Can commercial real estate bear the high cost of debt?

SVP at global real estate services company weighs in on what high rates have done to CRE assets, and the risks & opportunities they open up for investors now

Can commercial real estate bear the high cost of debt?

What is the first question CRE managers are asking these days? Alison Chave says it’s interest rates. Commercial real estate is a levered game. The sudden, steep rise in interest rates that took place particularly over 2022-2023, and subsequent volatility, was a real shock to many owners and impacted not only levered returns but created significant uncertainty for CRE owners as to future cash flows and values.

Chave, SVP and co-lead of debt capital markets at JLL, a global real estate services company, has seen the recent strain that higher borrowing costs and interest rate volatility has placed on CRE owners, managers, and lenders, and how it has affected pricing and liquidity. How is this playing out? While CRE managers are coming to terms with “higher for longer” interest rates, the rate hikes have made lenders and investors far more wary, and both are taking more of a ‘wait and see’ approach as they struggle to underwrite levered cash flows and market values with certainty. JLL has seen a marked drop in transaction and debt activity across commercial real estate investments since 2022: the market is much less liquid than during the frothy times of an artificially induced low interest rate environment during the pandemic.

In 2024, most lenders are really only lending to their existing clients, and CRE managers are paying significantly more attention to their debt levels, stress testing renewal rates and reaching out to lenders much earlier to see how much they can borrow and at what rate. Despite the broad trend of difficulty, however, she says that there is still plenty of capital available in the CRE space depending on the quality of the borrower and the nature of the assets.  

Chave explains that the impact of debt cost on an asset depends on the timing of debt maturity.

“Most professional managers and owners will have staggered their debt maturities, but for those who didn’t and decided to take a five-year window in 2019-20, are facing rates that will have doubled” Chave says. “Those who took ten-year money in 2020 or 2021 when the rates were very low, will not only be ok, but are able to transact assets with low existing debt at favourable prices.

Notwithstanding the current stress in the market, Chave believes that commercial real estate can bear the high cost of debt saying, “we have done it before, and we will do it again.”  She believes there needs to be a reset in expectations in value, based on the higher cost of capital, and we are seeing this as 2024 rolls out.

Concretely, the amount investors are willing to paying for each $1 of cash flow is dropping, simply because more cash flow is needed for the debt – if you want the same levered returns as before, you have to pay less for an asset. Long term, Chave sees levered returns on real estate reverting to the mean, with capitalization rates at more normal and sustainable levels. However, there is very little data for this as most investors are in “wait and see mode”. Those who entered the market at an all-time high when interest rates were artificially high and had little expertise or cash to inject in times of difficulty will need to sell their assets when their debt matures. This creates opportunity.

Chave says that office remains the most challenged area, with an unclear direction in occupancy rates and an expected increase in non-institutional tenant defaults. While there is uncertainty around the future of offices, and a rise in lender watchlist for this asset class, Canadian institutional investors in particular are unlikely to default on their loans. She says that ,any real estate investors are asking her firm if they have distressed assets for sale, but significant levels of distress are simply not materializing.

Chave explains that while many smaller private owners with less cash in hand are in “choppy waters” she does not expect a huge wave of takebacks to hit the Canadian office market.

“Nobody wants that in Canada,” Chave says. “Most problem loans are being extended for a year or so, as lenders wait to see what’s going to happen with office use and when volatility will drop.”

Beyond offices, Chave notes that multifamily assets are still very much in favour. CMHC has facilitated solid financing programs that allow for up to 50-year amortization periods, low interest cost and up to 95% loan to value. Without those programs, she says, there would be very little happening in the financing of existing multifamily and construction of new multifamily housing.

Retail has recovered faster from the impact of the COVID-19 pandemic than office has, Chave notes. Lenders are now looking somewhat favourably on major retail assets like malls and suburban power centres, especially if borrowers can densify and add multifamily housing to their properties.

Chave sees opportunity and growth in student housing, data centres and life sciences etc. “These are nascent asset classes, need to be understood, but they do have a lot of reward potential”.  Going forward, Chave advocates for stronger understanding among investors. “You need to have somebody that understands the asset class and can explain the risks and rewards,” Chave says.

At the end of the day, the definition of the “high cost of debt” is highly dependent on which timeframe you are using. Current Canadian bond rates are still below the long-term averages. In the “new normal” or “back to normal,” there will be winners and losers, but Chave believes that ultimately real estate will remain an attractive asset class, even in today’s debt environment.