Office market categorized as 'the big slowdown'

Invisible hand of commerce swats CRE with Will Smith-like slap

Office market categorized as 'the big slowdown'

Call it the Big Slowdown.

In a recently released mid-year outlook for the commercial real estate sector, Eisner Advisory Group LLC adopts the descriptive label to describe the space. And it’s no wonder, given the volatility of the market as the Fed struggles mightily to stave off inflation.

Indeed, the rollercoaster effect of Fed machinations has yielded some fuzzy math once reliable for prognosticating, wrote the study’s author. “In our 2022 outlook, we explored the heightened complexity within the real estate markets as economic dynamics alter the math in predicting investment yield,” Joseph Rubin of EisnerAmper wrote. “Most importantly, we are transitioning from an artificial landscape of monetary and fiscal stimulus that inflated returns and asset values toward a market-based interest rate and pricing environment as both the federal government and the Federal Reserve withdraw.”

That’s kind of a fancy way of saying that all bets are off. Rubin, senior advisor to the Real Estate Services Group at Eisner Advisory Group LLC, has previously spoken to Mortgage Professional America in providing insights into the CRE space amid volatile times.

“As the Fed reduces its balance sheet, it may have more of an impact on longer term rates,” Rubin said. “It’s very uncertain what’s happening in the interest rates environment because rates are going up but then they started going down because of recession fears. So there’s a lot of dynamics; it’s very complex. But I think what’s clear is that the real estate industry will be operating at a higher cost cap environment.”

Read more: Higher rates putting brakes on commercial real estate

It’s when one takes a more granular view of the numbers and how quickly they change that one begins to grasp the market forces at play, and the effect they have on real estate. The mid-year outlook breaks down the numbers, yielding the sort of immutable reality actual numbers can provide in their cold, unbending objectivity.

See for yourself how drastically key measures metamorphosed in a span of just six months:

Federal Reserve Rate

Jan 3, 2022: 0.08%

June 30, 2022: 1.58%

10-Year Treasury Rate

Jan. 3, 2022: 1.63%

June 30, 2022: 2.98%

30-Year Fixed Rate Home Mortgage

Jan. 3, 2022: 3.22%

June 30, 2022: 5.70%

Term SOFR (Secured Overnight Financing Rate

Jan. 3, 2022: 0.05%

June 30, 2022: 1.50%

CMBS AAA Credit Spread

Jan. 3, 2022: ~70

Jan. 30, 2022: ~150

To paraphrase John Adams, numbers are stubborn things. Significant global events beyond economics helped guide the storied invisible hand. “At the beginning of the year we knew interest rates would rise, but we didn’t know the pandemic would continue to unleash waves of new variants around the world, exacerbating global supply chain disruption,” Rubin said. “And we couldn’t know that the first major war in Europe in 80 years would erupt, causing unimaginable human tragedy, dislocating the energy markets, and intensifying already high inflation. What a difference six months has made. The magnitude and unpredictability of change has resulted in a riskier investment market for all asset classes and the accompanying requirement for higher risk adjusted returns.”

Read next: Real estate crisis? What real estate crisis?

Taking his turn at paraphrasing, this time Hemingway, Rubin said the impact to the commercial office sector had been gradual and sudden: “The immediate impact of this more challenging investment environment, particularly the higher cost of capital, has been a slowdown in transactions,” he said. “Higher interest rates to real estate are like fire to a scarecrow. They reduce profit margins on new deals and can spoil the anticipated exit on existing deals. Accordingly, investors and their lenders are taking more time to model cash flows and valuations. The longer-term impact will bring both opportunity and pain. As the market transitions so will owners and investors, from the sprint of the last few years to a marathon.”

Side effects of the pandemic – behavioral rather than clinical – continue to affect the office market, posing significant risks for investors and owners: “The number of workers going back to the office is increasing every month,” Rubin observed. “However, most workers no longer want to be in the office full-time, especially as gas prices increase the cost of commuting. Office tenants are listening to their employees and watching their check books. Many are trying to renegotiate rent and reduce space prior to the expiration of their leases. Others will clearly reduce space and move to higher quality properties as leases turn. A recent tenant study by CBRE found that over 50% of respondents expect to reduce office space over the next three years.”

The advice now is to focus on the longer-term horizon, seen as an appropriate strategy in a period of volatility but healthy for the markets. “In the next few years, as market participants adjust to the new reality, it will likely take more capital and sweat to achieve success in real estate investing,” Rubin said.