Real Estate Highlights and 2024 Outlook

Asset-based finance vehicles, such as commercial real estate (CRE) collateralized loan obligations (CLOs), have shown resilience despite challenges within the real estate sector.  The industry is adapting to economic pressure, with new financial structures and products. Read more to understand these trends and their implications for the future of the CRE market.

Market Trends

The year 2023 marked a turning point in market sentiment as the CRE industry was confronted with elevated interest rates, geo-political instability and the threat of recession. Due to these factors, which affected liquidity, investors have remained cautious, resulting in delayed decision-making. Despite economic pressure, asset-based finance vehicles such as CRE CLOs have shown resilience, even performing well in the high-interest environment. CRE CLOs contain floating-rate interest loans and are actively managed, meaning that the sponsor or collateral manager can generally add new loans or remove distressed loans. This flexibility is one reason why the performance of CRE CLOs is arguably outstripping conduit deals.

Collateral managers have received many requests for modification and relief to help issuers manage the pool of mortgage loans, protecting investors while giving borrowers scope to implement their business plans. Again, uncertainty over how long elevated interest rates will persist presents a challenge to determining the best loan modification package. Other forms of asset-backed finance remain healthy, such as warehousing, with traditional bank warehouse lenders still accepting deals with the right location, tenant mix and low leverage.

In terms of the assets that underpin deals, the office space sector has taken a hit in 2023, as businesses struggle to re-assert the former pre-pandemic status quo of regular office working. The uncertainty felt by office landlords has affected their lenders. Consequently, common business practices, such as valuations and appraisals, are in flux at a time when future demand is still an unanswered question. The insurance required by the debt investor is also now more expensive, harder to obtain due to a rise in extreme weather events caused by changing climate, and likely to remain so.

CRE is, however, a diverse asset class spanning a range of real estate options, of which office is a small part. Deals focused on industrial space such as warehouses, energy and data centers, where rent growth remains high, are in demand.

Legislative and Regulatory Developments

The commercial real estate sector spent 2023 preparing for the forthcoming "Basel III endgame" amendments to implement Basel III, the international banking regulations that set the guidelines on risk-weighted assets in the United States. The prospect of new risk-based capital rules will have an effect on how asset-based financings, such as warehouse facilities are arranged, as the chosen structure for the lending facility will affect the regulatory capital treatment it will receive.  

Achieving the most appropriate structure can make a significant difference to lenders in forging a competitive business line. 

The U.S. Corporate Transparency Act, which took effect in January 2024, will also have an effect on the CRE market. The law is designed to enhance transparency in entity structures and ownership to deal with money laundering, tax fraud and other illicit activity. The new rules require electronic filing of information for certain new and existing companies on beneficial ownership with the Financial Crimes Enforcement Network. The UK introduced an Act with similar aims in August 2022 – the Economic Crime Transparency and Enforcement Act – which requires the disclosure of beneficial ownership in certain types of land and property if held by an overseas entity.

Outlook

An estimated US$1.5 trillion of CRE loans are due to mature in the next couple of years, raising the question of how these will be refinanced given that high interest rates are predicted to persist. The UK and Europe face a similar wall of debt maturity, with an estimated £125 billion across both jurisdictions expected to mature in early 2025. The rising cost of debt, fallen capital values and the potential risk of additional ESG-related capital expenditure could lead to a trend of distressed debt in the year ahead.

The reality of refinancing property in current market conditions means that equity investors need to make hard decisions. The direction of that decision-making will depend on the existing investment structure and its limitations. Participants in the CRE segment seeking to find leverage against sub-performing and non-performing assets, to obtain yields commensurate with risk, may turn to non-performing loans securitizations. This could become a preferred option to facilitate the purchase, accumulation and finance of assets that need to be traded and repriced.

As an evolving finance sector, CRE is well positioned to adapt developments from other asset classes to create flexible financial structures, arrangements and products. Alternative capital providers, for example, have become an increasingly important feature in the CRE market, with a notable shift from equity to private credit funding – a trend that is likely to accelerate in 2024.

Sector Matter Highlights

• Dechert advised Citi, as lead lender, together with Morgan Stanley and Goldman Sachs, in the origination of a US$750 million mortgage loan to subsidiaries of a Digital Realty Trust and TPG joint venture. The loan is secured by three data centers – one of the most in-demand sectors for private investment.
• Dechert steered Wells Fargo through the workout of a US$750 million mortgage loan over a prominent, newly constructed mixed-use hotel and retail building in 20 Times Square, NYC, one of the largest NYC CRE loans recently in default. Pieces of the mortgage loan were put into five CMBS securitizations, and the special servicer acted on behalf of all those CMBS securitizations. The property was also subject to a US$150 million mezzanine loan, which was in default.
• Dechert advised Pretium Partners, LLC, as borrower, in connection with a US$900 million mortgage loan used to acquire single family residences.