The state of the commercial real estate (CRE) capital markets, particularly within the office sector, is characterized by both massive challenges and pockets of opportunities. Amid ongoing market recovery, the impending loan maturity wall persists, prompting the need for increased collaboration between borrowers and lenders with the goal of finding solutions for near-term property-level loan maturities. Maintaining strong cash reserves, relying on prior real estate cycle experience, and prioritizing lender and investor relationships is crucial for owners in this challenged environment.

Despite complex challenges, there are experienced operators that work with lenders to address loan maturities, modify loan terms, and explore refinancing options. It is important for borrowers to have transparent communication with lenders and strategic capital allocation in managing existing portfolios (e.g., maintaining deep fund-reserve levels).

Commercial real estate 2024: Key challenges

The private real estate market, compared to the public markets, is imperfect, especially during challenging periods. As a result, buyers are not able to accurately underwrite investments. In times of a strong market, the private market may trade similarly to how the public market trades, and there is generally agreement and consensus in the market with readily available information.

But in challenging times, like today, there is no consensus on various topics, including pricing, the future of CRE, work-from-home trends, and whether we are headed toward a soft landing, a recession, or a nearer-term recovery. This disparity allows experienced operators to distinguish themselves from less experienced or skilled operators.

Skilled investment managers with available capital may be well positioned to capitalize on distressed situations in which there is an opportunity to acquire high-quality real estate at a favorable cost. Operators with available cash may also act as a lender or provide bridge financing for owners in distressed situations that either lack the skill or the capital to meet near-term debt obligations. It is important for operators to work toward an amicable solution with lenders, as those relationships will be important for future transactions.

The continued bifurcation of commercial real estate sectors, especially in the office sector, is likely to become increasingly important in an investment context and should remain a consideration for investors when evaluating sector diversification. The marketplace, including many lenders, often groups all office assets into one bucket and does not view the office market as bifurcated despite the drastic differences between Class A and Class B/C office properties.

Particularly within the office sector, this trend is driven by interest rate increases and uncertainties surrounding work-from-home trends and continues to shape market dynamics, strongly and negatively influencing investor sentiment and transaction activity.

Valuations have decreased in the private CRE sector, and many values today are below the existing debt on the property, with many properties experiencing “negative equity.” Due to the illiquid nature of the private real estate market and the lack of “moment to moment” characteristics that a public market has, the recovery and price discovery will likely be slow for some time.

In navigating the current environment, institutional investors should exercise caution and scrutinize managers’ strategies, particularly owners that lack clear exit strategies for impaired assets. The rapidly evolving perception in the CRE marketplace regarding office properties, coupled with escalating borrowing rates, presents substantial challenges for owners, necessitating a broad reset of property valuations and possibly requiring a recalibration of investment approaches (e.g., less allocation to the office sector, or a change in underwritten assumptions including rental growth rates and cap rates).

Performance of private real estate managers that ebb and flow with market conditions (good performance in good times and bad performance in bad times) may be an indication that a manager is heavily relying on cap rate compression and leverage for returns rather than possessing real estate operator expertise and skillful/thoughtful investment decision-making. It is worth acknowledging that the past decade was a far more favorable time to invest in and return profits for CRE compared to the current and likely future environment. Managers that can continue to underwrite and transact, identifying opportunities amid current challenges, demonstrate resilience.

Amid current challenges lie opportunities for strategic asset acquisition and debt origination, especially for skilled operators with a deep understanding of CRE dynamics. When interest rates stabilize and investor sentiment moves in a positive direction, there is potential for a widespread valuation reset across the CRE market, which will lead to increased transaction activity, a positive indicator for the real estate cycle.