Commercial real estate investment sales have already been trending down for some time, with higher interest rates creating uncertainty about the future direction of property values. In the fourth quarter of 2022, overall investment sales volume in the U.S. plunged 62 percent compared to the year before, to $138.9 billion, according to research firm MSCI Real Assets.
But the potential for recession in 2023 is creating further unease for many real estate investors, while still opening up new opportunities for some of them.
To figure out which investors are likely to benefit or to face challenges in the short- to medium term, WMRE recently spoke with Marcus Duley, chief investment officer at Walker & Dunlop Investment Partners, a commercial real estate investment firm headquartered in Denver that has $3.4 billion of assets under management and advisory split between debt and equity. Below are Duley’s thoughts about the current state of the commercial real estate investment market and the most attractive of today’s opportunities.
This Q&A has been edited for length, style and clarity.
WMRE: How do you think different segments of commercial real estate will fare in 2023?
Marcus Duley: We’re still bullish long term on multifamily and industrial. We’re going to launch a dedicated multifamily and industrial fund. I think the underlying fundamentals are still strong, particularly on the demand side. That’s where our focus is. From my perspective, office is still opaque in terms of where supply and demand will shake out, particularly with the impact from work-from-home. And as you have looming maturities in the office space, there could be some distress from refinancing and as tenants roll from a leasing standpoint.
WMRE: What about retail?
Marcus Duley: I think retail, particularly from a grocery-anchored standpoint, will continue to be strong. It’s known to be very resilient, especially during COVID. It’s a product type from our perspective—we haven’t done a ton of it—that’s on the upswing.
WMRE: What are the expectations during the first quarter?
Marcus Duley: We’re early on in the first quarter, and it’s generally slow. We’re going through conference season and as people transact because they have to transact, they will set the market. It will be comps for appraisers and we’re seeing it now. Cap rates are adjusting.
WMRE: What kind of transaction volumes are you expecting?
Marcus Duley: There’s a lot of capital and dry powder that wants to transact on the buy [side]. I think on the sell side, you’re going to see tiers of transactions. You’re going to see people that are sellers because they have to sell, because they’re loan is maturing. They financed with high-levered floating rate debt and so there’s some sort of distress. Those will be the first group of sellers. As we have more clarity into pricing and the bid-ask narrows during this price discovery, you will see people sell because they are at the end of the fund life. They are in a position to maybe not make as much money as if they sold in 2021 or early 2022, but enough [that] they’re still achieving their targeted returns. Overall, my expectation is transaction volumes will be flat, but maybe down over 2022.
WMRE: Elaborate on what entities are most motivated to make deals right now on the sell and buy side?
Marcus Duley: The entities most motivated to make deals or transact are groups that have to transact. Groups that in 2021 financed with floating-rate bridge loans at 80 percent leverage, with interest rate caps at 2 1/2 percent that are rolling off. They have to act. Whether that transaction is a sale or a refinance that also requires additional capital vis-a-vis preferred equity or mezzanine in the form of a cash-in refinance, those groups will be the most motivated to make deals. On the buy side, capital is patient and waiting for transactions to hit the market at the appropriate pricing level. As these motivated sellers begin to sell, that will set the market precedent for pricing and cap rates.
WMRE: What about buyers?
Marcus Duley: Buyers won’t buy at prices where they will not hit their targeted returns. Ultimately, what will happen and has happened is cap rates are adjusting. As an investor, I cannot buy a property and take a lower return. Return expectations have not come down and if return expectations don’t come down in an environment with higher costs of capital, the value of the property has to come down. I don’t see return expectations changing for the relative risk category from value-add to opportunistic.
WMRE: What is the alternative to investors selling?
Marcus Duley: If you’re facing a maturity or facing other stress related to high interest rates, you’ll have to look for other sources of capital—either preferred equity, mezzanine or JV equity. I think for us there’s going to be a lot of opportunities to invest in these higher yielding debt products as a result of these looming maturities. There are a lot of groups that have capital or are raising capital to provide preferred equity and mezzanine. We’re positioned well at Walker & Dunlop Investment Partners for preferred equity deals. For us, we’re seeing tremendous demand. It’s helping fill out the capital stack from an acquisition standpoint. The refinance leverage is lower than what was available.
WMRE: Are you expecting to see a lot of foreclosures?
Marcus Duley: It depends. If lenders are willing to extend, which they may be willing to do, it’s going to cost. Borrowers can extend if they pay down a loan to x loan to value. If that doesn’t happen, there will be foreclosures. I don’t want to say there will be a foreclosure wave because there is rescue capital vis-a-vis preferred equity, so I think the first [thing] is to look to be recapitalized. But weaker sponsors with weaker properties are going to face foreclosure in some instances.
WMRE: What investors are in or out of the market right now?
Marcus Duley: From an investor standpoint, high-net-worth [investors] are in and institutions are in as are your pension funds and family offices. Everyone wants to transact [in] commercial real estate; right now there’s just not a lot of transaction volume. The caveat to that for investors who aren’t in, there are institutions, particularly certain pension funds that are over-allocated to real estate as result of what’s known as the denominator effect. Some institutional investors are out of the market as they look to rebalance their investment portfolio.
WMRE: What type of real estate investors are best or worst positioned for 2023?
Marcus Duley: Investors who are best positioned are those who don’t have any current portfolio issues or looming portfolio issues. Their portfolios are primarily [financed with] fixed-rate long-term debt with limited maturities in the near term and [they] have dry powder to buy at attractive basis today. Investors who have to deal with problems within their existing portfolio from a capital market standpoint are in the worst position. You have capital reserves to handle problems in your own portfolio. A looming maturity that may require you to put in cash or get an extension where you have to pay down the loan requires cash and negotiations with lenders and selling particularly at an inopportune time. Those investors will be distracted with managing their existing portfolio and managing the cash needs of their existing portfolio.
WMRE: What advice do you have for investors right now?
Marcus Duley: My advice is real estate is typically resilient and the short term maybe a little uncertain and choppy, but long term if you’re invested in quality properties, you’ll be fine. It’s really about staying power.
WMRE: What’s the question you get a lot from investors?
Marcus Duley: One question we get a lot is: where do you see the best opportunities in 2023? Where we see the best opportunities is middle market real estate. We define middle market as being transactions of $100 million and below. We think within that space there are better opportunities to achieve alpha, particularly with more local entrepreneurial sponsorship. That’s going to be true as you see certain distressed sellers. We’re hyper focused on the middle market space. We think that’s still the best place to find deals where you buy at an attractive basis and have an opportunity to truly create intrinsic real estate value and have an opportunity to outperform.
WMRE: Any particular geographical regions?
Marcus Duley: Generally speaking, it is in high growth markets. We are still bullish on the Southeast, with the major markets of Orlando, Tampa, Atlanta, along with Denver, Dallas, Houston. It’s in certain stable markets like Philadelphia, Minneapolis and major markets on the West Coast.