By: John Bell and Jon Kleinberg
March 06, 2023
Experience trading REO/CMBS and distressed assets has become a distinct advantage in today’s capital markets environment. Senior Managing Directors John Bell and Jon Kleinberg developed a practice focused on executing these types of complex investment sales transactions, giving them unique perspective on the factors driving today’s trends and what it takes to maximize value. Here, they explain current sector challenges, outline risks, and provide insight into how to approach investment sales strategically.
Are we seeing any recovery in the office sector?
The uncertainty surrounding future office space needs remains a top challenge for tenants, landlords and lenders. Many companies are still deciding on the best workplace strategy to bring employees back to the office and the effects of this change on space needs.
In turn, owners are grappling with how to best position their assets to serve existing tenants and capture new ones in an increasingly competitive market, while investors are reticent to deploy capital until the environment stabilizes. In some cases, it’s a chicken-and-egg scenario.
The substantial decline in transaction volume experienced during the second half of 2022 is expected to continue through much of 2023.The significant number of loans maturing this year will force borrowers unwilling or unable to refinance at higher interest rates and a lower loan-to-value ratio to sell or return properties to lenders.
However, we do see green shoots. Our most recent value-add endeavors in the office market have garnered robust attention from investors, as evidenced by confidentiality agreement counts matching the pinnacle of the market, albeit at reduced reset pricing. This reaffirms investors' faith in the feasibility of the office market – though with revised rental rates.
Can you explain the current real estate investment trends? And the risks?
Nationally, many tenants want shorter lease terms and smaller footprints to accommodate workplace trends, including WFH and hybrid strategies. Small to mid-size companies are more likely to have a higher ratio of employees working in the office versus larger corporate tenants.
Pre-pandemic, 5-10 year lease terms were the norm. Today, it’s 3–5 years, which creates more risk and vulnerability for a potential investor because shorter lease terms cause constant churn. Even stabilized offices are experiencing a continuous cycle of leasing costs.
There is a definitive flight-to-quality trend where new leasing is happening. Tenants want to be in contemporary office spaces that offer modern design, flexible workspaces and abundant amenities. In many markets, new suburban office assets are proving their ability to accommodate these demands, and typically have the added benefit of being closer to employees’ homes – an attribute that appeals to employers looking for ways to motivate their people back to the office.
For investors, the risk is that large businesses, such as financial companies and law firms, may need to downsize in a recession. This adds another layer of uncertainty and results in a 15% - 20% reduction in asset pricing. Other stressors on pricing include increased capital needed to get lease deals done, including higher costs for tenant improvement (TI) and construction delays which continue to plague all parts of the commercial real estate industry.
The conflict that remains unresolved concerns appropriate TI allowances. As tenants demand shorter lease terms, there must be a noteworthy decrease in TI for a deal to be financially viable. The asymmetry between the requested and granted allowance is still evolving.
What are the biggest obstacles to trading distressed assets?
Market uncertainty and availability of financing are the biggest obstacles. This includes everything from continued federal rate increases driving up interest rates to how WFH and hybrid work trends are impacting space requirements. Added to that is the lack of viable debt options, a multitude of loans maturing, and a valuation gap between sellers and buyers.
The ability to navigate the plane to a soft landing during turbulent times is critical. Drawing on our experience from the last recession, we apply lessons learned to address both similarities and differences for investors in the current climate. We like to think three moves ahead from both the buyer’s and seller’s perspectives, and then build flexibility to accommodate market changes. And of course, a deep yet targeted investor pool that creates a competitive bid environment to maximize value for buyers and sellers is imperative.
We rely on an extensive buyer network to achieve the best possible pricing. A simple email blast won't cut it when it comes to closing a deal – you need a proactive, approach that leverages multiple sales channels.
What creative ideas or methods are being leveraged in this environment?
It’s important to simplify the complex as much as possible – to educate the investment community on where the opportunities are.
More creative conversations are expected as owners and investors consider alternate uses for office and retail assets. Emerging solutions for reimagining office and retail sites include government offices, last-mile distribution, charter schools and universities, mini storage conversion and redevelopment to multifamily, medical or hotel. And to obtain maximum pricing, the marketing approach must be customized and expanded to target these specific groups.
The key, then, is to think beyond the obvious because there are so many more options now for preserving or repositioning an asset. And many investors are seeking opportunities outside of their traditional property type. For example, we get enormous interest in student housing from conventional multifamily buyers because they are presented with the potential for higher yield.
What gives you confidence in this real estate market?
The investor appetite for real estate remains strong. Unlike 2009 when capital was nonexistent, the current market does have capital – it’s just sitting on the sidelines. The fundamentals of investment sales brokerage – “blocking and tackling” – become even more imperative during difficult times. Educating buyers and sellers alike is the key to ensuring favorable outcomes.
Oftentimes, buyers and sellers are cautious of each other's motives. We've introduced "collaborative closing" to our clients: Buyers and sellers keep their respective best interests in mind yet work toward the common goal of closing the deal. Fostering trust, transparency and empathy has led to successful transactions that benefit all parties.
John Bell and Jon Kleinberg serve as Senior Managing Directors of Transwestern’s Southeast Investment Services Group. Based in Miami and Atlanta, respectively, they have successfully marketed and negotiated the sale of a wide variety of assets across the U.S., including multifamily, student housing, office, medical office, retail, and industrial properties.
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