2023 Real Estate Market Outlook
In this Ropes & Gray podcast, real estate partner Sally Davis and associate Michelle Janer discuss trends they expect will impact the commercial real estate industry in 2023. Sally and Michelle share their observations on desirable asset classes, how deals are being structured in the current economic climate, how to navigate the lender/borrower relationship, and more.
Sally Davis: Hello—thank you for tuning into this Ropes & Gray podcast. My name is Sally Davis and I’m a partner in the real estate investments & transactions group at Ropes & Gray, based in New York. We have a global real estate practice consisting of approximately 100 lawyers who focus on a wide variety of real estate and real estate-related matters, including joint ventures, acquisitions, financings, repurchase facilities, real estate M&A, and more. My practice focuses primarily on equity-side investing in real estate, but generally runs the gamut across joint ventures, acquisitions, dispositions, financings, sale-leasebacks, etc., across geographies and asset types. Today, I’m joined by my colleague, Michelle Janer, a senior associate in our group. Hello, Michelle—why don’t you tell everyone a little bit about yourself?
Michelle Janer: Hi, Sally—thank you. My name is Michelle and I am a senior associate in the real estate practice group, based out of the Boston office. Similar to Sally, I work on a pretty broad swath of real estate transactions and client groups, and luckily, some deals with Sally (only the most interesting ones).
Sally Davis: Of course—we certainly have worked on some interesting deals together, which is part of the reason we decided to do this podcast today. After an unprecedented volume of activity in 2021 and the first quarter of 2022, 2022 (and the first few months of 2023) exhibited significant deal activity slowdown in the commercial real estate transactional market, which is being felt across our client base and industry wide. We heard this firsthand at the recent National Real Estate Women’s Forum, hosted in New York, during which we had the opportunity to speak with several leaders in the field and hear their perspectives on trends, challenges, and opportunities. Particularly in light of the most recent events involving Silicon Valley Bank and other banks, we thought it would be interesting to share some of what we’re hearing and seeing, as well as expectations for the commercial real estate space in the coming months.
Michelle Janer: When I think about real estate trends, the first place I usually go is with respect to the types of assets that I’m seeing being traded. Despite the general deal slowdown Sally mentioned, there are some real estate asset classes that remain intriguing and have continued to perform well—in some cases, even surpassing prior year activity. For example, we’re seeing consistent deals in the residential space—so, this includes multifamily and single-family rental (SFR), industrial, logistics, cold storage, and data centers.
Sally Davis: Yes, I agree, Michelle. Multifamily, in particular, is interesting. Given how difficult it is for homebuyers to secure their own financing these days—and I think that’s something that’s potentially been exacerbated by the recent bank fallouts—we’re seeing a “flight to rental” by consumers, meaning single-family rental portfolios have become strong performers and even more desirable to investors than they once were, including several of our clients.
Michelle Janer: Yes, that’s a great point. I also thought it was interesting that I’m still seeing deals across the U.S., but largely outside of the traditional “primary” markets, like New York, Boston, LA, San Francisco—definitely more “secondary” market activity.
Sally Davis: That’s true, certainly in the case of multifamily, although, I think the opposite need be said for office, which has become somewhat of an “elephant in the room” in the industry. In general, office is having a rough time these days with investors steering clear (regardless of discounted pricing) and tenants being highly selective in their pursuit of “quality,” imposing extensive demands on landlords to provide enhanced amenities and building services.
Michelle Janer: Yes, not all office space is created equal. We’re certainly seeing this “flight to quality” in certain specific markets, such as the Wynwood neighborhood in Miami, Los Angeles with the film industry, and Austin, Texas, just to name a few, where alternative types of office space are being made available.
Sally Davis: Right, and for office space that doesn’t qualify as “quality” in those markets, investors are talking about potential conversion and repurposing of existing office space—going so far as to start applying for land use and zoning changes—although those are proving to be more costly than anticipated because of the way those buildings are constructed and, in large part, it all seems primarily just to be “talk,” at least for right now.
Michelle Janer: I think a large part of the problem is that society as a whole is still grappling with how remote work will factor into our lives moving forward. I’ve spoken with some landlords who are frustrated that tenants are looking to them to incentivize workers to come back to the office, when they see that as more of an employer responsibility—but these landlords are instead having to invest dollars into updating their amenities and renovating the properties when they are already pretty pressed for cash.
Sally Davis: Right, and again, I think this is primarily the case in what would be characterized as these “second markets” or “class B”-type properties. In general, while difficult to predict what will happen, I think it’s likely to be the case in these regions, and with respect to these properties, that ultimately, we might see tear-downs and trades based on land value.
Michelle Janer: Thanks, Sally. In terms of other trends, are you seeing anything new in the way deals are getting structured?
Sally Davis: Yes, I am. Because of the state of the current lending market—which we’re going to discuss more in a bit—we’ve spoken with several buyers and investors recently who have been having success in getting deals done by agreeing to assume existing debt (even with Fannie and Freddie debt).
Michelle Janer: I find this one particularly interesting because these kinds of assumption can often be extremely costly and time intensive, which previously, investors would not have had the patience to tolerate.
Sally Davis: Right, and investors need to balance the desire to get the deal done with asking for modifications to existing deal documentation. Depending on the lender, lenders may be more or less willing to engage in a discussion around modifications, but note that some (for example, around ownership and control requirements) will ultimately be needed. And that’s an area where it’s beneficial to engage counsel early in the process because we can help think through where modifications in the existing loan documents can and should be requested.
Michelle Janer: I completely agree. And while we’re on the topic, something else that we’re seeing is more activity in the secondaries market—so, I would think of this as buying LP interests in a fund or recaps of existing assets—which I think we’re seeing is largely attributable to rising discounts. I’m sure members of our funds team would have a lot to say on this just given how active they’ve been in this space recently.
We’re hearing from clients that discounts for secondaries deals are 30-50% compared to 10% in a typical market. But, for reference, discounts in the GFC were 50-100%, so luckily, we’re still not quite as bad as it was back then. And to your earlier point, Sally, many of these deals have existing debt—so, they wouldn’t be considered full “loan assumptions” per say, but they may still require lender approval, which can add another layer of complexity to consummating the transaction.
Sally Davis: So, speaking of debt, for months now, we’ve been waiting to see an onslaught of distressed assets triggering workouts and foreclosures, but it’s been slow to come to fruition. We’re starting to see more workouts for distressed loans—and deals to provide rescue financing on distressed assets—although, still not seeing large volumes of those deals just yet.
Michelle Janer: I agree, although this may change based on recent developments with Silicon Valley Bank, depending on how regulators react and how willing banks will be to work with borrowers.
Sally Davis: Right, exactly. The SVB/Signature Bank fallout might have been the catalyst the market has been waiting for to unlock pricing and start movement of debt (and seems to have accelerated timing for borrowers to start handing back keys and a desire for lenders to start “unloading paper”). In fact, we’re recently starting to see loan portfolios of performing office loans being traded (and at a significant discount)—and that also relates back to what we were talking about earlier in terms of how office is certainly perceived in the market these days. And even before the SVB development, we were hearing of smaller lenders being approached by larger banks to provide bridge financing, to effectively get regulators off their backs because their loans were out of compliance.
Michelle Janer: Interesting. Unfortunately, we’re also already seeing pullback by lenders in certain deals that they’re deeming too “risky” (for example, spec builds, even where there are credit tenants that are identified). Which begs the question: Are there any lessons to be learned out of this, and what should our clients do if they’re facing these types of challenges?
Sally Davis: We’ve seen firsthand—and this was echoed by some of the co-panelists on my panel at the Real Estate Women’s Forum—the importance of maintaining a good lender/borrower relationship and how this can directly impact the path forward for a troubled asset. The hope is that, if you’re a borrower, your lender is reasonable and commercial. In all likelihood, a lender doesn’t want to take the keys back and will be amenable to finding some mutually agreeable solution to get an investment back on track. So, to that end, we’ve seen lenders being proactive actually in evaluating when loans might need assistance and acting as partners with their borrowers.
Michelle Janer: Right, collaborative lenders will help find solutions and even bring in other partners (for example, Agency HUD platforms or bridge/mezz lender), they might help with a refi or even with insurance costs since the pricing on premiums has such an outsize effect on cash flows. Of course, there are predatory lenders out there too of which we need to be mindful. But, in general, borrowers will be well advised to be familiar with their debt documents and also be proactive about communicating with their lenders—and connecting with counsel—if they anticipate any problems so there is ample time to work something out or find a solution.
Sally Davis: Right. Now, of course, we’d want to make sure that appropriate documentation (for example, a pre-negotiation-type of agreement) is in place before the parties commence any meaningful, substantive discussion regarding a work-out or a restructuring, and that’s one reason why it’s helpful to loop in counsel early in the process.
So, before we wrap up today, Michelle, we wanted to pivot from the debt market, and spend a little time discussing a few recent trends that we’re seeing in the real estate joint venture space, which is where I focus my practice. Given asset performance and the general market conditions we’ve been talking about, we’ve actually heard rumblings in a few cases about capital partners in JVs who may be considering their options with respect to exercising manager removal rights as a means to ultimately unlock liquidity, primarily in cases where the negotiated list of removal “cause” events includes performance-based triggers (so, for example, if the GP fails to cause assets to hit certain investment criteria, the capital partner would have the right to remove on a “cause” basis).
Michelle Janer: I would be surprised if this picks up steam because this is likely a pretty difficult path to take in practice, particularly because a capital partner would be forced to prove (either in court, through arbitration, etc.—all depending on deal document requirements) that the GP’s actions actually caused the failure or breach, and we all know how arduous a process that can be.
Sally Davis: Yes, I think that’s right. And frankly, another consideration for many capital providers is that they’re going to be weary to go down this path because of concerns about impacts on their own reputation in the market.
Michelle Janer: But, at the same time, institutional capital providers are experiencing pressure from their own investors who want to take their money out of the vehicles or funds that they’re invested in, and, therefore, those capital providers will need to find sources of liquidity to cover those redemption requests.
Sally Davis: And that can be challenging, particularly in cases where the capital partner does not have available to it any type of forced exit or transfer rights under the joint venture agreement (for example, because of some sort of pre-negotiated lockout period), and the joint venture manager wants to stay in the deal and see it through to completion (in the hopes of hitting its promote).
Michelle Janer: Definitely, but, ultimately, similar to the lender/borrower relationship, it’s likely best to try and be collaborative and work something out with your manager or GP. And, either way, while the market is soft, it’s going to be difficult to find good exit opportunities.
Sally Davis: So, Michelle, where does this leave us?
Michelle Janer: Sally, it’s difficult to predict what’s to come, but I don’t think it’s necessarily a bleak picture. There will be opportunities for savvy investors who are not afraid to work with new and bespoke deal structures and who are focused on the qualitative aspects of their debt and equity relationships.
Sally Davis: Yes, and of course, we are always happy to help folks think through possible creative solutions and strategies for a path forward. So, on that note, I think that’s a wrap. For more information on the topics that we discussed, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we discussed—please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.