Commercial real estate tycoon says the industry is entering its final stage of grief: Acceptance

It’s been a rough few years for the commercial real estate industry with rising interest rates, increasing operational costs, fewer available loans, and the rise of the hybrid work trend—something that’s proven to be a thorn in the side of office owners.

Scott Rechler, CEO of the commercial real estate giant RXR, told Fortune that the industry even went through all the emotional hallmarks of the first four stages of grief—denial, anger, bargaining, and depression—in 2023 as the fallout from its challenges hit home. But now, according to Rechler, CRE leaders have entered the final stage of grief: acceptance.

The CRE industry is coming to grips with the fact that this is the start of an entirely new era—and it’s one that won’t be as friendly as others. Higher interest rates, fewer available loans, increased vacancies due to hybrid work; this is the new normal for CRE. “It really is the new interest rate regime after 15 years of almost no, or zero to low, interest rates,” said Rechler, who also serves on the Federal Reserve Bank of New York’s Board of Directors. “There is an acknowledgment: ‘Okay, this isn’t coming back. Now, we need to accept that values ​​are shifting, capital structures are broken. And we have to come to terms with that.’”

Rechler argued that 2024 will be the year the CRE industry—and its lenders—find out what “to come to terms” truly means. He’s forecasting shifting business models, with the rise of office to mixed-use building conversions; a need for capital infusions to lower debt levels; falling building valuations; and even more regional bank failures as the CRE industry’s backers pay the price for its woes.

In RXR’s upcoming annual white paper seen exclusively by Fortune—called “Capitalizing on Opportunities in Turbulent Times”—Rechler breaks down the “regime change” coming for the CRE industry, how to navigate these trying times, and the opportunities that will come with it all.

“The new normal in the post-COVID world means certain business models aren’t coming back,” he told Fortuneadding that “you’ve got to adjust and that’s why we have this whole concept of ‘crossing the chasm.’”

Crossing the ‘chasm’

The commercial real estate (CRE) industry’s nightmare began in early 2020 when the outbreak of COVID-19 forced office and business closures worldwide. Almost overnight, the reliable rental revenues that had pulled so much into CRE were tainted. No one was shopping at malls, going to bars after work, or attending conferences at expensive event centers; and that left numerous formerly money-printing properties empty and struggling.

Despite the pain, most CRE lenders, owners, and operators managed to make it through the pandemic with a little help in the form of government stimulus and near-zero interest rates. But that was before the second wave of pain for CRE.

In March 2022, with inflation racing toward a four-decade high, the Federal Reserve began hiking interest rates aggressively. Almost immediately, borrowing costs for CRE owners became concerned, and finding loans became a challenge. Office owners were then hit with a one-two punch as vacancy rates hit record highs due to the staying power of the hybrid work trend.

It all came to a head in 2023, with commercial real estate values ​​sinking 20%, lending volumes falling 46%, and sales plummeting 70%, according to the Mortgage Bankers Association.

Rechler argues that CRE industry leaders were trying to figure out if there would be a quick recovery for their businesses last year, something that had happened many times before. Was the era of “free money” that persisted for over a decade after the Great Financial Crisis and helped create a profit windfall in CRE coming back? Or would the industry face higher interest rates and challenging conditions for years to come? Many CRE vets couldn’t answer these questions, leading to what some called an “extend and pretend” era—where owners extended loans, praying rates would fall before they had to refinance.

But in 2024, nearly $930 billion of US commercial real estate debt, or around 20% of the estimated $4.7 trillion in total CRE mortgage debt outstanding, will mature, according to Mortgage Bankers Association estimates. And with interest rates having risen dramatically in recent years, much of that debt will have to be refinanced at a higher rate. For Rechler, surmounting this costly debt wall during a period of low loan availability and increased regulatory costs, while maintaining profitability, amounts to crossing a “chasm”—and not every CRE owner will make it.

The situation is especially volatile given that 25% of all office building debt will mature in 2024, and that the sector has become a hot spot amid remote and hybrid work trends. Office space values ​​have plummeted 41.4% from their March 2022 peak, according to William Blair Equity Research data. The national office vacancy rate also hit a record 19.6% in the fourth quarter of last year, according to Moody’s Analytics. This stress will make refinancing office loans a challenge. As Rechler explained, many lenders still view office real estate as “toxic.”

“There are a lot of institutions that are going to take significant losses on their office investments, so they’ll probably stay out of it for longer,” he warned.

For many CRE owners, crossing Rechler’s chasm will also involve more than just refinancing at higher rates. Higher maintenance costs, new working trends, and falling property values ​​will force many businesses to change how they operate. “It’s about not putting good money after bad, and making sure that you know what will work in the new normal,” Rechler said. “You have to find a way to reimagine [the business model] to be competitive.”

In the office sector, Rechler described how the competitive landscape has left higher-quality, so-called Class A, office space in demand relative to lower-quality offerings. “There is this real dichotomy between the higher-quality buildings and obsolete buildings,” he said. This mismatch in prospects means many lower-quality office buildings will need to be converted into mixed-use buildings in order to generate sufficient revenues.

Rechler noted that his company is already pursuing office-to-mixed-use conversions—which is often easier said than done—for some of its traditional office buildings, enabling them to lower their loan values ​​and make more buildings viable investments over the long term .

Many CRE owners, in every sector, will also be forced to look for capital infusions to lower debt levels on their now far less profitable buildings, according to Rechler. To his point, the commercial real estate loan distress rate—or the percentage of loans that have been delinquent for over 30 days—soared 480% from February 2023 to 8.6%, signaling more capital is needed in the sector.

All in all, Rechler warned that some segments of the CRE space are going to “cross the chasm” into the post-COVID era “more easily and some are going to have a harder time.” And while the office sector will likely struggle—they’re not the only ones. Regional banks will face pressure, too (read more here).

A generational opportunity?

Despite the current pain, there are also opportunities in every crisis.

William Blair’s macro strategist Richard de Chazal explained in a March 1 note that even though CRE losses could lead to “some further wobbles” in the industry this year, there is evidence that investors are trying to take advantage of the carnage. “Anecdotally we have also heard of many vulture funds getting ready to swoop on perceived cheap assets,” he said.

Private funds are becoming increasingly interested in CRE as property values ​​drop. Nadeem Meghji, Blackstone global co-head of real estate, told Bloomberg just last week that he sees a “generational investment opportunity” in the industry, arguing that most of the bad news has already been “priced in.” Meghi said he also sees CRE values ​​“bottoming” with the prospect of interest rate cuts on the horizon, but investors need to be particular about which sector they choose. Blackstone has moved into data centers, for example, hoping the rise of AI, increased infrastructure spending, and falling rates help their profits for years to come.

Rechler’s RXR is ready to pounce as well. He says it’s a “stock pickers’” market in commercial real estate—meaning investors need to be selective—but some buildings are now undervalued.

“No one wants to go to an investment committee or credit committee with an office building because it’s toxic,” he said. “So the arbitrage, the opportunity is to better identify which of the buildings will outperform when things normalize because they have the tenant demand.”

Rechler argued that because everyone is painting every type and quality of buildings in the CRE industry “with the same brush,” there are some discounts available for savvy buyers.

Still, at the end of the day, the current CRE regime change isn’t going to be pretty for most. Rechler said that many owners will have to make tough decisions about whether to sell buildings at a loss, regional banks will fail or consolidate, and it will take through the end of 2025 before the CRE industry truly recovers. “While it will be painful, this process is the basic function of capitalism,” he wrote.

Ending on a positive note, Rechler cited John F. Kennedy’s famous quote about the word “crisis” having two meanings. “When written in Chinese, the word ‘crisis’ is composed of two characters—one represents danger and one represents opportunity,” he wrote. “At RXR, we recognize the danger, and as we have done before, we are acting with conviction to capitalize on the opportunity.”