NEW YORK – Real estate is at the heart of the banking crisis, said experts at the 2023 Real Estate Capital Markets conference.
Our annual Real Estate Capital Markets (RECM) conference, which we co-host with Columbia Business School, brings together thought leaders from across the real estate ecosystem to talk about forces shaping the sector and opportunities for leaders, innovators, and investors. Last week was our 16th RECM – and thanks to our many speakers and participants, it just seems to get better every year.
This short piece is our attempt to boil it all down into a handful of headlines to give a flavor of what was discussed at the event. For those who would like to view or revisit the full sessions, videos are available on our RECM Conference 2023 page.
We would love to continue the conversations. Please let us know if any of these points resonate or if we missed something that we should have highlighted here.
1. Phase two of the banking crisis is just getting started
The failure of Silicon Valley Bank in March 2023 marked the beginning of what may be a two-stage banking crisis, precipitated by a steep increase in interest rates over the past year. If stage one was about duration risk (a mismatch between short-term borrowing and long-term investing), stage two will be about credit risk, with rising defaults limiting the potential for banks to provide loans.
There seemed to be a consensus at the conference that a credit crisis is highly likely but that it has not really started yet. The crisis is likely to develop slowly at first and could take years to play out.
In his keynote session, Scott Rechler, CEO and chairman of RXR, put it this way: “We’re at the beginning of this process. I would frame it as a slow-moving train wreck – but once it starts, it’s going to pick up steam. It is similar to what happened in the 1980s, but because it is more widely distributed across the country, it’s going to take longer to work out.” For more on Rechler’s views, see “An Emerging Credit Crisis Could Reshape Real Estate.”
2. Real estate is at the center of the emerging crisis
The banking crisis is having a ripple effect across industries, with real estate at its core. Regional banks are very exposed to the real estate sector, noted Eric Rosengren, former president and CEO of the Federal Reserve Bank of Boston, and they often pursued similar strategies:
“In a sense, [many] real estate firms were taking the same position as Silicon Valley Bank. They had short-term financing tied to LIBOR, and they were getting plenty of cash returns while interest rates were low. When interest rates rose suddenly, they had negative cash flow. Do they continue to invest in the building? Increasingly, at least in some cities, firms are likely to return property to banks. That will result in nonperforming loans on bank balance sheets. Banks have to hold reserves to cover those nonperforming loans, and that depletes capital.”
Until this can be worked out, the market may be caught in a loop where defaults reduce access to financing, driving the cost of capital higher and pushing real estate prices lower. For more on Rosengren’s views, see “An Emerging Credit Crisis Could Reshape Real Estate.”
3. ESG remains an essential bridge to the future
Even in an uncertain economic environment, the real estate sector cannot afford to deprioritize environmental risk. Firms will have to be more focused, but the future depends on an ability to understand, mitigate, and manage environmental factors that will inevitably increase volatility and drive up costs.
Indeed, climate is a form of duration risk, requiring real estate businesses and investors to understand how investments made today will perform in an unpredictable future environment that is likely to be very different from today.
Jacques Gordon, a lecturer at the MIT Center for Real Estate and former global head of research and strategy at LaSalle Investment Management, showed that 2022 was a record year for weather disasters. This not only presents a direct risk to buildings and property but also increases the risk of dependency on infrastructure that may be vulnerable to weather events.
Ahmad Wani, CEO of One Concern, showed how such dependencies have created billions in losses for commercial buildings as well as rising insurance premiums. Over the next ten years, climate risk is the greatest threat to our physical infrastructure, Wani said, and asset managers focused on real estate will be expected to manage the risk this presents to their investments.
4. Office buildings are the new malls
Offices are now subject to many of the challenges that have plagued shopping malls and physical retail stores. Trends that accelerated during the COVID-19 pandemic (particularly working from home, facilitated by digital communications and commerce) have driven occupancy rates to historical lows.
A number of participants opined about zombie buildings and the threat they pose to the vitality of cities such as San Francisco. Many called for public-private partnerships to repurpose buildings for residential and other uses.
Roger Morales, head of commercial real estate acquisitions at KKR, discussed the likelihood that challenges extend to real estate asset classes beyond office: “I think a good amount of the office sector is going to be stressed or distressed over the short, medium, and potentially the long term. The question is whether other asset classes with healthier fundamentals will face stress. Rising costs of debt creates cash-flow problems across sectors. In addition, banks have to reserve more capital and will be very selective on new loans going forward – the pain in office loans means less debt availability across commercial real estate.”
5. Every crisis is an opportunity
Longer term, there is tremendous optimism for real estate’s growth potential. Nancy Lashine, managing partner at Park Madison Partners, put it this way: “We have a short-term capital blip. How long that blip lasts is TBD. But once we get through this period of taking all the excess money out of the system and getting to a more normal level of interest rates, there’s huge optimism about growth and all the things that will be developed over the next decade or so.”
Even in a challenging environment, there are opportunities.
“Investors are also looking beyond traditional underwriting,” noted Ann Cole, managing director and global head of real estate client strategy at JP Morgan Asset Management. “We are coming off a period where there was a lot of buying, but the future is about finding growth, not necessarily owning every asset.”
In that vein, operational real estate is a promising trend that can generate higher margins compared to traditional real estate strategies. Investment models can range from simply linking lease rates to operational performance, to fully managing the operations of the business that uses the underlying real estate asset. Those who can provide valuable services have an edge.
Alternative lending will certainly step in to fill the need for financing as the market tightens, and borrowers with compelling long-term value propositions will be first to be financed. Here again, sustainability plays are likely to be attractive, as are strategies that leverage technology to capture efficiencies and improve quality and service.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
© Mondaq Ltd, Goodwin Procter LLP