The world is changing fast and to keep up you need local knowledge with global context.
*This content is brought to you by OrbVest
US real estate experts are warning of a potential looming crisis in the US office real estate sector over the next year or so, driven by high-interest rates and falling office occupancy.
In June, Fox Business reported that higher US interest rates, combined with tighter credit conditions and a hybrid work-from-home model that companies were adopting post covid, impacted commercial real estate valuations, making it harder to refinance debt when it falls due. It said Morgan Stanley Wealth Management had advised clients that a peak-to-trough price decline in commercial real estate of as much as 40% was expected, which would be greater than in the 2008 Great Financial Crisis. Morgan Stanley said that about half of the $2.9 trillion in US commercial real estate mortgages would have to be refinanced over the next 24 months when interest rates are expected to remain high.
TO TACKLE INFLATION, the US Federal Reserve has hiked its target Fed Funds rate 11 times by 525 basis points in 17 months. Economists are predicting another 25-basis point increase this year and that from then on, the Fed may keep rates on hold for a period before cutting. Economic data will guide its decisions.
At the end of Q2 2023, vacancies in US offices, according to Moody’s, had reached 18.9%, and in their view, this was a structural, not a cyclical trend, which began even before the Covid-19 pandemic. US office workers are coming to the office half as often as they did before 2019. Office property valuations have declined by 3.3% since Q3 2022, with more to come, Moody’s warned. All this spells a significant risk of defaults, which are already rising alarmingly.
But within the US commercial real estate sector are many subsectors that are not similarly affected. Medical office is one of the real estate subsectors mostly benign to the general trend for various reasons. For the most part, healthcare service providers need to examine patients in a professional environment physically and can’t work from home. This is reflected in the data, which shows that the medical sector performs differently from the general office sector. Average occupancies across the US have remained between 90% and 92% since 2019, and leasing activity is still brisk.
Stable medical real estate occupancy levels are underpinned by a switch from inpatient care (hospital stays) to outpatient care. Advancements in technology and pharmaceuticals have resulted in more procedures being performed in ASCs (ambulatory surgery centres) than before, enabling patients to walk out and go home rather than remain in the hospital for several days of recovery and observation. But ASCs require a significant investment in theatre build, and tenants require long leases to amortize the investment over time. The same applies to dentists, imaging and oncology facilities, and pathology laboratories.
OrbVest, the medical real estate specialist in the US, has just paid record quarterly distributions to its investors for the second quarter of 2023 and reported strong lease-up activity and renewals across their core medical buildings.
OrbVest has focused on buying well-maintained “Core and Core Plus” almost fully tenanted with average lease periods over five years. Specific states and cities are targeted with higher-income and faster-growing populations to underpin the demand and buildings and locations preferred are peri-urban areas close to road infrastructure, hospital campuses, and high economic activity.
While US inflation has fallen from a peak of 9% to around 3% in June 2023, it is still higher than it has been historically. To mitigate inflation risk, OrbVest targets buildings with triple-net (NNN) leases and converts tenants that are renewing, where the responsibility for paying the running costs of a building remains with tenants rather than the owner.
OrbVest generally uses 60% debt and 40% equity when it buys a property. Its current strategy when it buys a property is to secure the financing at a fixed rate but retain the flexibility to refinance at a lower interest rate within the targeted five-year holding period, should interest rates fall.
OrbVest’s mandate is to find medical buildings that can return a 7% to 9% annual return to investors during the investment period and a 10% internal rate of return (IRR) on the sale of the building (which results mainly from annual rental escalation). When interest rates are high, buyers will pay less for a building than when rates are low, but the prices of medical buildings have remained resilient because of firm institutional demand, underpinned by the stability of rental returns from long-term leases and tenants that are regarded as sticky.
OrbVest’s strategy is aggressively acquiring new buildings in the current buyer’s market to maximize capital growth.
Lifting the curtain a little shows a window of opportunity to capitalize on niches in the commercial real estate sector, like healthcare, to earn robust returns.
Cyril Ramaphosa: The Audio Biography
Listen to the story of Cyril Ramaphosa's rise to presidential power, narrated by our very own Alec Hogg.