For the better part of the last 18 months, commercial real estate has been on ice, frozen in place to weather a storm the world is still struggling to understand. The wait-and-see approach can only last so long. As the U.S. economy begins to unfreeze, dealmakers are looking to understand the damage from the thaw. Before transactions can begin again in earnest, underwriters must account for the fallout. New methods of valuation and assessment will be needed to keep pace with the accelerating speed of information.
“COVID accelerated a decade-long process down to a year and a half,” Professor Tim Savage said. Savage teaches at the NYU Schack Institute of Real Estate. Before life in academia, Savage worked with CBRE to build out the brokerage’s powerful econometric tools. “COVID accelerated the recession, the challenges of brick and mortar retailers and the outsized performance of industrial.”
Accounting for that rapid pace is now the biggest challenge to accommodating a growing investor appetite for deals. Accelerated trends are hitting new top speeds and show no sign of slowing down. In the second quarter of 2021, U.S. GDP jumped 6.5 percent, making it one of the strongest quarters in nearly 20 years. Strong GDP reflects broader growth across the economy, a sign that things may be getting back on track. Retail sales are up nearly 16 percent, hourly wages are up, homes sales are up, air travel and lodging are back to pre-pandemic levels. All of these key macroeconomic indicators are boosting macroeconomic optimism, luring investors back into the game. Microeconomic indicators tell a much different story. Office owners know their buildings are still mostly empty. Brick and mortar retailers are still in retreat. Industrial rents and development numbers continue to break records.
The conflicting narratives have created two different versions of reality. On paper, Midtown Manhattan is full of office workers. Tenants are still paying rent, so when assessing the value of a property, that space is considered occupied. But it isn’t. On paper these buildings are one thing, in reality, they are another. The problem is investors value the asset based on the income the assets are producing, not occupancy. Sticky forms of cash flows are distorting reality in asset valuation and underwriting. During most of the pandemic, offices have been useless. E-commerce warehouses have been essential. On paper, the essential industrial facility is worth a fraction of the useless office. That’s a potentially cataphoric problem. When valuations are untethered from market realities, disaster often soon follows. The new reality of the market after COVID is still taking shape. Remote work and commerce are fundamentally shifting daily American habits, the places they visit, and the spaces they need. Underwriters and appraisers will need better tools to reflect the shifting value of real estate in this new paradigm.
“It’s important to begin to think about real-time pricing of space in commercial real estate,” Savage said. “We have an example, they’re called hotels. Appraisals will need to happen more frequently, even large holders won’t have the luxury of doing it every six months. The commercial real estate industry will have to behave more like other industries that do mark to market valuations every day.”
Mark to market (MTM) accounting is a method of valuation that accounts for fluctuations over time based on market conditions. Value is based on what the owners would get for the asset if it was sold today. MTM is common in the financial industry, where lenders must account for borrowers defaulting, marking down the assets as bad debt to its fair value through the use of a contra asset account. The process creates a marketplace that reflects real-time data. Real-time data powers the modern economy. Anyone with a Bloomberg terminal can see real-time prices and valuations of trillions in assets, securities, commodities, and goods with just a few clicks. Commercial real estate operates more like a bond, Savage explained.
Long considered the safest investment, office rents from highly rated tenants are thought of as guaranteed. The landlord signs a 10 year deal with a tenant, collects checks for nine and a half years, then shows back up to ask the tenant if they want to sign another lease. Those deals could soon be a relic. Leases are shrinking, tenants are demanding more flexibility and competitively priced coworking spaces are taking big bites out of the traditional office market. Locking in tenants and rent payments may have saved the commercial real estate industry from pain during the pandemic, but it hasn’t served tenants. How much longer tenants who may not need an office are willing to put up with the office landlords’ tough tactics is a question no one has the answer to yet. Still dealing with the coronavirus pandemic and the deadly Delta variant, the industry is still at a standstill, hoping to stay fresh on ice.
“If the current thinking is we work from home one or two days a week, that reduces foot traffic by at least 20 percent,” Savage said. “That has a major impact on office and retail underwriting. In the office sector, we have to get beyond the WeWork debacle and start to think about valuing the optionality of space. We also have to recognize impairment in retail. Lenders are going to have to recognize that real assets simply are worth less today than they were 18 months ago.”
No one likes being told what to do, but the commercial real estate world especially hates being told what their assets are worth. Dealmakers play everything close to the chest, using their own methods to value assets depending on who wants to know. That’s caused the world of commercial real estate to look fundamentally different than residential. Desktop underwriting is common in residential real estate, where practically anyone can input data into an algorithm to understand the value. Rapid underwriting in residential real estate creates transparency and better reflects real-time pricing, creating the basis for the multiple listing services that facilitate the bulk of transactions. Decentralized valuation and underwriting in residential real estate that reflects real-time pricing more accurately reflects the risk of an investment.
Unlike residential, where information is in the hands of the many, in commercial real estate, information is far more centralized, creating major barriers to transparency that hold the industry back. In residential real estate, deal makers make deals. In commercial, the best deal makers spend most of their time overcoming information asymmetry. The most successful commercial brokers are often the ones with the most information, executing deals most brokers dont even know are on the table. With so much information behind high walls, calculating risk for accurate underwriting and valuation is even more difficult. Now more than ever it is critical to see the new risk landscape for what it really is, continuing to rely on dated methods of underwriting is building a house of cards.
“Transparency is not a hallmark of commercial real estate,” Savage explained. “Transactions are private and they tend not to be aggregated. There are institutional features in the industry that challenge the creation of something like an open-sourced CoStar. I challenge the industry. We have the technology today that we didn’t when CoStar launched. We can have an open MLS that can help us measure risk better, allowing high-quality brokers to do what they do best: bring useful insight about the current state of the market and where it’s moving.”
What little information is reported is highly selective, always after the fact. Information brokers like Real Capital Analytics and CoStar are limited by what data they’re given or what data is willing to be shared. None of them are open-sourced, they all traffic in proprietary technology for paying customers. In commercial real estate, there are no independent third parties that store data and valuation models to base deals and underwriting on. In this respect, residential real estate does a much better job. Closed deals are the best indicators of value, but when no one is closing a deal, no one can understand the value. Price discovery isn’t happening because no one’s buying. Without deal flow, valuing the largest asset class in the country is next to impossible. That’s where most of the industry is at now because the technology to build a different system doesn’t have any buy-in from stakeholders with information.
Despite being adept swimmers living much of their life in the water, penguins can be apprehensive about diving in. They inch forward slowly, standing at the precipice, waiting for someone to fall or be pushed. When one finally makes the plunge, the others look to see how they fare. If no leopard seals or killer whales make their move, the rest of the penguins eagerly join them. The odd behavior is how penguins assess risk. It’s oddly similar to how commercial real estate deal-makers assess their own risk. Everyone is waiting for someone to dive in and make a deal to see if it’s safe. Someone is going to pay for price discovery that helps everyone but could hurt them. It doesn’t have to be that way. Instead of acting like penguins on a cliff diving into the dark water, the commercial real estate industry could leverage technology to see what dangers lurk beneath the surface.