Navigating the High Cost of Debt: Opportunities in Commercial Real Estate

Credits: Can commercial real estate bear the high cost of debt?

Thank you for reading Lasting Financial Security.

To continue receiving my posts, please follow Adrian C. Spitters FCSI?, CFP?, CEA?, and sign up for my newsletter, Lasting Financial Security.

Please also check out and join my new group, The Counter Narrative.

With all the economic and market uncertainty, you may have questions or concerns about your financial well-being. As a valued Lasting Financial Security subscriber, we are offering a complimentary portfolio evaluation to confirm if your current?investment strategy?will meet your financial objectives. To learn how we can help you protect and grow your wealth during these uncertain times, please email me at [email protected] or use my Calendly Link to book your private strategy session.

Do you find value in the articles I write? Please subscribe to my weekly newsletter, which summarises my best stories of the week: SUBSCRIBE.

Now, Let's get started…

The Interest Rate Conundrum

In the ever-evolving landscape of commercial real estate (CRE), one question is on the minds of managers and investors alike: interest rates. The sudden, steep rise in interest rates, particularly over the 2022-2023 period, coupled with subsequent volatility, has sent shockwaves through the industry. This unexpected shift has not only impacted levered returns but also created significant uncertainty regarding future cash flows and asset valuations.

The Ripple Effect on Transactions and Liquidity

Alison Chave, SVP and co-lead of debt capital markets at JLL, a global real estate services company, has witnessed firsthand the strain that higher borrowing costs and interest rate volatility have placed on CRE owners, managers, and lenders. This strain has had a profound effect on pricing and liquidity, resulting in a marked drop in transaction and debt activity across commercial real estate investments since 2022.

As Chave explains, "The market is much less liquid than during the frothy times of an artificially induced low-interest rate environment during the pandemic." Lenders and investors have become increasingly wary, adopting a 'wait and see' approach as they grapple with the challenge of underwriting levered cash flows and market values with certainty.

Adapting to the "Higher for Longer" Reality

In 2024, most lenders are primarily focusing on their existing client base, leaving CRE managers to pay closer attention to their debt levels. They are stress-testing renewal rates and reaching out to lenders much earlier to assess borrowing capacity and rates. Despite the broader trend of difficulty, Chave emphasizes that there is still ample capital available in the CRE space, depending on the quality of the borrower and the nature of the assets.

Timing Matters: The Impact of Debt Maturity

The impact of debt costs on an asset largely depends on the timing of debt maturity. As Chave explains, "Most professional managers and owners will have staggered their debt maturities, but those who didn't and decided to take a five-year window in 2019-20 are facing rates that will have doubled." In contrast, those who secured ten-year financing in 2020 or 2021 when rates were at historic lows are better positioned to transact assets with low existing debt at favourable prices.

Resetting Expectations and Finding Opportunities

While acknowledging the current market stress, Chave remains optimistic about commercial real estate's ability to bear the high cost of debt, stating, "We have done it before, and we will do it again." She believes that a reset in expectations regarding asset values, based on the higher cost of capital, is necessary, and this adjustment is already underway in 2024.

Concretely, investors are becoming more cautious about the prices they are willing to pay for each $1 of cash flow, as more cash flow is now required to service the debt. To achieve the same levered returns as before, investors must pay less for an asset. In the long term, Chave foresees levered returns on real estate reverting to the mean, with capitalization rates reaching more normal and sustainable levels.

Asset Class Perspectives: Opportunities and Challenges

While the office sector remains the most challenging, with uncertainty surrounding occupancy rates and an expected increase in non-institutional tenant defaults, Chave notes that Canadian institutional investors are unlikely to default on their loans. She also highlights the resilience of the multifamily sector, supported by CMHC's solid financing programs that facilitate low-interest costs and favourable loan-to-value ratios.

Retail assets have recovered faster from the impact of the COVID-19 pandemic than offices, and lenders are now looking more favourably on major retail assets like malls and suburban power centers, especially if borrowers can densify and add multifamily housing to their properties.

Chave also sees opportunity and growth potential in emerging asset classes such as student housing, data centers, and life sciences. While these asset classes require a deeper understanding, they offer attractive reward potential for those willing to invest the time and effort to comprehend the risks and rewards.

The "New Normal" and the Path Forward

As the industry adapts to the "new normal" or "back to normal," there will inevitably be winners and losers. However, Chave firmly believes that real estate will remain an attractive asset class, even in today's debt environment. The definition of the "high cost of debt" is highly dependent on the timeframe being considered, as current Canadian bond rates are still below long-term averages.

To navigate these challenging times, Chave advocates for a stronger understanding among investors. "You need to have somebody that understands the asset class and can explain the risks and rewards," she says.

Take Action to Protect Your Wealth

In these uncertain times, prudent high-net-worth Canadians may want to consider diversifying their investments into alternative assets like private equity, private debt, private real estate, and infrastructure. These alternative investments can produce steady cash flow and upside returns uncorrelated to public markets, potentially mitigating risks and capitalizing on unique opportunities during periods of volatility.

As a valued Lasting Financial Security subscriber, we are offering a complimentary portfolio evaluation to confirm if your portfolio is positioned to weather the current economic uncertainty. Email me at [email protected] or use my Calendly Link to book your complimentary portfolio evaluation and learn how we can help you protect and grow your wealth during these uncertain times.

This no-obligation consultation may help you understand how we strive to protect and grow our client's wealth through a "capital preservation first" philosophy and exclusive access to alternative investments, including Private Equity, Private Debt, Mortgages, Private Real Estate, and Infrastructure.

To continue receiving my posts, please follow Adrian C. Spitters FCSI?, CFP?, CEA?, and sign up for my newsletter, Lasting Financial Security.

Do you find value in the articles I write? Please subscribe to my weekly newsletter, which summarises my best stories of the week: SUBSCRIBE.

FOLLOW ME ON LINKEDIN.

#CommercialRealEstate #InterestRates #DebtFinancing #AlternativeInvestments #PrivateEquity #PrivateDebt #PrivateRealEstate #Infrastructure #PreciousMetals #WealthPreservation #PortfolioDiversification #FinancialPlanning

?