How to Avoid Financial Shock on Commercial Real Estate

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The commercial real estate sector has always been one brutal battleground. Whether you’re an originator, a broker, an investor, a lender, or a landlord, you’ve probably weathered many economic storms.

But today’s challenges feel somewhat different — and understandably, many are questioning if the industry can bounce back the same way it has in the past.

The pandemic didn’t just shock the financial system. It also reshaped how we approach work, home life, retail, and leisure — its effects are still evident in the CRE segment. Are these changes permanent?

Time will tell, but one thing is for sure: commercial property investors need to brace for enduring transformations as societal norms continue to shift.

The immediate problem

A lot of leases are coming up for renewal in 2024 and 2025. In fact, over 60 million square feet of leases will expire each year — and there are more than 5,000 leases expiring during these two years overall.

The number of expiring leases will decrease slightly in 2026 and 2027 before increasing again in 2028.

As these leases expire, executives worldwide must decide whether to return to the office or cut costs. Office space is a significant expense for many companies — often making up around 10% of their budget — so they may try to cut costs by reducing their square footage when the economy is tough.  This is one of the imminent problems CRE investors need to prepare for.

Pessimistic numbers

Underuse is another looming issue. Premium office spaces in city centers have traditionally been underutilized, with desks and meeting rooms busy for 40 hours of a possible 168-hour week.

However, that usage has plummeted to about 24 hours (only 14% utilization) since the pandemic. This underuse wastes resources and signals a sharp decline in property value, increasing the risk of plummeting prices.

Despite the allure of futuristic workplaces, flexible arrangements, and cutting-edge technology, the appetite for traditional office spaces doesn’t seem to be returning any time soon. This issue is a strategic long-term headache for the CRE industry.

Now caught in these profound shifts are CRE companies that once invested in significant asset classes that are attractive to investors. Rising supply chain costs and energy prices are pushing construction and operational costs while demand for space drops.

And with interest rates climbing and property values falling, the outlook is grim. Expectedly, lenders and investors are edgy, construction starts are down, and government spending on infrastructure is lagging.

Refinancing issues

Banks will be significant in helping the economy recover from this situation. Even though the cost of borrowing money varies, many businesses will need to refinance their debt soon. Over $2 trillion in commercial real estate loans will come due by 2027 in the US alone.

The practical winners in the refinancing race will be those who already own the assets — they will have the best chance of refinancing their loans.

In the most challenging scenarios, lenders may adopt a strategy of extending and pretending— they might extend loans, hoping that market conditions will eventually turn around. After the financial crisis of 2007-2009, banks and governments in Western countries are generally reluctant to foreclose on properties.

In general, properties rated A- or B+ are at risk because they are more likely to be financed with debt, making them more vulnerable to economic downturns, interest rate increases, or changes in market conditions.

That said, high-quality properties (especially green buildings that are good for the environment) should keep their value. Class C properties are generally safer because the owners often don’t rely as much on financing.

Slowing market

Globally, CRE investors are concerned about the economic turmoil in China — particularly Evergrande. This Chinese real estate giant has been famously struggling with a massive debt crisis, creating concerns about a potential contagion effect on the broader Chinese CRE market and global economies.

Unsurprisingly, these developments and geopolitical tensions have prompted international advisors and accountants to approach global capital flows more cautiously.

Even so, large-scale projects like Saudi Arabia’s Neom continue to attract significant capital, talent, and resources. And despite the overall economic challenges, some industries are doing well and offering hope in a challenging market. High-end hotels in many cities are surprisingly popular.

Analysts say it’s wise to focus on holding and improving properties in this market. While this might be tough if your business model relies on profit from buying and selling properties, it opens up doors for new ideas and sustainable practices.

By investing in technology to manage your properties, you can adapt to the changing times and get ahead of your competitors.

How to survive in an uncertain CRE environment

There is no such thing as a universally optimal approach to navigating current CRE challenges. The right solution will differ across businesses and industries. That said, some age-old strategies still hold strong. Here’s what works:

Assess and manage balance sheet risks.

Take a hard look at your balance sheet. Is it time to secure alternative financing or new equity? Seize opportunities to offload real estate assets at a profit.

Now is also the time to start embracing digital tools built for CRE. Invest in modern systems such as contract management software to help you identify and prevent legal issues. Use data analysis for risk management and ensure adequate insurance coverage.

Refocus on winning sectors.

If you are looking to buy CRE during this time, pivot your strategy towards booming sectors, such as distribution and logistics, student housing, and, of course, the two fastest-growing CRE sectors: healthcare and assisted living.

After all, the US population is aging. The number of older people (65+) proliferated between 2010 and 2020, increasing by 38.6% and reaching 55.8 million in just ten years. This was the fastest growth since 1880-1890.

Serve your customers well.

In an era where everyone can voice their opinion online, you must deliver standout customer service to elevate your CRE property.

Take a cue from new home builders who make it easier for their customers to get financing and move into their homes. Use the same approach to give your property an advantage.

For example, if you own a multifamily CRE building, why not provide a centralized platform where tenants can access important documents, pay rent, and communicate with property management?

Allow tenants to pay rent using various methods such as online payments, checks, or money orders, and consider offering options like automatic payments or recurring billing.

If you can provide personalized service, timely responses, and go above and beyond, you can retain and attract more tenants than competitors.

Cut costs and improve margins.

Slash costs across the board. No part of your business — not even the executive suites — should be off-limits.

As high-margin activities falter, you must refocus on your financial backbone: property and financial management. Push for greater efficiency in these areas to protect your profitability.

Look closer to find more money.

Be sure to examine smaller and often overlooked units within your CRE business. You might be surprised at how much money you can save by improving margins in areas you haven’t considered previously.

For instance, perhaps it’s time to review your preventive maintenance programs to minimize unexpected repairs and expenses.

After all, well-maintained properties tend to attract higher-quality tenants and command higher rental rates. Proper upkeep can also lead to increased tenant satisfaction and reduced turnover.

A quick CRE survival guide

  • Maintain a strong balance sheet. To strengthen your financial standing and create more room to maneuver, consider refinancing high-interest loans or selling non-core properties.
  • Home in on growing sectors. Investing in properties tailored to the needs of an aging population — such as assisted living facilities — can ensure a steady income as demand in this area grows.
  • Make superior customer service your trademark. Offer personalized and responsive service to boost client retention and attract new business.
  • Aggressively cut costs, including at the top. Renegotiate contracts with suppliers to secure the best terms and optimize operations to trim fat.
  • Explore cost-saving technologies: Consider implementing technologies that can improve efficiency and reduce costs, such as intelligent building systems. Consider investing in energy-efficient upgrades to reduce utility costs and potentially benefit from tax breaks given to environmentally sustainable CRE.
  • Focus on smaller business units often overlooked to profit from the periphery. Streamlining operations like property maintenance can cut costs and boost the profitability of these essential services.

Conclusion

Most of these approaches are well within CRE firms’ existing capabilities. The important question is how tenaciously you (and your executive boards) will invest in and pursue them.

Some new technologies, like data and artificial intelligence, are still being developed. Implementing these ideas will take time, especially as the commercial real estate market continues to change.

As you position your CRE to weather volatility and downturns, don’t underestimate the importance of financial resilience. This won’t be easy—in fact, avoiding financial shock during the next few years will require a lot of patience and creativity.

Access to flexible and reliable financing is also essential. Private Capital Investors is ready to help you as we are private commercial real estate lenders. Talk to us about your concerns, and we will tailor a CRE financing solution to address them.

Want to learn more? Get in touch with us today.

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