Commercial real estate has been a hot topic this year. Investor concerns about the sector center around high interest rates and the cost of refinancing these properties, many of which are due in the next two years.
CBRE Group (NYSE: CBRE) is one company that knows the industry inside and out. It is the world’s largest commercial real estate business, with nearly $149 billion in assets under management (AUM). It provides services that include leasing, property sales, appraisals, property management, and development.
Earlier this year, CBRE Group expected a rebound in commercial real estate activity in the second half of 2023. That view recently changed, however, which could affect the company and others in the industry. Here’s what we learned.
Commercial Real Estate properties include office buildings, multifamily housing, warehouses, malls, hotels, and medical facilities. These properties can be a source of dependable returns and dividends, but rising interest rates pressure companies operating in the sector.
Loans on commercial properties tend to have terms between five and 10 years, with a large balloon payment at the end. Most property owners don’t make that large payment at the end of the term and opt to refinance the properties instead. As a result, a steady stream of commercial properties always needs to be refinanced as old loans roll off and new ones replace them — making the sector particularly sensitive to changes in interest rates.
According to MSCI, $900 billion in U.S. commercial property loans will mature over the next two years. Property owners will face a tough decision: Refinance the loans at today’s high borrowing costs, wait it out as long as possible and hope interest rates stabilize, or walk away from the property entirely.
CBRE Group has several businesses sensitive to interest rates, including capital markets, investment sales, and loan origination. When interest rates are low and stable, these businesses perform well and can be a steady source of income. When interest rates rise and are highly volatile, as they have been for the past year, players in the industry tend to step back and wait for the dust to settle before jumping back in. That’s precisely what is happening today.
CBRE CFO Emma Giamartino discussed this last week during Barclays’ Global Financial Services Conference. She noted that “transaction activity has slowed significantly,” and that in the past six weeks, “Transactions just weren’t happening.”
Buyers and sellers can’t agree on prices due to the volatility in interest rates and the uncertainty about the path of future rates. Since March 2022, the Federal Reserve has raised interest rates from around zero to an upper limit of 5.5% to put a lid on inflation. This cycle of increasing interest rates is one of the fastest ever.
Inflation has come down as measured by the year-over-year Consumer Price Index (CPI) change. The CPI measures the change in the price of consumer goods and services. After peaking at a 9.1% year-over-year change in June 2022, it steadily fell to 3% this past June. However, inflation is rearing its ugly head and has climbed in the last two months, creating uncertainty about what the Fed will do from here.
Unpredictable interest rates have led to pauses in commercial real estate deals. Lenders and borrowers cannot agree on prices for deals, so not much has been getting done. CBRE previously believed investment sales and originations revenue would grow from Q2 to Q3. That’s no longer the case.
Six weeks into the quarter, Giamartino said the “rise in rates really [stalled] transaction activity in a way that I don’t think the market was expecting.” A recovery in Q3 is “clearly not happening.” CBRE says a rebound could happen early next year but doesn’t rule out the possibility of it getting pushed further into the back half of 2024.
Commercial real estate companies face severe headwinds in today’s volatile, high interest rate environment. A company like CBRE has a diversified business model across different commercial real estate properties and businesses and should weather the storm better than some competitors. However, that didn’t stop the stock from dropping over 6% following its CFO’s comments.
Other companies in the space will face steeper challenges. Those that are highly leveraged, or those in higher-risk properties, like office, could struggle as interest rates stay elevated for longer. Commercial real estate companies face a big challenge ahead, so I’d avoid buying stock in many companies in the sector for now.
If volatility in commercial real estate companies results in a stock sell-off, it could be an opportunity for investors. CBRE believes that multifamily and industrial properties will recover faster than others.
Source: The Motley Fool, Courtney Carlsen, September 25, 2023.