💣️ Bond Market Turmoil, Increasing Yields, and CRE Investment Outlook

Good morning,

Bond market turmoil, increasing yields, and cre investment outlook; office-to-apartment conversions face financial headwinds; shifting trends shape cre across the globe; and the Tides saga continues. Let’s delve into today’s topics.

📈 Market Update

💣️ Bond Market Turmoil, Increasing Yields, and CRE Investment Outlook

The recent sell-off in the bond market has driven the 10-year Treasury yield close to 5%, leading to a more cautious outlook on commercial real estate investments. Higher yields are not due to inflation—which is under control—but rather a combination of economic strength, consumer spending, increasing term premiums, a growing government deficit, and the Federal Reserve's quantitative tightening. With the anticipation of higher cap rates and lower capital values, CBRE adjusted its growth projections for CRE investments in 2024 from +15% to -5%.

Market Volatility:
Major CRE brokerages are anticipating the market to bottom out and hope for a rebound in leasing and capital markets activity by the second half of 2024, though this is later than previously expected. This shift is due to persisting high interest rates, stringent lending conditions, and a slowdown in business expansion.

🔍️ The Outlook:
The real estate industry is bracing for tough times ahead, with some executives and analysts suggesting that the market downturn may persist through 2024, with recovery not starting until 2025. This outlook reflects a conservative stance taken due to uncertainties in transactional activities, shrinking corporate footprints, and challenges in refinancing. Despite this, some industry leaders remain optimistic, noting that the fundamental drivers for a rebound are in place, but the timing remains uncertain due to broader economic factors. The sentiment across the board suggests a guarded approach, with hopes for recovery balanced by the reality of current market challenges.

🏢 Office-to-Apartment Conversions Face Financial Headwinds

Despite efforts to repurpose vacant office buildings into apartments amidst a national housing shortage, these projects remain rare and challenging due to financial and practical hurdles. In the United States, less than 1% of new apartments were created through office conversions last year, with only 3,575 units developed according to RentCafe. While CBRE predicts a rise in such conversions due to increasing office vacancies, the viability is constrained by factors such as slowing rental market growth, with a national decline of 1.2% in asking rents, and higher costs for construction loans which have risen sharply. Permitting delays exacerbate the problem, particularly when paired with higher interest rates, leading to stalled projects as developers struggle to secure financing.

↪️ The Takeaway:
Some cities and the federal government are attempting to incentivize the office-to-apartment shift through tax breaks and faster approvals, but even with these measures, few buildings are suitable for conversion. Gensler, an architectural firm, is involved with projects that have thousands of apartments in the pipeline, yet they are on hold due to financing difficulties. High costs of conversion, such as interior demolition and environmental remediations, add to the complexity. Despite these challenges, when old office buildings are acquired at low prices, conversions can still be profitable; however, several high-profile projects have faced foreclosures, highlighting the risks involved. Analysts suggest that conversions of strip retail into housing might offer a more feasible solution to the housing shortage, potentially yielding over 700,000 units, indicating a pivot in strategy might be necessary for urban redevelopment.

📉 Shifting Trends Shape CRE Across the Globe

CRE is grappling with a significant downturn, instigated by central banks' interest rate hikes aimed at curbing post-pandemic inflation, along with a shift towards remote work and online shopping reducing demand for office and retail spaces. This has led to a third drop in the MSCI World Real Estate Index from early 2022 to October 2023, and in the US, around $1.2 trillion in real estate debt is now in jeopardy. Office buildings are particularly hard-hit, with record vacancy rates leading to foreclosures and financial losses for major firms like Goldman Sachs. The increased cost of borrowing and higher loan-to-value ratios due to falling asset prices are making it difficult for property firms to manage $2.2 trillion in loans maturing by the end of 2025. Conversion to residential spaces is one option for empty offices, but such renovations are often not financially viable without significant investment in upgrades and energy efficiency—a challenging prospect given banks' hesitancy to lend amidst the growing crisis.

🏘️ Tides Saga Continues

Tides Equities is facing financial strains with $150 million in debt marked as delinquent by servicers, highlighting ongoing debt management issues despite the firm's claims of being current on a notable $100 million loan. The situation stems from delayed payments on securitized debt for properties in Fort Worth and Las Vegas, with some loans potentially nearing default and thus transferred to special servicing—a process aimed at restructuring troubled debt. While Tides had previously negotiated modifications on significant portions of its debt, particularly with its primary lender, MF1 Capital, current challenges persist with special servicers now in play, who will seek to protect bondholders' interests without allegiance to the borrower, potentially involving stricter terms and necessitating additional capital from Tides for resolution.

✍️ Further Reading

• Austin Eliminates Parking Requirements for New Projects, Becoming Largest US City To Join Bandwagon (CS)

• Argosy Real Estate Partners Raises $472 Million for Investments (CS)

• Private Credit Giants Are Butting Heads Over a Hot New Asset Class (BBG)

• What Renters Want: More Pickleball Courts and Fewer Fitness Centers (GS)

• Corporate CLO Outlook: U.S. Issuance to be Consistent in 2024 (Trepp)

• Why Student Housing Investors Need to Go Off the Beaten Track (MHN)

📊 Chart of The Day