Deep Dive: Who’s afraid of commercial real estate?

With headlines about “zombie workplaces” and “debt timebombs,” the commercial real estate industry has had no shortage of bad news coverage.

One of the more visceral demonstrations of the property sector’s struggles came from New York Magazine in July. On the cover: an aerial view of Midtown Manhattan, spanning from Bryant Park to Hudson Yards, littered with arrows pointing out prominent defaults, mounting foreclosures and staggering vacancies. The thrust of the piece was captured in a succinct title: “Worth less.”

Such ominous overtones in general news publications are painted with broad brushstrokes, but the pitfalls of office markets are being projected onto the entire asset class.

“Commercial real estate has a branding problem at the moment,” says Ryan Cotton, head of Bain Capital Real Estate, the real estate arm of Boston-based private investment firm Bain Capital. “Office is about 20 percent of the equity value of commercial real estate in total, so we’re letting one-fifth of the assets speak for the whole asset class. That is misleading and it definitely creates anxieties, curiosities and some stilted opinions that are probably biased by those headlines.”

PERE spoke to more than a dozen market participants – including managers, investors, capital raisers and consultants – about how this poor publicity is impacting sentiment around capital formation and deployment, and what the industry is doing about it.

Most say negative headlines are not shaping decisions. But they hang like a dark cloud over the sector. With a litany of legitimate issues in the space, including rising interest rates, broad-based economic uncertainty and use-change dynamics for commercial space, it is hard to summarily dismiss the doomsayers.

“We’re trying to distinguish the signal from the noise,” says Gijs Plantinga, director of North American investments for the Dutch pension investor Bouwinvest. “Obviously, there are issues in commercial real estate, particularly in office and to a lesser extent retail… so, of course we have concerns and are watching the situation.”

Plantinga and other investors say they trust their managers more than news reports. For managers and their advisers, this puts them in control of their own destiny. But it also puts greater pressure on them to finetune their messaging and distribute it appropriately.

“The cadence of our public communication hasn’t really changed. But we have certainly increased communication with our investors – we want them to know what we’re seeing, what’s happening in our portfolio and what the opportunity set is out there,” says Justin Pattner, head of KKR’s real estate private equity business in the Americas. “While we’re always transparent, we are mindful of how important communication is during periods like this.”

Despite the distress afflicting the sector, offices are, in some ways, just the tip of the iceberg for groups looking to raise new funds. It is one thing to avoid a specific property type. It is another to identify viable alternatives in a period of elevated uncertainty and secure commitments from a limited pool of available capital.

“It’s always hard to raise capital. It’s particularly hard right now,” says Doug Weill, co-managing partner of capital advisory firm Hodes Weill & Associates. “Diversified managers have to be differentiated but also have a track record over multiple cycles, because they are competing with large managers that have been getting a disproportionate share of capital allocations. If you are sector focused, you have to be in the right sector with the right capabilities. Attracting capital today is very, very competitive.”

Stepping up communication

The issues facing the US office sector run deep, but they have surfaced at a time when the property type’s relevance to the private real estate fund industry was at a nadir.

Once the bedrock of all institutional real estate portfolios, offices have taken a backseat to logistics, multifamily and even niche sectors such as self-storage in recent years as managers and investors alike have become more sophisticated and look to diversify their portfolios.

“There is certainly a lot of negativity around the office sector, much of it justified, and most clients are reluctant to commit capital to office-focused strategies,” says Marc Cardillo, global head of real assets for the consulting firm Cambridge Associates. “But many other sectors, such as industrial, leisure-oriented hotels and various types of residential assets, are in much better shape in terms of current supply-demand dynamics, and don’t face the challenges facing many office assets.”

Because of this, some firms have been happy to combat the negativity around offices through social media posts and other public appearances.

Blackstone, for example, has been vocal about the fact that “traditional” US office properties make up just 2 percent of its global property portfolio. President and chief operating officer Jonathan Gray reiterated this point during the firm’s Q2 2023 earnings call in July, while also making it clear that Blackstone’s real estate investment activities were focused in an entirely different region and sector.

“Today, the area we’re most active in is actually European real estate, particularly in logistics,” Gray said during the call. Logistics is the largest real estate sector for Blackstone and, together with student housing and data centers, represents 50 percent of the firm’s global portfolio, he pointed out.

Other managers prefer to be more targeted in their communications.

Brian Kingston, chief executive of Brookfield’s real estate business, says the firm – which has emblazoned its name upon many city center towers and shopping centers – has primarily used its own balance sheet for such investments. The firm’s buy-fix-sell approach to opportunistic investing generally does not jibe with large office buildings, Kingston says, so the firm feels more comfortable positioning these assets as long-term holds.

Rather than communicate such nuance with the masses, Kingston says the firm opts to speak with their investors directly or share insights with specialist news outlets like PERE: “Our investors tend to be long-term, patient, institutional investors and we can have direct conversations with them. We certainly do that and we’re getting around to see them regularly. It’s hard to do that if you have 30,000 retail investors in your funds. In that case, it makes more sense to blanket social and traditional media.”

Green light, red light

Despite managers’ outreach efforts, however, negative headlines have impacted some investor commitment decisions.

In an interview published in April, California State Teachers’ Retirement System chief investment officer Christopher Ailman told the Financial Times the US pension plan was bracing for write-downs in its $52 billion property portfolio – in part due to the correction in the office market.

“Office real estate is probably down about 20 percent in value, just based on the rise of interest rates,” he said in the interview. “Our real estate consultants spoke to the board last month and said that they felt that real estate was going to have a negative year or two.” Indeed, CalSTRS reported a -0.5 percent return for real estate for the 2022-23 fiscal year ended June 30, down significantly from 26.2 percent for the previous fiscal year.

“What does that say to every other CIO when he says that?” asks David Boyle, co-founder and managing partner of London-based manager NW1 Partners. “That’s one small example, but obviously an important group out there and an important person. So I think it’s that uncertainty of ‘what’s going to happen in real estate?’”

The widespread coverage around the US regional bank failures and the significant exposure those lenders had to commercial real estate also heightened fears over the sector, he adds: “That put more uncertainty into the decision-making process. It’s the headlines particularly around ‘is real estate going to cause distress here?’”

Headline concerns around commercial real estate are compounding several other factors keeping institutional commitments at a standstill.

The first half of 2023 represented the slowest two quarters for private real estate fund closings in recent history. Just $72.3 billion was raised across 94 vehicles, compared with at least $100 billion during the H1s of the past five years, PERE data shows. Meanwhile, the number of funds closed for this year is on pace to amount to less than half of the five-year average of 493.

Lori Campana, managing director at the advisory firm Monument Group, says the biggest issue dating back to last year has been the impact of the so-called ‘denominator effect,’ in which declines in one part of an investor’s portfolio crimps its ability to grow its investments in other asset classes. As public equities were sold off amid rising inflation and recession fears, institutions saw their real estate allocations freeze or shrink.

Stock market gains have eased those pressures in recent months, but investors remain cautious and focused on repositioning their portfolios, says Campana. Some are aiming to reduce risks and others seek to free up liquidity to invest opportunistically.

Complicating matters are mixed signals internally at some institutions regarding new real estate investments. “It used to be the real estate team and CIO were in pretty good sync,” notes Boyle. “The real estate team knew what the CIO wanted of them and knew what they could deliver. Now, I think the message from the CIO to the real estate team is unclear. It feels like they’re charging forward and they have the green light, and they come back and are like, ‘wait a second now, we have the red light’ from the CIO level. Now we have the yellow light, we have to slow it down.”

CIOs are conflicted because they are of two minds about commercial real estate, he adds. On the one hand, they know market dislocation will present rare buying opportunities and therefore are inclined to greenlight high-quality investments even when the investor is already at their allocation limit in the asset class. “But the other side of the CIO’s mind is saying, ‘is real estate going to be a cause of the problem?’

“It’s a very challenging environment to figure out for anybody right now. So I think CIOs are struggling with what’s happening in the macro environment, and how that translates down into the directions for the real estate team and whether to allocate or not or where and how.”

This indecision has contributed to longer fundraising periods. Traditionally, managers would hold a final close a year after the first close for a fund. Now, it is getting more common for the time from first to final close to take up to 18 months, Boyle says.

Office bifurcation

For many investors, office is a four-letter word. Others see it as a contrarian opportunity.

Among managers still actively engaged in the sector, most are not seeking out trophy office towers – despite the leasing success of Manhattan new-builds such as One Vanderbilt and 30 Hudson Yards. Instead, they are looking for amenity-rich properties in thriving neighborhoods, places that incentivize workers to show up by choice or make them feel compensated for being compelled to do so.

Sondra Wenger, head of CBRE Investment Management’s Americas commercial operation division, describes this as “responsive” office space, because it responds to the needs of its occupants. She notes that such space is particularly appealing to research and development-oriented tenants, digital content providers, financial service groups and some start-ups.

Wenger says CBRE IM has been able to refinance construction debt on recently completed projects and purchase loans from banks looking to shed commercial real estate exposure. The stigma around offices broadly, she says, has enabled her firm to access quality products at attractive prices.

“What’s going to come out of all of this is a bifurcation in office,” she says. “The responsive office assets that we believe make for an interesting buying opportunity are getting incorrectly lumped in with older, legacy office.”

Meanwhile, Steven Hason, head of Americas real assets for the Dutch pension investor APG, says no property type is off limits for his group – despite the consistent negativity about the sector in mainstream media. Instead, he says the focus is on owning “the right assets in the right markets,” which could include offices.

Overall, the broader negativity around commercial real estate has not hurt APG’s appetite for the asset class, and Hason feels the same is true for most experienced investors.

“Institutional investors that are in the market for longer cycles, they can see we’re more than a one-sector asset class,” he says. “There’s a lot of headline noise, but I think that sophisticated institutional investors can actually see through that and see which sectors and markets will continue to perform well.”

Overly optimistic headlines

As sensational as the headlines are around US offices, they are not entirely unwarranted

The sector is dealing with two critical, overlapping issues: a supply-demand imbalance, and deteriorating financial market conditions.

Many white-collar workers have yet to return to full-time in-office work after the covid-19 pandemic, causing firms to rethink their office footprints. This is an acutely American problem, as top European and Asian markets have largely snapped back to something close to pre-pandemic norms. Office experts attribute these disparities to cultural differences and labor market dynamics that have made it harder for US employers to claw back remote work allowances.

Some analysts and managers expect remote working to wane as employers find ways to draw workers back to offices, and as a cooling economy erodes labor’s bargaining power. But one issue will not resolve on its own: the oversupply of office property in the US and its rising obsolescence.

In this instance, mainstream headlines can be overly optimistic, especially those about office-to-residential conversions. What housing advocates and politicians call a chance to kill two birds with one stone, adaptive reuse experts call a pipedream.

Shaul Kuba, co-founder and principal of Los Angeles-based CIM Group, says that while his firm has experience converting downtown office properties, many of them are not typically conducive to residential use, as these spaces fail to meet most city housing ordinances.

Making this type of repositioning economically and politically feasible would require significant public sector support, he says.

“To create a formula that will work to transform these office buildings today, you need a combination of many things including a market reset for office as well as the right legislation, ordinances from the city and from the state, and allowances from banks,” Kuba says. “I couldn’t tell you today exactly what the formula should be, but there is a disconnect between the cost of these conversions and the public support to meet the continuing need for multifamily housing.”

Deceptively negative headlines

Also dominating news coverage is the issue of debt, which is befuddling owners of all categories of commercial properties – even strong-performing ones such as multifamily

More than $500 billion of commercial real estate debt is set to mature this year, according to data compiled by analytics firm Trepp, with $2 trillion more coming due in the following four years.

Recapitalizing assets means not only paying to offset equity losses, but also absorbing significantly higher financing costs, as interest rates have risen significantly during the past 18 months.

Brookfield and Blackstone experienced these issues firsthand. Last year, Blackstone made news by defaulting on a $308 million loan on a Manhattan office building, 1740 Broadway. Brookfield, meanwhile, defaulted on portfolios in Washington, DC and Los Angeles earlier this year.

Here, again, the headlines can deceive, because those properties were financed through securitized mortgages, in which restructurings must be negotiated with a special servicer that represents the bond holders. The only way for a special servicer to be appointed is for the borrower to stop paying. So, while a default may appear damning at first glance, it can also be the most prudent course of action.

Ronald Dickerman, president and founder of Madison International Realty, a New York-based manager that focuses on recapitalizations, says firms in need of liquidity must first overcome a few key mental obstacles.

“You have to make sure there’s cap rate capitulation, that the cap rate in a seller’s mind is properly marked to market and reflects the current state of affairs. There’s a large bid-ask spread right now because a lot of sellers haven’t acknowledged that the cap rate environment has moved,” Dickerman says.

“The second thing is negative leverage. Now that the interest rate on borrowing is higher than the rate of return they earn on the real estate itself, most investors using conventional leverage are going to have to accept some periods of negative leverage, then raise rents or improve assets through leasing to rectify the situation over time.”