Is Commercial Real Estate in Trouble? Is There a “Perfect Storm” Brewing?

Commercial real estate has historically been a favored asset class of private equity groups, offering opportunities for diversification in holdings and a reliable income source through cash flow generated from rent payments. Commercial real estate investments have the potential to appreciate in value over time, as demand for space and rents on leases rise in growing markets. 

Yet there have been noticeable shifts in the commercial real estate market in our current post-pandemic, inflationary environment. Is there a “perfect storm” brewing? Is commercial real estate in trouble?

The Impact of COVID-19 on Commercial Real Estate

The COVID-19 pandemic and its aftereffects have dramatically altered the commercial real estate landscape. The pandemic caused a shift from in-office to remote work for employees, which resulted in many commercial office buildings sitting unoccupied. Despite recent return-to-office mandates, vacancy rates continue to rise for office space, particularly in tech-heavy metro areas. 

According to an August 2023 market report, nearly 20 out of the top 25 markets recorded an increase in vacancies over the previous year. The national vacancy rate stood at 17.5% at the end of August. With old commercial leases expiring while space remains vacant, rental prices and property values are declining. 

However, vacant office spaces are not the only effect COVID-19 has had on commercial real estate investors. Much of the larger economic fallout from the pandemic — namely inflation and subsequent interest rate increases — has also had a negative impact on the profitability of commercial properties for private equity investors.

The Added Impact of Rising Interest Rates

Many private equity groups have leveraged their commercial real estate acquisitions with mortgages because interest rates have been so historically low for the past decade. With low-interest rates came “cheap money,” and private equity groups increased their buying power and made larger acquisitions with commercial real estate mortgages. 

However, most commercial real estate loans have variable rates tied to an underlying benchmark. These rates are typically adjusted every five years according to their benchmark. Rising interest rates to curtail inflation have all but eliminated access to “cheap money,” so the private equity firms whose mortgage rates are being adjusted are in for an unpleasant and substantial increase in their payments.

Consider this scenario: If a private equity group borrowed $1 million at 3.75% over a 25-year term, their principal and interest payment totaled just under $62,000 a year. If you reset that 3.75% interest rate to a current rate of 7.5% — not an unlikely scenario given today’s average rates — that annual mortgage cost jumps to just under $89,000 a year. That difference has reduced the profit by a substantial $27,000 for the year. 

Unfortunately, rising interest rates are not the only hit to their profit…

How Are Commercial Real Estate Lenders Responding?

The lenders who hold these commercial mortgages have the right to request more capital from their borrowers as a result of the changes to their interest rates. These capital calls essentially prove to the lenders that their borrowers still have enough “skin in the game” to be committed to their mortgage payments. 

If we continue with the above example where a private equity group may face a doubled interest rate on a $1 million mortgage, the lender could request an additional cash infusion from the borrower to buy down the mortgage balance of as much as $304,000. (Of course, this is assuming that there hasn’t been a comparative doubling of rental income to make up for the profit loss. If the rental income has also doubled to make up for the profit shortfall, lenders may be less motivated to invoke a capital call.)

Historically, banks have been reluctant to invoke capital calls and have taken the position of “extend-and-pretend.” As long as commercial real estate loan payments are made on time, they typically won’t make an additional capital call. 

Changes in Policy

That unspoken policy has likely changed since the collapse of Silicon Valley Bank. In order to increase oversight, limit future stressors, and prevent another bank collapse, the Federal Reserve announced earlier this year that they will increase regulation on mid-sized banks, with more stringent amounts of capital and liquidity requirements for these banks.

How does this impact commercial real estate? Small and mid-sized banks account for 80% of commercial real estate lending in the United States.

In general, banks have limited options to raise capital. One option is to raise deposits and thereby increase the amount of their amount of liquidity; this has proven difficult in the current financial climate. Rising interest rates have led banking customers to seek out higher returns from vehicles like brokerage money market accounts. 

Another option to raise capital is for banks to sell additional bank stock. This has also proven difficult in the aftermath of the collapse of Silicon Valley Bank and other subsequent banks. These banks are left with one remaining option — make the capital call to the private equity groups holding commercial real estate loans.

What Does This Mean for Private Equity Investors?

What does this all mean for private equity investors? 

In the short term, private equity groups are likely going to hold off on new commercial real estate acquisitions until they can determine how much of their capital is at risk to bank capital calls on their commercial mortgages. 

They will also need to adjust for potential lower profits from higher interest rates and falling valuations. If a property only generates “x” fixed income and interest rates are “y” higher, then the balance means the property is worth “z” lower.

There is a silver lining, though. Private equity groups that have a strong cash position, with few leveraged properties, can take advantage of the commercial real estate bargains out there. This influx of capital could potentially help to stabilize the commercial real estate market.

How Chicago Trust Administration Services Can Help

Self-directed investors are known for their financial creativity and ability to pivot when market conditions change. While I can’t say what’s going to happen with commercial real estate in the next five to 10 years, I am confident that private equity firms will come out on top. If you’re wondering how changes to the commercial real estate landscape may affect your portfolio, give me a call. 

At Chicago Trust Administration Services, we can help investors diversify their retirement portfolios to include non-traditional asset classes through the use of self-directed IRAs. Alternative assets are highly regulated by the IRS and the transactions can be complex. 

As self-directed IRA administrators, we make your investment transactions for you so you can concentrate on growing your retirement portfolio and generating the returns you’re seeking.

To see how we can help, schedule a complimentary meeting with us by calling 312-869-9394 or emailing steve@ctasira.com.

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*The content and opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

**CTAS professionals are not financial advisors and cannot provide advice or recommendations regarding specific investment decisions.