Commercial real estate’s moment of truth

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Citypoint was the City of London’s first skyscraper. When it was built in the 1960s, as an office for British Petroleum, it was the tallest building completed in the square mile since St Paul’s Cathedral in 1710.

Today, the tower near Moorgate station is again leading the market in City real estate — but in a different way.

Brookfield Corp., the Canadian investment group, last month put Citypoint on the market, seeking offers over £500 million ($897 million). If it sells, it would be the largest office building to change hands in the City in more than two years.

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The hiatus in dealmaking has been the main outward symptom of a downturn in commercial real estate that began after interest rates started to rise in March 2022. Higher rates make the debt that is the lifeblood of real estate deals much more expensive.

Prices across commercial property, a category that includes shops, offices, hotels and warehouses, have fallen about 20 per cent from their peak in 2022, analysts estimate.

But predictions of a crash akin to the one that followed the 2008-10 financial crisis have so far not materialized. Relatively few buildings in distress have surfaced, and only a handful of lenders have been hit by bad loans.

The question is whether the storm is now over for the battered commercial property sector, or the worst is yet to come. Lagging valuations mean investors and lenders can avoid facing up to bad news about falling property value immediately. Financial damage from the downturn may emerge for years after the market starts to recover.

The lack of deals has made it harder for valuers to pin down exactly what properties across the multi-trillion-dollar market are worth. In parts of the sector, like big London offices, there is scant market evidence.

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Citypoint was last independently appraised for its lenders in March 2023 at £670 million. But rating agency S&P Global Ratings put its value at £431 million in August, down from £457 million in autumn 2023. The key issue is whether it can sell for more than the roughly £460 million of debt secured against the building.

The Citypoint sale is comparatively transparent because of its high profile and the disclosures required for the commercial mortgage-backed securities linked to the building.

But some investors warn there are worse realities lurking within unsold portfolios. “The beauty of our industry is that it is so opaque and inconsistent,” says one senior executive at a private equity group.

The strategy in that case is just to hold your breath long enough that values come back and you never have to write it down

Hamid Moghadam, chief executive, Prologis Inc.

“Some managers will be more honest. And some have been more optimistic. I think it’s all over the place. And we won’t really know until the transaction volume picks back up.”

Not all property investors conduct third-party valuations like the one applied to Citypoint, relying instead on their own appraisals.

Hamid Moghadam, chief executive of Prologis Inc., the largest U.S.-listed commercial landlord managing around US$200 billion, says some managers are posting “phoney baloney” returns because they have not written down property values to reflect market reality during the downturn.

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“The strategy in that case is just to hold your breath long enough that values come back and you never have to write it down,” he adds. “But I don’t think that is the right way of treating your investors.”

Any investors who are “holding their breath” on old valuations will be running out of air. Now that interest rates seem to have peaked, dealmaking is picking up. Other large London office buildings, including one known as the “Can of Ham” owing to its distinctive shape, are also now on the market. Larger portfolios of warehouses, retail parks and apartments are changing hands.

This resurgence will be welcomed by those who want to realize their investments or hope to buy at discounted prices. But it also brings a moment of truth on pricing.

Peter Papadakos, head of European research at advisory firm Green Street Advisors LLC, says values will become clear as more properties are pushed on to the open market.

“That is where the truth comes out,” he adds.

Brookfield has brought Citypoint to market in part because the debt against the building, which was extended last Christmas at a higher interest rate, falls due in January.

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The building is also owned by a fund within the group that dates back to 2012 and is largely selling its remaining assets. Overall, the fund has reported strong performance, with a realized 18 per cent net internal rate of return — an industry measure of annual returns. Brookfield declined to comment on how it valued the building for fund investors.

The Canadian group, which also co-owns London’s Canary Wharf and flagship offices in Manhattan, has invested around £40 million improving Citypoint, boosting its occupancy rate to around 90 per cent and securing better rents.

It is trying to sell at a challenging time.

Transaction volumes globally fell 45 per cent from 2022 to 2023 and have since flatlined at the lowest levels in a decade, according to MSCI. Its analysts said deals had been held up by “a mismatch in buyer and seller pricing expectations that must narrow further for liquidity to return”.

In the United States, MSCI’s measure of property-related financial distress reached nearly US$100 billion in June, but remained far short of the almost US$200 billion recorded at the previous peak in 2010. “Do not go get your ‘I Survived the Great Pricing Reset’ t-shirt quite yet,” MSCI analysts wrote.

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Investors also debate whether current pricing in markets hit by the shock of higher borrowing costs and geopolitical events is the best way to measure an asset’s long-term value.

Green Street estimates that across the industry many real estate investment trusts and institutional funds are still valuing their properties at roughly 10-15 per cent over what could be achieved right now.

The picture varies widely. In areas like apartment blocks, warehouses and some retail properties, rising rents and customer demand are giving investors confidence. Offices are more troubled, partly because of uncertainty about the level of demand in a post-pandemic world of hybrid working. But values also vary hugely depending on location, age and quality.

Scrutiny over valuations has been felt acutely by a few large investment trusts managed by property giants including Blackstone Inc. and Starwood Capital. Group LLC

During the pandemic, the two famed investment groups were the most successful on Wall Street in attracting investment from wealthy individuals using private funds that offered limited opportunity for withdrawals.

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Do not go get your ‘I Survived the Great Pricing Reset’ t-shirt quite yet

MSCI analysts

Their two funds, Blackstone Real Estate Income Trust (BREIT) and Starwood Real Estate Income Trust (SREIT), collectively attracted over US$60 billion between 2017 and 2022, and went on a buying spree that peaked in 2020 and 2021 when property values were high and interest rates were near zero.

Both BREIT and SREIT have considerable leeway when it comes to valuing assets and were slow to mark down property values when interest rates began to rise quickly in 2022.

But fund investors formed their own views, pulling about US$20 billion out of both funds since late 2022 and forcing managers to limit redemptions in order to conserve cash and reduce the amount of property they had to sell.

Blackstone’s executives offloaded some of BREIT’s most profitable assets, including a stake in the Bellagio Hotel in Las Vegas. The vehicle also secured US$4.5 billion of new investment from the University of California in early 2023 to bolster liquidity and avert a fire sale. But the return guarantees it promised the university have created a US$751 million liability on Blackstone’s balance sheet.

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Since 2022, Blackstone has sold US$27 billion of property at an average premium of four per cent to carrying value. In recent months, redemptions have slowed sharply and Blackstone has paid out investors’ requests in full. President Jonathan Gray said this month the fund was on track to begin drawing new money again.

The company said the semi-liquid structure of BREIT had worked as intended. It added that rising prices, falling debt costs and lower levels of new construction activity “all point to a continuing recovery in commercial real estate.”

Starwood sold fewer properties, because founder Barry Sternlicht believed real estate markets were in panic mode. To meet about US$5 billion in redemption requests, Starwood sold US$2.8 billion of assets but also used internal cash and drew down almost all of a US$1.5 billion credit line.

Starwood was able to sell its properties “within two per cent of SREIT’s gross carrying values,” it has told investors, implying about a four per cent discount to their marks when including debt.

But by paying back investors with its own cash, Starwood has depleted its coffers and in May was forced to restrict quarterly redemptions from up to five per cent of the fund’s net assets to just one per cent. The move caused a furor among SREIT’s investors.

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In September, SREIT met just four per cent of redemption requests, according to public filings. Investors had placed orders to withdraw nearly US$780 million from the US$9.4 billion fund last month but received just Us$31 million in cash, the filings state.

The fund has begun marketing properties like apartments and logistics facilities in recent weeks, say two people familiar with the matter, adding that it has received some price indications above the most recent valuations.

The company declined to comment, but Sternlicht previously told investors that redemption restrictions on SREIT could last into mid-2025 “in anticipation of a lower interest rate environment and an improved real estate capital markets picture.”

It will probably take years for real estate pricing, and the damage to investors and lenders, to fully shake out.

On the plus side, lower overall debt levels going into this reset in pricing have made the sector more resilient compared with the years after the 2008 financial crisis.

Lenders’ attitudes and tolerance towards bad loans and troubled properties are the key factors in whether managers can ride out the downturn without ever having to fully address the trough in property values.

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“We are never going to see a large enough quantum of distressed sales that the volume of distressed sales itself will impact on the overall pricing of commercial real estate,” says Green Street’s Papadakos.

“In the [global financial crisis] we did have a lot of distressed sales that cascaded those values even deeper into the red.

“This time, the valuations will trickle down to flat for a long time. Maybe for 24 to 36 months,” he adds. The recovery will be “protracted…because no one is forced to do anything.”

In the United Kingdome, nearly 80 per cent of property loans had a loan-to-value ratio below 60 per cent, according to Bayes Business School’s mid-year report. Default rates have risen, but only to two to four per cent on bank loans and 14 per cent for debt funds set up specifically to finance real estate, Bayes said.

There are pockets of more acute risk in commercial real estate. I think those are increasingly recognized and marked

Mark Carney

Raimondo Amabile, co-chief executive of PGIM Real Estate, says lenders are showing “a lot of patience” for assets that may currently be worth less relative to the loans against them, but where there is solid income and the situation is improving as interest rates fall.

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Only some subsectors are causing headaches for lenders. “Behind the scenes, there is a lot going on in the office sector. If you go to talk to the banks, there is a lot — 90 per cent [of actual or potential distress] is office and the other 10 per cent is struggling retail,” he says.

“Is this going to generate a huge wave of distress in the market? No,” he reasons, because these troubled assets are too small a part of commercial real estate overall.

Mark Carney, the former Bank of England governor who is now chair of Brookfield Asset Management Ltd., told the Financial Times this month that post-financial crisis regulations meant that banks were stronger and real estate risks were less concentrated.

“When there have been hits…it is more broadly diversified,” he said. “There are pockets of more acute risk in commercial real estate. I think those are increasingly recognized and marked.”

Property values are stabilizing, and beginning to rise in some sectors like U.S. residential properties and European logistics. Most investors expect that positive trend will gather momentum as more interest rate cuts come through.

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One big risk to that recovery is a divergence between central bank interest rates and actual borrowing costs. Baseline borrowing costs in major financial markets have risen in the past month, even though policy rates have remained unchanged or fallen.

Blackstone’s Gray previously told the FT that a significant risk to real estate would be if the large scale of government deficits around the world led to a rise in the cost of capital “separate and apart from inflation.”

“This recovery would take longer if you [had] that,” he said.

Debt repayment deadlines are not the only factor pushing properties on to the market. Investment managers, especially those with time-limited funds, are under increasing pressure to return cash to their investors.

Papadakos says many managers “need desperately” to exit, especially if they are trying to raise a new fund. “If you go around asking a pension fund for £500 million, they will probably tell you: ‘give me [back] the £350 million that I gave you in 2021,’” he says.

Selling can be double-edged if the price agreed implies a mark down to the rest of the portfolio. Under pressure from lenders and investors, managers can try to sell those properties that will change hands at or close to their book value.

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Provided borrowing costs remain stable or decline, most market analysts expect commercial real estate will not experience a squeeze akin to the one following the global financial crisis.

Amabile of PGIM predicts that many distressed loans will ultimately be sold by the banks to opportunistic funds, which buy them well below face value in the hope of recouping value later on.

“Normally, the market crashes. There are a couple of years of ‘extend and pretend.’ They realize there is no solution. And then they end up in [non-performing loan] sales,” he says.

It was through a distressed debt deal that Brookfield acquired Citypoint. The building’s previous owners had paid £650 million in 2007, just before the market crashed, and defaulted on their loans in 2012. Brookfield bought the debt in 2014 and took full control of the building in 2016. The price they paid was enough for the lenders to recoup their money, according to press reporting at the time.

The building’s history is a reminder that there are winners and losers in the trading game around prime commercial properties, but the play never stops.

© 2024 The Financial Times Ltd

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