Two More “Shoes To Drop” In The Real Estate Market Until…

Two More “Shoes To Drop” In The Real Estate Market Until…

Current Realities — and Possible Consequences — of How the Commercial Real Estate Market May Play Out in the Months Ahead

I recently learned the origin of the phrase “waiting for the other shoe to drop.” In the late nineteenth century, residents in New York City apartments could hear the noises of the neighbors living above them. One common sound was removing shoes; once you heard the muffled thump of a shoe hitting the floor, you expected to hear the other shoe drop shortly after.

The first shoe in the US housing and commercial real estate market was the entire year of 2022: consistent interest rate hikes, a significant reduction in sales volumes, and a cold draft in real estate prices. Three of the top six new homebuilders in the country recently reported net new orders for fall 2022 with declines of 15% (Lennar
), 38% (DR Horton), and 80% (KB Home
). In December 2022, the U.S. Department of Commerce reported sales of new single-family houses dropped 27% from December 2021.

For commercial real estate firms, particularly in the office market, conditions remain dire. According to recent studies, up to 71% of office space could support “four times their current usage.” Statistics like these put national statistics about office vacancies into serious question.

Let’s be honest; 2022 wasn’t pretty. Yet experts still aren’t certain how 2023 may shape up. How many more shoes need to drop before we can call the proverbial “all clear” in housing and commercial real estate? The answer is two and a possible third (for all those spades players out there):

  1. Audits
  2. Municipal taxes
  3. (Possible) forced selling

The First Shoe to Drop: Audits

Most real estate private equity firms have a December year-end and must provide audited financial statements to their banks and investors by the end of March or April. Because December 2021 was literally the lowest interest rate environment in history while rents were rising very quickly (i.e., inflation) the value of real estate was near gravity-less. Fast forward to the end of 2022 and conditions were very different, yet many real estate investors have not proactively reassessed the value of their real estate holdings in the face of dramatically higher interest rates.

Why haven’t certain real estate investors reassessed their values? On one hand, rents and therefore profits were likely still rising in 2022 vs. 2021. On its face, real estate owners like to believe that if they are generating more profitability they are creating more value, which is true. But in real estate, valuation requires you to multiply your profits by a valuation factor to get the final answer (just to make things a bit more confusing). You divide your profit by a percentage — called a capitalization rate — to get your property’s current value. Cap rates tend to follow interest rates. As interest rates rise, cap rates rise. When cap rates rise, the value of real estate falls.

So all else being equal, if a real estate owner made more profit in 2022 than in 2021 on their real estate holdings they are still likely to have lower valuations vs. a year ago because interest rates rose by nearly 5 percentage points.


And audit season is the moment of truth. With significantly fewer transactions — which means fewer comps for appraisers who value commercial properties — real estate investors are going to have to defend their values for the first time since the rate spike. All of this “revaluing” is happening right now and will last for the next 60 to 90 days. There is a relatively low probability of the value being higher than last year.

Why is all of this important? If an investor’s loan-to-value maximum with their lender is 80%, the bank will only loan you 80% — even if the value of your property drops. What happens if the investor owes the bank more than what they are willing to lend you? You either need to pay the entire loan back or give the bank more cash (or other assets) as collateral. During the pandemic, banks were quick to make modifications and cover investors anyway, but things are very different today.

The current financial market conditions are dramatically tighter. Owners who may have been safe in recent years could now be forced to find other financing options. Or become forced sellers.

There are investors that have been both astute and proactively honest in the face of rising interest rates (even though income was still climbing on their properties), but many have kept their values the same as in 2021. Some have even lifted them.

Those who have been kicking the valuation can down the road may be forced to acknowledge the fact that interest rates are up. Even if they are performing well, banks may force them to answer the question: Do your loans meet the value test?

The Second Shoe to Drop: Reduced Tax Rolls

If you’re a city, county, or school district that collects real estate taxes, your income is based on two things: 1. Millage rates (tax rates) and 2. The value of the properties you’re taxing.

There’s always a difference between what an appraiser says a property is worth and what the taxable value is. Very significant reductions in property values are likely to play out in the courts over the next couple of months and quarters. As auditors and property owners duke it over how high values can be for audited financials, those same property owners tend to fight the courts to get the lowest possible tax assessment value from municipalities.

So what does that mean? If higher interest rates result in lower values through the audit season, the real estate investors that own those properties will be making their next trip to the courts to reduce the amount of taxes they are paying to municipalities.

A reduction in property values and an increase in vacancy rates means lower tax revenues for cities. Because cities play a very important role in providing different forms of financing to get real estate deals across the finish line, it is problematic to envision significant tax receipt reductions in places where infrastructure improvements are vital for real estate development to advance.

To put it simply, lower tax revenues mean fewer opportunities for developers.

This particular shoe is going to be very regional. Municipalities have varying states of financial viability. Those with smaller office markets, for instance, are likely to fare better. The tax roll concern could also be mitigated by a lift in tax rates, which could temporarily fix a receipts hole, but ultimately makes any place less attractive to investors long term.

The (Possible) Third Shoe to Drop: Forced Sellers

Let me make one thing clear: I’m not predicting a forced seller’s market. It may happen; it may not.

But as we watch the two first shoes drop, we all need to keep our ears open to hear whether that third shoe drops for the housing and commercial real estate markets. It’s quite possible that the combination of these first two factors — audited valuations and reduced tax revenues — results in investors becoming forced sellers.

The questions we need to ask now are, “When will we find out?” and “How long will it take?” The short answer is we’ll probably know by summer. Spring is a great time to see the strength of the consumer market because the spring selling season is when the majority of consumers purchase new homes (in time) for the next school year. The early tea leaves on the spring selling season appear to be okay, but that could change quickly if interest rates pop for some reason.

It will also be summertime before banks are able to decipher solutions for those that don’t meet their loans’ LTV tests.

If lower valuations of properties don’t result in forced selling, I believe we will be approaching the all-clear in the housing market. Most housing down cycles are much longer than a year, but everything is more volatile in commercial real estate than it used to be. The peaks are higher, the speed of declines is swifter, and I believe that when investors feel like rates are stable and the risk of forced selling is neutralized there will be a real demand for real estate assets.


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