‘Dark Days Ahead’

For the leaders of some of the biggest investment vehicles in commercial real estate, the matter of whether the U.S. is on the verge of a recession is no longer a question of if, but when.

Less than 24 hours after the Federal Reserve lifted interest rates by 0.75 percentage points, fund managers and other finance executives gathered at Bisnow‘s National Finance Summit at 780 Third Ave. in Manhattan. KKR Head of Real Estate America Chris Lee said that his firm is now predicting some form of mild recession in 2023.

“It’s gonna be an interesting time on the optimistic side, but also a time where values will continue to deflate in the short term,” Lee said. “I think there will be some people forced to, maybe not trade assets, but will need some sort of structured capital.”

Fed Chairman Jerome Powell said Wednesday he is focused on bringing inflation back down to 2% — it is currently over 8% — and the Fed indicated more large increases ahead. The move, though anticipated, fueled recession fears and U.S. stocks tumbled as a result. On Thursday, the Bank of England said that country is now in a recession, as its central bank raised rates to 2.25%. The raises come against a backdrop of a looming energy crisis in Europe and Vladimir Putin’s plans to intensify Russia’s war efforts against Ukraine. With the macroeconomic and geopolitical climates changing rapidly, uncertainty is rising, throwing cold water on the real estate sales market.

“All that uncertainty I think has ground transaction activity to a halt,” Morgan Stanley Real Estate Investing co-CEO Lauren Hochfelder said. “I think we’re getting into a period where I don’t think we can rely as much on market tailwinds, and we’re gonna have to manufacture our own returns.”

Certainly, there have been some high-profile cases of office owners handing back keys to lenders. This week, Hines agreed to turn over a downtown Washington, D.C., office building back to its lender after the anchor tenant left. In New York, Blackstone gave up on a Midtown Manhattan office building earlier in the year, and multiple Chicago skyscrapers have suffered the same fate.

“That just goes back to the fundamental issue that it’s extraordinarily expensive to carry the asset now, let alone to pay for the restabilization costs,” Eastdil Secured Managing Director Grant Frankel said of offices being handed back. “So I think you’re gonna see a lot of that.”

But panelists largely pointed to a market that has very little activity, mainly because the outlook is so murky.

“The issue is that there’s just not a lot of depth in the market today in terms of liquidity,” Apollo Real Estate Private Equity partner Daniel Kwon said. “If we had a deal, generically, where we would’ve gotten 10 to 12 bids a year ago, or even six months ago, for that matter, now you see two to three bids.”

He said today’s real estate valuations are based on an environment of much lower interest rates over the last 12 years, which rapidly changed with the Fed’s benchmark rate now at its highest level since 2008.

“I just think that’s going to have to go out the door and we need to rethink about what valuation looks like on a go-forward basis,” Kwon said.

Apollo, one of the largest asset managers, has hit the brakes on deals, he said, while it, like everyone, seeks insight into what is happening with the economy. Until there is clarity, the market won’t normalize, he said.

“I’m not so sure that the recession is going to be a mild one. I think we’re toeing a really fine line right now with the Fed where if inflation persists, it that is going to do whatever it can to destroy demand,” he said. “That includes a hard recession. Recessionary planning, that’s not out of the question.”

That view is growing in the business community. JPMorgan CEO Jamie Dimon told the House Financial Services Committee there is only a “small chance” a “soft landing” is going to actually happen. Other economists and business leaders have echoed those views, but not everyone agrees. Evercore ISI Chief Equity and Quantitative Strategist Julian Emanuel has said that a soft landing is more likely than not, Bloomberg reported. But Deutsche Bank analysts said in a note this week that the Federal Reserve would have to lift rates to 5% to get inflation under control. Invesco Managing Director Charlie Rose said his firm has seen a significant drop in transaction volume — though he said there are still strong fundamentals underpinning the real estate market.

“Dark days ahead, most likely,” Rose said, but made sure to stress how different the situation is now compared to the Global Financial Crisis.

“We do not see this being a 2008-type of event for commercial real estate,” he said. “Supply is much more in check, credit standards are just in a totally different place compared to what credit standards were during that 2005 to 2007 time period.”