We predicted the storm in commercial real estate

Key takeaways:

• Our 2023 white paper described an approaching hurricane that, true to our predictions, wreaked havoc on CRE and presented what we believe to be a golden opportunity to CRE debt investors. The storm’s not over, in our minds. But the opportunity set in CRE debt remains.
• As we said in our original piece, property values declined, especially in the office sector. Banks continued to pull back on CRE loans, and others stepped in to the fill the void. And, a wide swath of CRE debt investors posted robust returns.
• We continue to believe that CRE debt is a more compelling option when compared to CRE equity, barring a rapid decline in interest rates, which we do not expect to see. In fact, after multiple years of CRE investors hoping for lower rates, it may be time to realize that the macro conditions that could cause rates to fall quickly would likely be devastating.
• We weren’t perfect. “Extend and pretend” has gone on longer than we imagined, and banks have held up better than we thought. But were our predictions wrong, or just early? We think the back half of the storm will likely prove us right.
• As in many other areas of the economy, uncertainty reigns across the CRE universe as we look ahead. Nonetheless, we stand by most everything we said in 2023. We’ll look at what’s next in the space and offer some hints on how opportunistic investors can position themselves for the longer haul.

In this paper, we’ll take a look back at what we said in 2023, how things worked out, what we got right and what we got wrong—though we argue that those takes are more about timing than accuracy. We’ll also discuss where things stand, the robust opportunity set that remains, and what to expect after the storm moves on for real.

Conclusion

Two years ago, all of our forecasting models were aligned, making our hurricane prediction a fairly easy call. Today, there’s more uncertainty. These days, it’s a bit more like wondering where the storm will track, where it will hit, and how much damage it will do. We don’t know whether the back half of the storm will be mild or disastrous, but it’s coming, with another wave of stress. In our minds, there’s no avoiding it.

And that’s perfectly fine. Corrections are a reality, and they are healthy. They can be painful, but also therapeutic. Markets do not function well without losses, and capitalism does not work without consequences, and whatever pain we do feel will be matched by a robust opportunity set.

As for the eye of the storm, enjoy it while it lasts. The first part of the hurricane damaged the equity portion of the capital stack, completely wiping it out in some cases. The back half of the storm will hit credit. Banks, LifeCos, debt funds and mortgage REITs will eventually mark their books to market, and there will be losses.

We view the order of magnitude as fairly easy to call: It will be worst in the office sector, which will combine with 1980s-and-older vintage, class B and C multifamily assets in secondary and tertiary markets to make up the majority of the pain. The balance of the multifamily market could well be next, followed by industrial/logistics, then retail and hospitality.

Still, the environment will continue to offer some of the best risk-adjusted returns CRE debt investors have seen in decades. The winners, in our view, will be disciplined and nimble. They will be selective, with a defensive mindset, but they will be ready to jump in when the time and the opportunity is right. Portfolio positioning will be a key. Meanwhile, choosing the right partner may be the most important decision any investor makes—regardless of where things stand in the market cycle.