TIP537: The Surprising Opportunities in Commercial Real Estate w/ Ian Formigle

Episode Summary

Executive Summary: Ian Formigly argues that commercial real estate is being reshaped less by fundamentals than by a sharp capital-markets reset: higher rates, tighter lending, bank stress, and refinancing risk. He sees pockets of opportunity in industrial, retail, and selected multifamily, while office remains under pressure until price discovery and restructurings create a clearer buying opportunity.

Main Topics: 2022-2023 CRE market reset and transaction slowdown (Priority: 5/5): Commercial real estate prices and deal volume fell sharply in late 2022 as rising rates, tighter financing, and weaker capital markets caused retrading and fewer closes. Formigli expects 2023 volume to likely end below 2022, with conditions improving only if liquidity returns later in the year. Interest rates, floating-rate debt, and cap-rate behavior (Priority: 5/5): He explains that the speed of rate hikes—not just the level—has been the main shock to CRE. Floating-rate loans and expiring interest-rate caps from 2020-2021 are now resetting much higher, creating cash-flow stress and some recapitalization needs. Cap rates are driven more by supply-demand and growth expectations than by rates alone. Relative value by asset class (Priority: 5/5): Using long-term Green Street trend analysis, he identifies industrial, retail, hospitality, and selected multifamily as the most interesting current opportunities, while emphasizing that asset class dispersion widened materially after 2015 and now matters much more than in prior cycles. Office sector distress and future recovery (Priority: 5/5): Office utilization remains far below normal and the market is splitting into top, middle, and bottom tiers. Class-tops are functioning well, the middle tier may offer later-cycle value through repositioning, and the bottom tier may be economically obsolete and trade near land value after defaults and workouts. Retail’s overlooked resilience (Priority: 4/5): He sees grocery-anchored and neighborhood retail as a hidden opportunity due to historically low supply, strong occupancy, durable tenant behavior after COVID, and cap rates still high relative to other sectors, making current cash flows more attractive. Investment tactics in a dislocated market (Priority: 4/5): Formigli says the best strategies right now are buying non-performing loans and discounted recapitalizations, because both exploit financial distress rather than fundamental property weakness. These approaches work best when a low basis creates negotiating leverage and upside optionality. Capital calls, leverage, and investor decision-making (Priority: 4/5): He explains how to evaluate unexpected capital calls by reading governing documents, assessing whether distress is sponsor-driven or macro-driven, and treating the new capital as a separate investment if the original stake is already impaired. He also outlines how debt-service coverage and positive/negative leverage affect returns.

Key Arguments: Transaction volume and pricing fell mainly because of capital-markets dislocation, not broad real estate collapse; deals are being repriced and delayed due to higher debt costs and uncertainty. The rapid pace of Fed hikes has forced repeated repricing, reduced lender appetite, and created stress from floating-rate debt and expiring rate caps originated in 2020-2021. Cap rates are influenced more by supply-demand and growth expectations than by interest rates alone, though higher rates still push cap rates up when buyers cannot justify returns. Industrial remains attractive because supply is tapering and rent growth is still solid, though it is no longer at bargain pricing after 2021’s surge. Retail is attractive because new supply is minimal, occupancy is high, brick-and-mortar sales remain dominant, and grocery-anchored centers still offer meaningful cash flow at higher cap rates. Hospitality has recovered operationally, but real (inflation-adjusted) recovery is incomplete and financing remains a constraint, making it a selective opportunity. Office is undergoing a multi-year reset: top-tier assets should hold value, middle-tier assets may be repositioned, and obsolete buildings may eventually need foreclosure, conversion, or land-basis valuation. Non-performing loan purchases and discounted recaps are favored strategies because they capitalize on lender pressure and allow investors to negotiate from a lower basis. Capital calls should be judged on the revised project economics and the capital-call investment itself, not as a sunk-cost decision tied emotionally to the original investment. Negative leverage can still make sense when assets are bought at enough of a discount or when current rents are far below market and can be reset upward. Debt-service coverage requirements are a proxy for lender risk; when rates rise, loan-to-value drops and proceeds decline even if the asset quality remains decent.

Data Points: Green Street Commercial Property Price Index (CPPI), 2022: Down 13% - Broad private/public commercial real estate price decline for the full year 2022. CPPI decline through May 2022: About 1% down - Prices were relatively stable in the first part of 2022 before declines accelerated later in the year. CPPI decline from May to year-end 2022: About 12 percentage points - Most of the annual price drop occurred in the back half of the year. Real Capital Analytics 2022 transaction volume: Just under $729 billion - Total U.S. CRE transaction volume for 2022. 2022 transaction volume change vs. 2021: Down about 15% - Compared with the record 2021 transaction volume of roughly $855 billion. Q4 2022 transaction volume: About $139 billion - A sharp drop from Q4 2021's record quarterly volume. Q4 2022 transaction volume change YoY: Down 62% - Year-over-year decline in quarterly transaction volume. Dallas transaction volume rank: #1 for the second straight year - Dallas led U.S. markets in CRE transaction volume. Manhattan 2022 transaction volume change: Up 8% YoY - Only top-10 market to post an increase in transaction volume in 2022. Nashville 2022 transaction volume change: Up 25% YoY - One of only three top-25 markets to increase volume. Philadelphia 2022 transaction volume change: Up 5% YoY - Another top-25 market with increased transaction volume. Fed rate hikes by mid-March 2023: 8 increases - Described as the fastest pace of hikes since the 1980s. Current benchmark rate increase: Up 4.75% - Cumulative increase referenced during the interview. Typical price retrade in 2022: 5% to 10% lower - Average price reductions accepted by sellers after rate-driven retrades. Industrial cap-rate expansion since early 2022: About 90 basis points - Industrial cap rates widened from record lows. Multifamily pricing from peak: Off about 20% - Current multifamily pricing relative to its early-2022 peak. Multifamily cap-rate expansion: About 130 basis points - Increase in multifamily cap rates from peak levels. U.S. multifamily units under construction: Over 1.1 million units - CoStar estimate cited for current multifamily construction pipeline. Multifamily starts in 2022: About 627,000 units - The year’s starts contributed to the highest new-start rate in 36 years. Retail inventory under construction: About 0.5% - Retail is one of the most undersupplied major asset classes. Retail share of all retail sales: Over 85% - Brick-and-mortar still dominates retail sales despite e-commerce growth. U.S. office stock today: About 5.56 billion square feet - Cushman & Wakefield estimate of current office inventory. Projected U.S. office stock by decade end: About 5.68 billion square feet - Minimal growth expected in office supply by the end of the decade. Projected occupied office space by decade end: About 4.61 billion square feet - Implied vacancy based on future office demand forecasts. Projected office vacancy by decade end: 19% - Equivalent to roughly 1 billion square feet vacant. Current office vacancy rate cited: 18.2% - Cushman & Wakefield December 2022 U.S. office report. Office utilization (current): Around 50% - Office occupancy utilization recovered from roughly 30% post-pandemic to about 50%. Austin office utilization: 68.1% - Highest among the markets in Castle Systems data for the referenced week. San Jose office utilization: 40.6% - Lowest among the markets mentioned in Castle Systems data. Retail sales growth vs. e-commerce: Brick-and-mortar outpaced e-commerce over the last year - Used to support the case for continued retail relevance. Hospitality RevPAR peak pre-pandemic: Just under $100 - National RevPAR high in summer 2019. Hospitality RevPAR trough: $17 - National RevPAR in April 2020 at the pandemic low. Hospitality RevPAR peak recovery: $110 - National RevPAR hit in July 2022. Office conversions underway nationally: 125 - CBRE estimate of conversions in progress. Office-to-multifamily conversion cost example: $600,000 per unit - Estimated conversion cost in a cited project, excluding acquisition. Office acquisition cost example: $230,000 per unit - Price paid for the vacant office building in the conversion example. Comerica Tower sale price: $83 per square foot - Example of a distressed Dallas office asset enabling partial conversion. Typical stabilized DSCR for multifamily and industrial: 1.25x to 1.3x - Common lender requirement for stabilized assets in these sectors. Typical stabilized DSCR for retail: 1.5x to 1.7x - Higher lender cushion required versus multifamily/industrial. Typical stabilized DSCR for hospitality: 1.75x to 2.0x - Highest among the asset classes discussed. Amazon warehouse leverage example: Up to 95% LTV and 1.1x DSCR - Illustrates how long-dated, highly certain cash flows can support more leverage and lower coverage requirements. Loan-to-value decline with higher rates: 10% to 15% lower - Observed reduction in lending proceeds over the last year. Investor dilution on capital calls: 1.5x is fairly standard; up to 2x - Typical punitive dilution provisions if an investor does not participate. Number of office conversions in firm's experience: Fewer than 10 out of more than 740 projects - Shows how rare office conversions are in practice.

Pivotal Quotes: "We are searching for pockets of opportunity where we feel assets are mispriced due to special circumstances while acknowledging that conventional assets simply maybe won't trade or may not present enough value to make sense." — Ian Formigly: On how CrowdStreet is approaching commercial real estate in 2023. "The answer is a little bit nuanced, but I think if you start from a causation versus correlation perspective for interest rates and cap rates, my study of the market suggests that it's really supply and demand that mainly causes cap rates to expand or compress over time." — Ian Formigly: Explaining the relationship between cap rates and interest rates. "This is about dislocation in the capital markets, like first and foremost, and second and third and fourth and fifth." — Ian Formigly: On why the current market is challenging despite generally resilient property fundamentals.

Implications: Listeners should expect continued CRE stress in 2023-2024, especially in office and refinancing-heavy deals. The best opportunities likely come from distressed debt, recaps, and sectors with real pricing support like retail and industrial.