy, and the rates aren't what people would like to see, but the capital is there.”

He concluded, “I think the transaction market could revive once there's more clarity on where things will trade; then investors can make informed decisions.”

“We got spoiled as an industry,” Chang said. “Things were going up and up and up. And the cost of debt was cheap,” for the roughly 10 years between the recovery from the global financial crisis and the onset of the pandemic. “The cost of capital during that cycle was not too far off from where we are or where we're going.”

He also said that if you look back even further to before the global financial crisis, the cost of capital was much higher than it is today, as were cap rates and yields. “Relatively speaking, we're not in a bad place. It's just that we're going through a transition.” He added that getting back to a more “normal climate is challenging.”

“I think that the sentiment will shift over the next six months, depending of course on the Federal Reserve taking a pause,” Chang said. “If they do, I can see the market going through a recalibration process over the next three months and then starting to fill the pipeline again in the fourth quarter of this year. That translates to rising transaction activity going into 2024, because it takes about 90 days to close.”