Is the Worst Behind Us for the Office Market?

2023 CRE Investor Outlook: An Exercise in Patience

As 2023 progresses, investors are facing a complex and contradictory market. According to CBRE, overall investment volume in the Americas dropped by 63% in Q2, reaching $80B. The office sector experienced a 63% decline, retail fell by 65%, while industrial showed the smallest decline at 48%.

Difficult capital markets: The continuing difficulty in the capital markets is a major challenge for investors. The Mortgage Bankers Association estimates that lending volume for commercial and multifamily properties will drop by 38% in 2023 to $504B. Interest rate volatility, value uncertainty, and asset fundamentals concerns are causing a standstill in deals and lending.

Recession uncertainties: The prospect of a recession is another wildcard for investors, closely tied to the impact of interest rates. While the Fed no longer expects a recession, an inverted yield curve suggests that a recession in 2024 cannot be ruled out. The pace of investment will closely follow interest rate trends and the spread between the risk-free rate and the return.

Location, location, location: Looking ahead, investors need to focus on location. Justin Basie, president of real estate at Mark IV Capital, emphasizes the importance of monitoring local markets and their key fundamentals. Mark IV Capital is focusing on the industrial sector and has projects in Reno, Phoenix, Sacramento, Denver, and Round Rock. Challenges may arise for investors with excessive leverage or floating-rate debt with short-term hold periods.

➥ THE TAKEAWAY

Patience is a virtue: Despite the challenges, there are still opportunities for selective and patient investors. Office products that have come online since 2015 have consistently performed well, with 112.5MSF of positive absorption since the beginning of the pandemic. Additionally, the pipeline of new office construction is slowing down, and office leasing volume has witnessed an uptick in Q2. The medical office niche continues to outperform the rest of the sector. Investment opportunities in office and retail may arise as capital availability improves in the coming years. Overall, better times and clarity are expected to arrive as early as next year, leading to a market recovery.

In October 2022, MHCI Group added Green Forest Estates, a 122-space Manufactured Housing Community, to its portfolio, with promising results that surpassed expectations.

Deal details: The property was acquired for $2,050,000, with $500,000 seller-financed at 4% interest over 7 years. Identifying rental potential, MHCI noted an $85 rent disparity compared to nearby properties, while ownership of a neighboring 96-space property solidified their market position. The presence of tenant-owned homes ensured stable tenancies and fewer operational concerns.

Exceeding Expectations:

✔️ Delinquency Turnaround: Resolved 30% delinquency within a month, saving an estimated $75k-$100k. (which resulted in a 100% collection)

✔️ Community Cleanup: Spent only $3,500 of a projected $15,000 thanks to resident participation.

✔️ Efficient Infrastructure Fix: Essential lift station repairs were executed at just $43,000, well below the projected $120,000.

The ROI: Investors reaped a remarkable 22.64% cash-on-cash return within 17 months, while the property's value surged to $3,400,000-$3,580,000. MHCI Group's adept acquisition of Green Forest Estates underscores their expertise in maximizing value and returns in mobile home communities.

*Disclosure: This post contains sponsored content.

Forecast Vs. Reality: Is the Worst Behind Us for the Office Market?

While the office market panic is showing signs of calming with improved REIT performance, lingering risks remain, particularly if interest rates remain high and financing challenges persist.

REIT resurgence: The Bloomberg REIT Office Property Index has rebounded significantly, rising by about 25% since its low point in late May, outperforming the S&P 500 Index. Dividend yield spreads on office property REITs, which measure perceived risk, have also narrowed closer to historical levels after peaking following the banking crisis. This is largely driven by receding recession fears and successful property sales, such as SL Green's 245 Park Avenue $2B deal.

Quality divide: Office REITs, holding higher-quality assets, may not accurately reflect the broader office market's condition, with potential challenges likely occurring in less transparent, closely held market segments. Demand for prime office spaces in central business districts is expected to persist despite remote work trends.

Dividend dilemma: The narrow yield spread is also partly due to firms cutting projected dividends to preserve capital. Some office REITs have made substantial dividend cuts, potentially impacting investor confidence. Vornado Realty Trust (VNO) halted its dividend temporarily following a prior reduction of approximately 29%. Additionally, several other office REITs, comprising roughly 18% of the index, have made significant dividend reductions in the past year.

Market headwinds: Yields on 5- to 10-year Treasury notes are at their highest since 2007, leading lenders to demand an additional 305 bps on five-year fixed-rate office mortgages with an LTV above 60%. This results in an all-in mortgage rate of 7.2%, posing challenges refinancing older loans. While some investors may overlook this if they believe high rates are temporary, if interest rate expectations remain anchored at current levels due to inflation fears or government deficits, the wave of refinancing in the coming year could become problematic.

➥ THE TAKEAWAY

Interest rate uncertainty: To ensure the resilience of the office real estate sector, property owners must demonstrate their ability to refinance expiring mortgages despite challenges with regional banks. In the long term, either a return to pre-pandemic office space demand (unlikely) or a sustained reduction in borrowing costs (possible but uncertain timing) is needed to address the situation.

🎧 Listen: In this episode of WSJ’s The Journal, Allison Pohle unpacks the impact of NYC's stringent enforcement on some of the nation's toughest short-term rental laws that caused a decline in Airbnb listings.

The Cost of Inadequate Disclosures: $20.5M in Fines

Real estate investment firm Prime Group Holdings has agreed to pay $20.5M to resolve allegations of insufficient disclosures of brokerage fees it charged to investors.

Settlement saga: The SEC revealed that Prime failed to disclose that millions of dollars in brokerage fees paid by fund investors from 2017 to 2021 went to a company owned by Prime's CEO. Prime has agreed to a settlement, including a $6.5M penalty and approximately $14M in repayments to investors, which covers both principal and interest. As part of the settlement, Prime neither admitted nor denied the charges, and the firm's CEO and affiliated brokerage firm were not named or charged with any wrongdoing.

SEC's enforcement: The SEC played a pivotal role in this settlement, claiming that Prime Group Holdings failed to inform investors about fees going to an affiliate of the company and the potential for conflicts of interest, rendering the fund documents inadequate and misleading. However, the SEC issued an order related to a $700M fund established in 2017, which acquired properties through deal teams incentivized to convince small storage operators to sell to Prime's fund, with the CEO's brokerage firm receiving nearly $18M in fees from 2017 to 2021.

Self-storage success: Prime, which manages approximately $4B of investor capital, primarily focuses on acquiring and managing self-storage facilities. The self-storage sector has gained significant investor interest due to its resilience during economic downturns and strong performance during the pandemic. Prime recently closed its largest fund ever, raising $2.5B for its third self-storage fund.

➥ THE TAKEAWAY

Market impact: The SEC has been intensifying its oversight of the $27T private funds industry, citing issues such as insufficient fee disclosure and hidden conflicts of interest. The SEC recently proposed comprehensive rules to enhance fee transparency and other aspects of private equity management, which has faced opposition from industry lobbyists who filed a lawsuit to block the proposed regulations.

Moody’s Analytics experts examined the performance of large office buildings in major metros featuring 10+ skyscrapers to determine where the greatest YTD vacancy increases are taking place.

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