Pressure on American offices, but real estate can still be a refuge for investors.

Commercial real estate, especially office buildings, is going through a challenging period: rising interest rates are impacting this sector at the same time that tenants are seeking new, more resilient architecture in new areas of the country. "Currently, there is a problem of relevance in commercial real estate, related to the presence of a large number of outdated properties, which is particularly noticeable in the office sector," says Miriam Wheeler, head of the Global Real Estate Financing Group at Goldman Sachs Investment Banking. At the same time, in the medium term, the sector will be able to attract capital from around the world, as investors seek assets that are better protected against inflation and geopolitical upheavals, says Neil Volitzer, managing director in GS Real Estate Investment Banking.

We talked to Wheeler and Volitzer about the increase in the additional yield (spread) on commercial mortgage-backed securities that investors demand over risk-free bonds, the large volume of obligations that need to be repaid in the coming years, and expectations of losses and financial difficulties. How do you assess credit ratings in commercial real estate?

Miriam Wheeler:

Let's take a look at the market for commercial mortgage-backed securities (CMBS), as it is the most liquid market: in the first quarter of 2022, we saw an increase in the spread of rates and a credit squeeze following the start of the invasion of Ukraine and a record volume of CMBS issuance in 2021. The largest spread was reached in the fall of 2022 amid ongoing rate volatility and concerns about the future of the credit portfolio. In January and February of this year, we observed some resilience in the market. This is partly due to a lack of supply - CMBS issuance in the first quarter of 2023 decreased by more than 80%. However, after the crisis in regional banks in March of this year, the CMBS market began to significantly lag behind other corporate credit instruments, returning to the levels seen in the fall of 2022, while investment-grade loans and high-yield bonds remained relatively stable. So, I think that overall, investors are concerned about the valuation of commercial real estate and are starting to factor in either loan extensions or losses.

We are also closely monitoring the regional banking sector, as these banks are the largest lenders in commercial real estate. According to a Goldman Sachs study, they account for about 70% of the total volume of loans for commercial real estate provided by banks, and interestingly, the smaller the bank, the greater its exposure to commercial real estate. Therefore, we are concerned that as regulations tighten and potential exposure limits are imposed, regional banks will either become more expensive for borrowers or completely withdraw from lending in this area. We believe this will particularly impact the construction market, where regional banks are actively involved and where there is no effective substitution (unlike the stabilized asset market, where we believe CMBS could increase its share). At the same time, we think this will create a very attractive environment for some debt funds and private equity, which have been drawn in as some more traditional banks begin to retreat, and as fractures continue in the CMBS market.

There are concerns about a "wall" of maturing commercial real estate debt. How do you think this will affect the market?

Miriam Wheeler: It's important to consider the repayment timelines across asset classes. About 23% of these repayments are related to office assets, and I think there will be significant issues with these repayments. Some of these loans will be extended, but I believe there are borrowers who no longer have positive asset value and therefore are not interested in contributing additional capital. Outside of the office sector, there is plenty of capital available for the remaining debt payments. Just look at how well the revenue has performed in the segments of multifamily housing, industrial real estate, warehouses, and hotels. Although valuations have decreased due to changes in rates and liability sides, there are still assets with sufficient cash flow that need financing. I also want to point out that there is a lot of private capital available right now to fill the gaps in these situations. You will see strong demand for multifamily housing, industrial properties, warehouses, and hotels.

How can this be compared to the situation in the office real estate market?

Neil Volitzer: I think we don't have a problem with offices - we have a problem with "second-tier" offices. We've seen a similar situation with regional shopping centers in the U.S. While many second-tier shopping centers faced operational difficulties and ultimately changed their purpose, the largest shopping centers continued to thrive, and there was overall consolidation in the sector. Today, the remaining players in the regional shopping center market are some of the best public real estate companies with strong balance sheets, significant free cash flow generation, and ongoing strong operational performance. I believe the same will happen with office assets: buildings with good lease expiration conditions and favorable rent growth will continue to be in demand, while older buildings with poor lease expiration conditions will struggle to attract tenants and see growth in net rental rates. The current moment for the office sector is occurring in a significantly more volatile macroeconomic environment than that of regional shopping centers over the past few years. The office sector is significantly larger than regional shopping centers, and cash flows differ substantially from those in shopping centers and can be quite volatile during periods of reduced tenant demand. I think it may take a considerable amount of time for offices to become a preferred asset class for institutional investors again.

The issues with regional shopping centers are still fresh in my mind, and now they are being cautious when allocating capital as they face both real and imagined challenges in this market.

Miriam Wheeler:

I would add that banks and institutional capital are currently very concerned about their office real estate, so obtaining new loans—even for good office assets—has become extremely difficult. We see in the CMBS market that if you look at the conduit product—this is a product where borrowers pool loans for different types of real estate from various lenders—historically, we had an office concentration of about 30-35%. But in recent deals, this figure has been reduced to 15-20% based on investor demand. I think we can expect even more pressure on office spaces, so there are practically no financing opportunities for offices right now.

What other trends in the real estate market do you find important?

Miriam Wheeler: One of the important shifts is the preference for new, higher-quality assets, as noted by our research colleagues. There are currently a lot of outdated properties, which is especially noticeable in offices. But this is true in general, and therefore, when we consider lending, we focus on institutional-quality properties, new assets that meet the modern requirements of tenants.

Neil Volitzer: I completely agree with Miriam.

How long do you think it will take for the losses to impact the commercial real estate market?

Miriam Wheeler: If we look at the views of our research colleagues at Goldman Sachs regarding the Great Financial Crisis, they suggest that the maximum losses in commercial real estate occurred only four years after the crisis. I think this time it will happen a bit faster for two reasons: first, there is a huge amount of fixed-rate debt in the market right now—much more than in previous cycles. When you think about this fixed-rate debt, the typical fixed-rate term is five years, but in the first two years, only the first two years are fixed. So, rates are dramatically undervalued in the market right now, and borrowers will have to make a decision about refinancing or not in the second year, as required by the loan terms. Therefore, I think these discussions about loan repayments will start earlier. And regarding Neil's opinion, everything will depend on capital. Many distressed office assets need capital. And so, especially in the case of fixed-rate loans, these lenders will face the decision to support the assets sooner rather than later due to rising rates and the need for more capital, which could accelerate some distress, at least in the office sector.

However, I would also like to draw attention to how significantly the revenue of various asset classes can vary. I think that sometimes there is a tendency to be too early and skeptical about commercial real estate. Commercial real estate is sensitive to interest rates, but historically it has been quite resilient to inflation. We continue to observe strong growth in many asset classes, although it may have slowed down a bit. Neil Wolitzer: Real estate is extremely sensitive to interest rates, and in light of recent changes and rate volatility, it will take some time for market participants—both lenders and borrowers—to adjust to what constitutes the "new normal." Real estate has weathered many historical storms and is likely to endure this period of uncertainty and volatility as well. However, what may be somewhat different in this cycle compared to previous ones is the significant reduction in available credit. If you think about it, the current real estate ecosystem has been built on decades of very low cost and availability of credit capital. This credit capital has been very effectively allocated to real estate borrowers through the banking market and structured financial markets, such as CMBS. Today, these channels for delivering credit capital are not functioning properly to provide the necessary level of support for the real estate sector and real estate assets—partly due to political regulatory measures concerning banks and partly because capital markets are demanding significantly higher risk premiums to allocate capital to this asset. I think we may still be at the beginning of a period where we are rapidly transitioning from a decade-long cycle of expanding credit capital to a potential prolonged cycle of contracting credit capital.

There is one good piece of news. Every day, people pay insurance premiums. Pension contributions continue to come in from both public and private enterprises, along with unionized companies, and investors are looking for target stocks with a yield that typically ranges from 7-10% per year. In the preceding low-interest-rate environment, these investors in top-priority bonds, mortgages, and investment-grade bonds received minimal returns, which forced them to seek higher-yielding and riskier investments in private equity to achieve their target profits. The same pension funds and insurance investors can meet their investment goals with a mix of high returns and low risk by focusing on standard credit for real estate.

However, the real estate ecosystem has relied so heavily on banking and capital market channels for a long time that it will take time and energy for this new source of capital to meet the significant demands of commercial real estate borrowers facing debt payments in the coming years. Another positive aspect is that during this period, the supply of new construction will significantly decrease. For example, a substantial portion of construction loans has been obtained from regional banks - the provision of this capital is expected to shrink due to changes in the operational and regulatory activities of regional banks. The reduction in construction loans will lead to a decrease in the supply of new properties, which should enhance the pricing power of property owners in the medium term, especially for new, higher-quality assets located in markets with population and job growth (for instance, in the Sun Belt, Texas, etc.). From a 30,000-foot view, I remain optimistic about commercial real estate in North America in the medium term.

It seems that the world is experiencing more geopolitical uncertainty. I'm not an expert in foreign policy or geopolitics, but I feel that we have gone through a unique period of expanded global trade and relative geopolitical stability over the past three decades. If we are indeed moving away from this period of extensive globalization and geopolitical stability towards a more uncertain and dangerous world, people around the globe will be very carefully considering where to place their capital in the long term. Of course, we have our own issues, but putting myself in the shoes of a global capital allocator, North America has many advantages, especially in a more volatile and harsh world - natural resources, infrastructure, protective oceans, and relatively stable demographics (for example, we have young adults here, while many countries lack this key demographic group). I can't think of a better geopolitical hedge among assets in North America than real estate. If you can overlook the short-term volatility caused by a sharp contraction in credit and financial capital expansion in the U.S., I believe that commercial real estate in North America is an excellent place to allocate capital in the medium to long term.

The information in this article is provided solely for educational purposes. The information contained in this article does not constitute a recommendation from Goldman Sachs to the recipient, and Goldman Sachs does not provide financial, economic, legal, investment, accounting, or tax advice through this article or to its recipient. Neither Goldman Sachs nor any of its affiliates make any representations or warranties, express or implied, regarding the accuracy or completeness of the statements or any information contained in this article, and any liability in this regard (including direct or indirect losses or damages) is expressly disclaimed.