‘This is going to be more of a slowdown than a major recession,’ Marcus and Millichap CEO
Marcus and Millichap CEO Hessam Nadji joins Yahoo Finance Live to discuss the Fed’s 0.25% rate hike, its varied effects on real estate sectors, the possibility of a recession, market sentiment, and the outlook for the economy.
JULIE HYMAN: Real estate is finding the positives in Powell, well, a little bit at least. Remarks from the Fed Chair yesterday hinting at the end of rate tightening. The news may come as a relief to real estate markets hoping for a timeline, but will that guidance be enough to offset the more immediate rise in rates that's already putting pressure on the sector?
Joining us now is Hessam Nadji, Marcus and Millichap CEO. Thank you so much for being here. And commercial real estate has gotten a lot of attention as of late, right? There's been a lot of discussion about whether this is one of the areas of vulnerability as we are seeing rates move higher. What can you tell us about that from inside the industry?
HESSAM NADJI: Good morning. Thanks for having me on the program. Well, the industry has been under a lot of pressure really since fall of last year when the success of interest rate increases really created a challenge in valuing commercial real estate given the extremely rapid rise in the cost of debt. Commercial real estate is very dependent on leverage. On average, we have somewhere between a 40% to 60% long-term average use of leverage in the transactions that occur throughout the United States. That's gone up as high as 70% or 80% at various times of different cycles.
But nonetheless, that is a significant portion of what makes the transaction work. And the shock to the marketplace from the successive and very aggressive rate hikes last year are still being absorbed. Now, the fact that yesterday we saw a quarter point movement instead of at the half a point movement that was planned prior to the banking crisis is a positive, not so much because of the rate is lower than the 50 basis points but the signaling that the Fed is nearing its tightening cycle.
It's really taken a sledgehammer to the real estate market in a way that the successive increases were so dramatic and could have been done at a much slower pace if the Fed had started tightening in 2021. So the catch-up factor is what's really hurt the transaction market and the underwriting. So far what we're seeing-- what we're seeing is sellers and buyers having to recalibrate on what the true valuation of commercial real estate is. Of course, that varies by property type and marketplace.
But we're still in that recalibration phase of price discovery. The clarity that the end of the tightening cycle will bring is a positive move. Second to that will be clarity on whether we're going to have a recession or not. We still believe this is going to be more of a slowdown than a major recession.
The employment market is still way too strong and has a lot of great foundation, as does the consumer, to point to any kind of a dramatic serious recessionary forces coming into the picture. So with those two things coming together in the next few months, I think there will be more clarity. But the market needs time to absorb this readjustment of valuations.
BRAD SMITH: So trying to synthesize all of that, what would be in your calculus for either shallow or severe or mild, whatever it looks like, type of recession, the knock-on effect on the real estate market considering that, I mean, it's not normal for rates to be at zero or near zero for as long as they were and for the market to be able to set its own positions around that and then now have to normalize when rates are actually getting back towards levels that many would say are actually perhaps a little bit more normal.
HESSAM NADJI: You bring up a great point in that 5% federal funds rate is not all that unusual and actually considered a nominal interest rate. We're coming to that 5% federal funds rate from zero at a very quick pace. That's what's really shocked the markets and created this dislocation. Had that process been more gradual, had the Fed had been a little bit further ahead of the curve on inflation and not relied on the transitory judgment that was placed on what we were seeing in 2021 postpandemic, we wouldn't have caused as much of a shock to the marketplace. So you're right, it's the absorption of that shock that's going to take time.
Meanwhile, the unintended consequence of this rapid rate increase, of course, has showed up in the banking system. And there is a lot of concern about mortgage performance for commercial real estate. Commercial real estate is a significant part of the massive holdings throughout the banking system in the United States, particularly regional and local banks.
The good news is when the current loans that are maturing were issued five to seven years ago, values were a lot lower than they are today. Occupancies and rents were a lot lower than they are today. And the foundation of commercial real estate assets is much stronger than it was going into 2008, 2009 because we haven't overbuilt. We haven't overleveraged. And all of that gives the industry a lot more of a solid footing going into this rather uncertain phase of what's going to happen with the maturing loans.
So having said that, there is going to be some nonperforming loans. We're seeing some office buildings get handed back. We're seeing some challenges in refinancing maturing loans that are coming due that were short-term loans, maybe issued two or three years ago, with a very short-term maturation cycle. And some of that is going to be problematic in the marketplace.
And part of our job is, as advisors and brokers, is to actually solve those problems with our clients, which we're actively doing. And there is a wide gap between the performance of, let's say, office buildings right now and multifamily properties and retail, for example. Those are all performing at a very different level.
JULIE HYMAN: But it sounds like, overall, that the perception that there is this huge bomb lying in wait or bombs lying in wait on balance sheets, especially bank balance sheets, it sounds like your message is that that's mistaken, or at least has been overstated by quite a bit.
HESSAM NADJI: I agree with that. Overstated is probably the best way to describe it in that there will be issues. I don't want to gloss over that. But I just don't think it's going to be as systemic as some of the panicky headlines have suggested. And we've seen lenders work out solutions with owners when there's been those kind of maturing loan situations or bridge loan necessity to kind of help an owner get through a particular period of time in the cycle where we're having these forces come at us that are very unusual.
You have to remember, commercial real estate has been through a pandemic, a very rapid recovery, and then a massive tightening of financial conditions unlike anything we've seen in modern history. So the last three years have moved the industry through a significant roller coaster.
BRAD SMITH: And so with that in mind, isn't it kind of a viable argument that the environment for commercial real estate has changed so drastically, whether that be the office workplace, whether that be a retail storefront footprint, all of that has dramatically shifted?
HESSAM NADJI: It definitely has, not all in a bad way. There is always opportunity in commercial real estate. In every down cycle we've seen, those investors that can reimagine a piece of real estate or can basically think long term, whether it's holding on to an asset or investing in new assets, come out as winners. And this is no different.
What we're seeing is the dramatic difference between property types where in a way you can call office the new retail because retail, for the last 10 years, was going through a complete revolution because of e-commerce. Brick and mortar retailing was changing in every way. And what emerged from that was the experiential retail, fitness, and health-oriented retail that has been so successful, was successful before the pandemic, has become successful again postpandemic, and is driving retail to be, in many ways, the darling of the industry.
That is a contrarian move if you think about four or five years ago when those investors that went into shopping centers made those very important moves. On the other hand, office buildings, because of the hybrid workplace, because of the migration to the suburbs, especially office buildings in urban areas have been hit very, very hard. We still have leases that have three to four years left, on average.
And when those renew, we're going to see shrinking of footprints and lower demand for office space but not as bad as it seems today because we're still recovering from the postpandemic effects. Nonetheless, there is definitely shift. Multifamily is coming out as a winner because home affordability is now a major issue. And people are opting to rent again instead of buying homes given what's happened with interest rates. And then you have other property types like self-storage, for example, or manufactured housing or life sciences that are doing extremely well.
BRAD SMITH: Yeah. No, no, no. It's a great point in terms of office certainly becoming the new retail in Brookfield's case, and then additionally retail becoming the new experiential or gym in Lululemon's case. And then you can go on and on in just how storage is becoming the new data center, basically. Hessam Nadji, who is the Marcus and Millichap CEO, thanks so much for joining us here this morning. Appreciate it.