From a wave of consolidation among mortgage companies to a dramatic drop in office valuations, trends that played out in 2023 will carry implications into next year. At the heart of any recovery will be interest rates, which rose at historic levels earlier this year before reaching a plateau in the second half.
Here's a rundown of where the industry stands after another not-so-normal year for the commercial and residential sectors alike.
Rising Rates
Historically, sharp interest rate increases in 2023 dominated both the commercial and residential real estate industries.
Rate increases have frozen investment activity, bogged down construction work and spooked homebuyers.
The residential real estate industry, in particular, is still reeling from a home-buying frenzy when rates were low during the pandemic that has stopped altogether as rates have shot up, said Marty Green, a Dallas-based principal with Polunsky Beitel Green.
As a result, margins for mortgage companies have collapsed, prompting a series of mergers and other consolidations across the industry. Homebuyers face interest rates on a 30-year-fixed mortgage approaching 8% in December — near a 25-year-high. Institutional investors that poured money into single-family homes are now on the sidelines thanks to higher rates, Green said.
"It's been a whipsaw in terms of the industry being busier than they could possibly be during the pandemic to barely a trickle at various times as interest rates skyrocketed from where they were," Green said.
Meanwhile, as one consequence of higher rates for commercial real estate, banks are now offering less favorable financing terms or restricting lending altogether after years of providing cheap credit, said Richard Fries of Sheppard Mullin. That's been an opportunity for private lenders to fill the void, stepping in to offer loans on short notice or with creative terms.
Office Distress
The COVID-19 pandemic left the U.S. office market in shambles. Vacancies are at an all-time high. And it's not yet clear what could eventually become of all that empty space.
Despite some splashy office-to-residential conversions — at New York's Flatiron building, for instance — such projects aren't possible in many midcentury buildings with scarce natural light, said Heather Horowitz, a partner with K&L Gates.
"It's not practical, probably for the bulk of office assets that we have," she said.
In the meantime, the value of office space has fallen dramatically.
In the face of such distress, some property owners have opted to turn in their deeds to lenders to avoid foreclosure. Sheppard Mullin's Fries said that's usually an easy calculation for property owners to make.
"[Some property owners] are saying, 'I am done. I don't want to litigate. I don't want to assert lender liability. I don't want to trip my guaranties. I value my relationships with lenders and my reputation, and I do want to live for another day. I am a victim of falling property values and I have no current upside. Here are the keys,'" Fries said.
Many banks taking on deeds may not be eager to become landlords or developers — especially after enduring three years of loan modifications following the pandemic. Regional lenders, in particular, are moving to reshape portfolios that are typically concentrated in commercial real estate, Fries said.
So, banks want to sell off portions of their commercial real estate portfolios.
"I don't think office is dead," Fries said. "Office valuation is clearly being right-sized. But tenants need space. I think office is an unbelievable long-term investment opportunity."
Stabilization
Despite a series of increases early in 2023, the Federal Reserve hasn't raised the federal funds rate since June.
Fries said there are other signs that the worst could be over after a "perfect storm" for commercial real estate following the pandemic.
"It has been scary and unsettling out there. But right now, it is less scary than it has been for two years," Fries said. "Banks are stabilizing. The supply chain has stabilized. Interest rates are already falling. The economy — knock on wood — is getting healthier, slowly but steadily. Asset health, real estate industry health, fiscal health — it's all foreseeable. You can feel it coming down the pike."
Amid the woes in the office market, Horowitz said she's seen the hospitality industry recover in the last year, with some assets trading hands.
And despite elevated interest rates, multifamily construction projects are also proceeding in some markets — such as the Pacific Northwest and the Sun Belt.
"There is a need for housing, and we're finding sponsors that are still in a position to make the economics of it work," Horowitz said. "That is encouraging notwithstanding the rate environment."
Green, meanwhile, said more lenders are again beginning to issue loans for housing construction projects to help address a lack of inventory. New home sales have remained strong in 2023, although high rates have held down existing home listings.
"Moderation of interest rates should allow some sellers [of existing homes] to get off the fence, which should add some inventory and help move things along a little bit," Green said. "But it's going to be a slow unlocking, not a fast one."
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