Understanding Commercial Real Estate

Recently there have been a lot of scary reports about how commercial real estate (CRE) may become a big landmine for the US economy. As of October 2023, US banks held almost $2.95T in CRE loans, which makes them vulnerable to weaknesses in this sector.

CRE relies heavily on debt financing. While developers need to contribute some equity, most of the financing for a project is debt. High interest rates make it harder to raise money, as these projects need to compete with the ten-year US treasury bond. That does not even consider the condition of the economy — if it is headed for a downturn, and if the market for a particular type of CRE is changing.

It is also a local business. While the gloom and doom of national statistics may look scary, the picture will be rosy in some areas but bad in others. That is because each area has its own demand and supply dynamics.

Next, we need to understand that there are basically five types of CREs. These are:

• Office spaces

• Commercial retail space, like shopping malls, strip malls, and leased space for retailers, service shops, banks, restaurants, and stores

• Industrial, like warehouses, data centers, factories, and the like

• Multifamily housing

• Special purpose, like gyms, stadiums, parks, parking spaces, terminals, and others not included in the descriptions above

When multiple functions above are grouped in one location, we call that a mixed-use development.

The pandemic has overturned the market for office space. Technologies like Zoom and Google Meet allow workers to work from home and just occasionally drop by the office for once-a-week or infrequent meetings. Artificial intelligence (AI) has also cut down the number of white-collar jobs that would normally require an office. Although Class A office space is still in demand from Fortune 500 companies, demand for older Class B and C office space is down. Often these older offices are dark, look old, and are not ESG compliant.

Since many retail and restaurant spaces in big cities need the working crowd for their business, they have been negatively affected too.

While office spaces may suffer higher vacancies, open storage, warehouses, depots, and data centers in the right locations are quite profitable because of the internet and e-business growth.

How CRE Investors Measure the Health of a Project

CRE investors generally have some metrics to consider so they do not lose money on the property. This is of course after they have considered "location, location, location" as a factor since foot traffic for retail, desirability as a place to live for multifamily, or access to logistics points for industrial CRE are factors to consider.

Some of the metrics they need to consider include:

• Net operating income. The amount you net each year from leases and rentals after property maintenance, taxes, property management costs, insurance costs, debt-servicing costs, and other costs are subtracted from the gross revenue.

• Cap rate. This is the amount of net operating income you get per year divided by the total cost of the property to get a percentage. Hence if your net operating income after all costs have been subtracted is $5M a year, and the property costs $100M, then your cap rate is 5%.

• Cash on cash. This simply means the pretax return you get from the amount you invested versus the amount you invested in the property. As a grossly simplified example, if you invested $1M in a real estate project and your pretax share of the total earnings that year is say $100,000 then your CoC is 0.1 or 10%.

• Loan to value (LTV). If you are getting co-financed with a loan, such as from a bank or other institution, this is something to consider. For example, if your group has $3M total to invest as total equity, and the property costs $10M, then you need to take out a $7M loan. Hence, your LTV is 70%.

• Debt service coverage ratio (DSCR). This is a metric used by debt issuers to determine if your project will get a loan, and it can also cause you to trigger some action from the debt issuer if you fall below an acceptable minimum. For example, if your $7M loan is payable in ten years at $710K per year, ideally you should be making more from the rentals and leases so that the property pays for the payments. A low DSCR could trigger the bank to ask the developer to add more equity.

Again, interest rates have a major impact on CRE, considering that most of it needs debt financing. Higher interest rates from the Fed and higher or lower 10- and 30-year treasury bond rates can all contribute to whether a real estate development gets a loan to proceed or continue.

Rocky Times Ahead

If your CRE property is really in demand, and the tenants are relatively unaffected by macroeconomic and monetary factors, then lucky for you. But if you are unlucky enough to have an outstanding debt for something like a Class B or C office space, and there are far too many of that office building in your area for you to make demands on your existing tenants, then you need to decide if you want to spend to upgrade your property, convert it, tear it down and build a new CRE, or just sell out to other parties without falling into foreclosure proceedings.

CRE as a business gets harder as interest rates rise because of its large debt component. As a sector, it is a major part of our US GDP and an asset class that many investors and banks hold. Hopefully, it can survive these next few months and years, but most likely we should expect some pain in the sector soon.