Commercial Real Estate Outlook: Opportunities Amid Distress
Text on screen: PIMCO
Text on screen: PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized.
Text on screen: What is the current state of the commercial real estate market?
Text on screen: John Murray, Portfolio Manager, Commercial Real Estate
Murray: The commercial real estate market is in a state of disarray – public securities are wrapped up in the broader public market volatility, lenders are retrenching, and equity buyers and sellers are paralyzed with uncertainty around cap rates, recession risks, and higher debt and construction costs
With this backdrop, traditional transactions are dead and there’s limited visibility into pricing, but regressions and our ground-level experiences suggest pricing is down as much as 5-20%+, depending on the sector
Text on screen: Commercial real estate owners have turned to “special situations” financing
Images on screen: Commercial real estate exteriors
a lot is happening beneath the surface, as CRE owners needing liquidity have turned to much more specialized solutions.
Text on screen: Stages of distress in commercial real estate markets
For commercial real estate, this is the biggest downturn since the Global Financial Crisis of 2008, and we see this downturn following the same general stages as past downturns.
Text on screen: Stage 1: Public market dislocations
Images on screen: Office exteriors
The first stage is characterized by public market dislocations, which we’ve certainly seen this year.
FULL PAGE GRAPHIC: TITLE – REIT Values Have Declined… and CMBS Spreads Have Widened. The graphic consists of two line graphs, one depicting price changes of REITs (Real Estate Investment Trusts) and the other depicting the spreads of CMBS (Commercial Mortgage Backed Securities). The REIT graph spans the period of March 2019 until October 2022, while the CMBS graph spans from January 2021 until October 2022. The REIT graph shows an increase in 2019, a large decrease in 2020, a very large and rapid increase in value over the course of 2021, and a large decrease in value this year, 2022. The decrease is highlighted with a red box and the text “Decline since 2021.” Next to the REIT chart, the CMBS chart shows an increase in spread widening of almost 100% over the period it covers. Spreads started around 350 basis points in January 2021, and remained in this neighborhood throughout 2021, with a brief dip near 250 in June 2021. In December, they began to rise over the course of the next year. Currently, basis points for CMBS spreads sit around 650, almost double where they were a year earlier. The chart shows that while equity values are declining in the REIT sector, credit spreads are rapidly widening in the CMBS sector.
REITs are down over 25% year-to-date, and CMBS BBB spreads have widened by over 200 basis points.
Now, this public volatility has hit private commercial real estate, as REITs are forced to the sidelines, CMBS originators have disappeared given the volatility in the fixed income markets, and even balance sheet lenders have tightened due to increased regulatory pressures and limited paydowns this year.
As a result,
Text on screen: Stage 2: Special situations
Images on screen: Office exteriors
we’re now entering stage 2, or, the special situations stage.
Over the past month, we’ve seen a dramatic shift from traditional buyer/seller deals to more complex and often under the radar restructurings.
Examples include multiple rescue capital situations where CRE owners now need bridge capital to finance upcoming loan maturities or existing projects.
On the lender side, we’ve seen a tremendous pickup in loan sales from banks looking to get ahead of risk downgrades.
Images on screen: Central banks
with central banks tightening aggressively, we expect this special situations stage to persist for at least the next 1-2 years.
Text on screen: Stage 3: Deeper distress
Images on screen: Office exteriors
a likely global recession would eventually push us into the final stage of a CRE downturn beginning in late 2023, where deeper distress builds as a recession leads to tenant defaults and downsizing.
These fundamental pressures will collide with ballooning loan maturities starting in 2023, foreshadowing a second wave of loan defaults and non-performing loan sales.
Text on screen: Where are the investment opportunities today, and what tail risks give you the most concern?
With dislocation comes opportunity, particularly for those who can provide creative structuring solutions and/or move across the four quadrants of public and private CRE debt and equity.
Text on screen: TITLE – Areas of opportunities: BULLETS – Public markets: Tactical opportunities in CMBS and REITs, Private markets:, SUB-BULLETS - Senior loans, Junior debt, Preferred equity, Discounted loan purchases from banks, Rescue loans to non-bank lenders
On the public side, given the broad and somewhat indiscriminate public market selloffs today, we see tactical opportunities in both CMBS and public REITs.
On the private side, it’s a great time to be a solutions provider. With nearly all forms of lenders shut out of the market, we’re seeing an explosion of opportunities in these stage 2 situations ranging from senior loans that can generate yields in the high single digits, to junior debt or preferred equity positions that offer mid-teens+ returns.
As CRE lenders look to reduce risk, we see a number of opportunities to provide solutions, including discounted loan purchases from banks facing regulatory pressures, as well as rescue loans to non-bank lenders facing margin call pressures.
In addition to the obvious macro pressures, commercial real estate faces another tail risk in the form of redemption pressures that could overwhelm open end core funds and create an unprecedented technical pressure on the commercial real estate market broadly.
Text on screen: TITLE – Why core funds face risk of reversal in capital flows: BULLETS – The “denominator effect”: public security mark-downs imply an over-allocation to private CRE, Little movement in core fund valuations despite CRE prices being down
As rates have reversed, these core funds face the risk of a significant reversal in capital flows from a confluence of factors:
First, the “denominator effect” is impacting allocations to CRE broadly, as the drop in public securities implies an over-allocation to commercial real estate for large pools of capital including pension funds.
Secondly, despite implied commercial real estate values being down 5-20%+ this year, core fund marks have barely moved.
FULL PAGE GRAPHIC: TITLE – Total Returns— ODCE Index vs Equity REIT Index. The graphic consists of a bar graph measuring the total returns of the ODCE Index (Open-End Diversified Core Equity Index) and the NAREIT Equity REIT Index (National Association Of Real Estate Investment Trusts Equity Real Estate Investment Trust Index), over a 10-year period, a 5-year period, 3-year period, 1-year period, and the 1H2022, the first six months of 2022. Over the 10 year period, 5-year period, and 3-year period, the ODCE Index outperformed the NAREIT Index by 1.4%, 2.2%, and 4.9%, respectively. It returned 9.7%, 8.9%, and 10.2% over these periods, while the NAREIT returned 8.3%, 6.7%, and 5.3%, respectively. Over the 1-year period and the 1H2022 period, the ODCE continued to outperform, by a far more dramatic margin. NAREIT values declined 5.9% in the year, and 19.2% in the 1H2022, while the ODCE returned a 21.5% gain in the 1-year period and a 12.5% gain in the 1H2022. The graph shows that ODCE has outperformed the NAREIT over many different periods of time, and, further, the outperformance has grown especially stark in the past year.
This is astounding when you consider the nature of a typical core fund portfolio, which includes substantial exposure to long term, fixed rate leases which have undoubtedly repriced in the private markets given the dramatic move in rates.
Logically, many investors in these funds are starting to anticipate that core fund marks will drop in the coming quarters, and are heading for the exits.
Considering the speed and scale of the rate moves this year, this wave of redemptions could be even worse than what we saw in the global financial crisis.
Core funds will eventually need to shed assets, which portends yet another negative pricing pressure for commercial real estate in the coming years.
Text on screen: For more insights and information, visit pimco.com
Text on screen: PIMCO
All investments contain risk and may lose value. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Collateralized Mortgage Obligations (CMOs) may involve a high degree of risk and are exposed to risks such as credit, default, market, interest rate, prepayment and extension, and certain classes or series may have more or less volatility depending upon the predictability of cash flow for such class or series. Investors may lose some or all of the investment and there may be periods where no cash flow distributions are received.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
The MSCI US REIT Index is a free-float adjusted market capitalization weighted index that tracks the performance of 136 equity REITs that trade on public markets.
The FTSE NAREIT All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. equity REITs. The 208 constituents of the index include all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property.
The National Council for Real Estate Investment Fiduciaries’ (NCREIF) Fund Index -- Open-end Diversified Core Equity (ODCE) provides quarterly and annual total returns for 28 institutional open-end commingled real estate funds. All the funds in the ODCE pursue a “core” investment strategy and some have performance histories going back to 1978. The NFI-ODCE is market-weighted and reported both gross and net of fees. The computations are time-weighted as described more fully on the NCREIF web site at http://www.ncreif.org
It is not possible to invest directly in an unmanaged index.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. | PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Irish Branch (Company No. 909462), PIMCO Europe GmbH UK Branch (Company No. 2604517) and PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 15 of the German Securities Institutions Act (WpIG). The Italian Branch, Irish Branch, UK Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority; and (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2). The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. PIMCO Asia Limited is registered as a cross-border discretionary investment manager with the Financial Supervisory Commission of Korea (Registration No. 08-02-307). The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Investment Management (Shanghai) Limited Unit 3638-39, Phase II Shanghai IFC, 8 Century Avenue, Pilot Free Trade Zone, Shanghai, 200120, China (Unified social credit code: 91310115MA1K41MU72) is registered with Asset Management Association of China as Private Fund Manager (Registration No. P1071502, Type: Other) | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862. This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs. | PIMCO Japan Ltd, Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No. 382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association, The Investment Trusts Association, Japan and Type II Financial Instruments Firms Association. All investments contain risk. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Taiwan Limited is managed and operated independently. The reference number of business license of the company approved by the competent authority is (110) Jin Guan Tou Gu Xin Zi No. 020. 40F., No.68, Sec. 5, Zhongxiao E. Rd., Xinyi Dist., Taipei City 110, Taiwan (R.O.C.). Tel: +886 2 8729-5500. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Av. Brigadeiro Faria Lima 3477, Torre A, 5° andar São Paulo, Brazil 04538-133. | No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2022, PIMCO.