The news in the commercial real estate (“CRE”) industry lately has been about as bad as it gets. In the 40 years I have been in the business the trajectory of the cost of capital has been largely downward for most of that time. Now that has pivoted and been aggressively pushed higher and faster than at any other point in the last 40 years. What does this mean? Unlike the Russian Debt Crisis in the late 1980’s, the S&L Crisis in the early 1990’s, the Dot Com Bust in the early 2000’s, or the GFC in that late 2000’s, this down cycle is being caused by exigent factors that have little to do with CRE. It’s basically all attributed to the Covid-19 pandemic and repercussions from actions taken to manage through it. CRE is suffering from “long covid” caused by changes in behavior in how space is utilized and rapidly rising interest rates driven by the Federal Reserve to combat inflation. Both changes in space utilization and inflation were caused by human reaction to mitigate the negative impact of the pandemic on the public.

In the case of space utilization, everyone stayed home and no one got fired for doing so. That not only created new behavior patterns but also provided anywhere from a 5% to 15% increase in take home pay. Workers saved on auto maintenance and gas, lunches and drinks, dry cleaning, clothes, haircuts, dining out, entertainment, travel, etc. Technology enabled many to be as productive at home as at the office. The result is that the false premise of office space utilization being necessary to be productive was exposed. Resistance to commuting to the office became a habit with a real value add proposition to the employees. Everyone got a raise and got to stay home. While there is a great deal of pressure in those services where collaboration for the producers is critical to be competitive and deliver sustainable value, WFH is not going away for those employees whose work is process oriented. Arguably, they make up 20 – 40+% of space utilization in many offices. If the value proposition of investing current time and resources (that have high immediate value) in going to the office to be rewarded with long term advancement (and remuneration) is not clear and tangible, the employee will always default to the near term value choice of WFH. Most government jobs fall into this category. Why go to the office if there are no negative consequences (short or long term) to staying home?

In the case of inflation, it is no surprise that when you flood the market with trillions of dollars of capital, people get raises, do not have to pay mortgages or rent, and can refinance their home with 2%-3% mortgages, there is a huge buildup of personal savings. When you flood the market with money, (dramatically increase demand) and keep companies from producing products (dramatically restrict supply), the obvious result is high inflation. The only way to bring down inflation is to detox off easy money and drive down demand. This takes time. The Fed cannot impact supply and interest rates are a very blunt tool to affect demand as interest rates only affect about 20% of the economy. Hence, we can expect higher rates for longer. To be sure, they are way too high now and will come down next year, but the days of 1%-2% interest rates are over for a very long time.

2023 has become a year of “risk off”, pencils down, paralysis by analysis, “tic tac toe”, thermonuclear war games. No one wins by being a first mover. That just results in self-assured destruction. The CRE industry is basically taking a breather while trying to figure out what’s next. Transactions across the board are down anywhere from 30% to 70% as participants wait to see how inflation moves and what the Fed is going to do with rates. This past week we saw positive news in a tepid employment growth with a resulting surge in the equity markets hopeful that the Fed will cease raising rates. There are trillions of dollars on the sidelines waiting for the “all clear” sign from the Fed. Once they see it, they will respond like a massive herd of wildebeest stampeding across the mara river fearless of the dangers lurking beneath the surface.

So, what do eternally optimistic people (virtually everyone in the CRE eco space) do when they cannot transact? They prepare. They work on underwriting models. They spend time on operations and asset management. They refine protocols and beat down costs while they investigate submarkets and investment opportunities in the capital stack where the paucity of available capital presents solid alpha returns. They spend time on networking and relationships. They prepare to raise capital. And some make lowball offers to try to find price discovery and test seller resolve.

Uncertainty will dominate sentiment and inhibit transaction activity through the remainder of 2023 and possibly into Q1 2024. Nevertheless, the capital custodians are getting anxious and they do have to place their capital sooner or later. If the Fed does take its foot off the gas and the market senses a return to predictability, the large money center lenders are likely to make the first moves and start the stampede selling assets to clean up their books. When they do, the smart money will be ready to feast.

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