Fuelled by rising interest rates and high vacancies, America’s commercial real-estate market has been in meltdown for some time, with data by MSCI Real Assets revealing a whopping 74% drop in the volume of commercial property sales in July (from a year earlier) – the lowest level in at least two decades.

But the worst appears yet to come.

Commercial property prices in the US have fallen 16% on average since their peaks in March 2022, according to real-estate research firm Green Street.

Unsurprisingly, in light of the covid-driven flight to working from home, today’s downturn has hit offices the worst of all, having shed 31% of their value since the Federal Reserve (The Fed) first began raising interest rates.

While current discounts would typically be regarded as mouth-watering for bargain hunters, the level of investment that many buildings need, just to bring them up to a standard to attract tenants, makes them difficult to sell.

Mind the widening gap

A cursory glance at MSCI’s bid-ask spread – which reflects the difference between what US property owners are asking for and what buyers are willing to pay – suggests a lot of sellers remain in denial over asset pricing.

But while prices for multifamily apartment buildings have fallen by a fifth since March 2022, the value of America’s e-commerce warehouses is holding up remarkably well, down only 8% from peaks (on the back of higher financing costs).

As of July this year, MCSI data provided by the Wall Street Journal (WSJ) reveals the gap between buyers and sellers were:

  • 11% for multifamily apartments, the widest it’s been since early 2012.
  • 8% for office and retail.
  • 2% for industrial warehouses.

While it took five years after the 2008 crash for the gap between buyers and sellers to reach sustainable levels, the WJS expects the adjustment to be much faster this time around.

Are fire sales pending?

Given the difficulty real-estate investors are experiencing refinancing debt right now, only 2.8% of all office deals in the US in the second quarter were regarded as distressed, based on MSCI’s numbers.

But what might be creating a false dawn right now is the limited number of loans that have matured.

Clearly, owners don’t want to take a haircut, but once there are refinancing considerations, “they will have that come-to-Jesus moment with lenders,” notes Jim Costello, chief economist at MSCI Real Assets.

Even though fire sales right now are few, Costello reminds the market that the value of US property in distress—in default or requiring special servicing—is climbing steadily.

While assets in distress reached US$71.8 billion in the second quarter of 2023, when factoring in those properties that look at risk, WSJ suspects the pool of potentially troubled assets is more than double this amount.

What the market is telling us

According to Green Street’s director of research, Cedrik Lachance, investors in US real estate have (over the past 20 years) required a return premium of 1.9 percentage points over the yield on investment-grade corporate debt.

By comparison, real estate is currently only offering a 1.3 percentage point premium.

For the relationship to normalise, hence making property attractive again, WSJ suspects US real-estate prices need to fall a further 10% to 15%.

The 10% discount to gross asset values that US-listed property companies currently trade at, based on Green Street data is also seen as a good measure of the size of the price falls investors still expect in private real-estate values.

It’s important to note that listed real estate is a bell-weather for downturns and recoveries.

That said, it’s equally noteworthy that at the end of June, (US) REITs had risen in value over three consecutive quarters and were 13% above their lowest point in the third quarter of last year.

Based on how long recoveries typically take to filter through to the private market, WSJ suspects (US) property values could hit the bottom within six to 12 months.