Willis Towers Watson Sees Headwinds in Commercial Real Estate

Willis Towers Watson suggested strategies for asset owners to navigate pullback in the commercial real estate market, such as diversifying their real estate holdings, and gave insight on the current state of the market in its new report, “Out of office: The status of the U.S office property sector amid bank turmoil and remote work.”

WTW also reported fewer developing projects being undertaken soon, as regional banks, which provide a significant amount of construction lending, have cut back.

According to the report, landlords will face significant refinancing risks in the next few years, as higher interest rates will result in pricier loans that will come due soon. Commercial mortgages are often structured as three- to 10-year loans for which property owners pay accrued interest in monthly installments over the length of the loan, with a one-time principal repayment at maturity.

Tightening conditions and higher rates, resulting in higher-cost loans, at a time when property values are declining make landlords’ ability to pay off, refinance or sell their properties more challenging. According to the report, $1.5 trillion in commercial mortgages will come due over the next three years, while delinquency rates have ticked up to 4.4% in July from 2.9% in January.

Want the latest institutional investment industry news and insights? Sign up for CIO newsletters. 

What to Expect in the Coming Years

Although the WTW report noted that delinquency rates are lower than in previous cycles, its analysts expect distressed activity to increase over the coming years. According to WTW, the most at-risk loans are those originated in recent years, most at peak valuations with variable interest rates.

There are other structural and cyclical headwinds for the commercial real estate industry, including the growth of remote and hybrid work and the current economic slowdown. WTW predicted office vacancies will rise and peak in 2025 as big tech companies and the federal government, some of the largest commercial tenants, reduce their office space.

According to the report, office attendance has been 40% to 60% of the historical norm. The report cites McKinsey & Co.’s July 2023 McKinsey Global Institute, Empty spaces and hybrid places: The pandemic’s lasting impact on real estate report that states office attendance has stabilized at 70% of the historical norm. “Regardless of the exact utilization figure, the paradigm shift in hybrid work arrangements will likely lead to a material decrease in the amount of office space tenants require, [and it] will take years to understand the effects on overall demand,” the WTW report stated.

While commercial utilization is decreasing, WTW noted that tenants are opting for less space, but in newer buildings—many with LEED certifications and numerous amenities (such as gyms and outdoor space)—near convenient transit locations.

According to the report, older office buildings are becoming obsolete and require significant investment by owners to maintain or renovate. The report cited data from Cushman & Wakefield plc stating that 15% of the U.S. supply of office space—mainly low-quality, older buildings—is responsible for 80% of the sector’s vacancies, as these older buildings struggle to attract tenants. WTW estimated this will result in more than 330 million square feet of excess space by the end of the decade.

WTW also estimated that 34% of commercial real estate can be suitable for use as residential or other space. This does come with its own challenges, the report noted, such as physical and zoning limitations of converting office to residential use.

How Investors Can Better Position Themselves

According to WTW, the pullback in commercial real estate debt markets presents an opportunity to fill the funding gap from non-bank capital providers. There is a big opportunity for alternative lenders, such as private credit and direct lenders, to take up commercial real estate lending as an alternative to local banks, explains Jon Pliner, WTW’s senior director and head of delegated portfolio management.

The report stated that shifting property values and tightening financial conditions have made it possible for lenders to derive equity-like returns by accessing different segments of the commercial real estate finance stack (such as senior debt, mezzanine debt and preferred equity).

Commercial real estate owners who have stakes in the newest, highest-quality buildings will better navigate any future headwinds, WTW noted, adding that commercial office space currently ranks last out of 14 different property types by interest from institutional investors. According to WTW’s report, investors should look into investing in different office subtypes, such as medical or life sciences, which are effectively immune to headwinds such as the economic downturn or remote/hybrid work.

Tags: commercial real estate, Jon Pliner, Willis Towers Watson, WTW

The South Carolina Retirement System Investment Commission allocated nearly $300 million to a number of alternative investment managers between June 1 and September 13, according to the fund’s September 14 board meeting.

The funds receiving investment from SCRS include KPS Capital Partners Special Situations Fund VI and Special Situations Mid-Cap Fund II, which will receive $100 million and $25 million from SCRS, respectively. Banner Ridge Partners will receive $40 million for its Secondary Fund V and $13.4 million for its Secondary Fund V Co, both private credit funds. Varsity Healthcare Partners will receive $50 million for its IV fund. Brookfield Strategic Real Estate Partners will also receive up to $100 million for a real assets fund.

As of June 30, SCRS allocated 13.6% of its portfolio to private equity and 9% to private debt, higher than the targets of 9% for private equity and 7% for private debt. The private equity allocation was also greater than the fund’s allowable range of 5% to 13%.

SCRS CIO Geoff Berg addressed the private equity portfolio and private market authorization exceeding the upper end of the “authorized range” in the meeting and noted that staff would be addressing the overage at a later date and that “the process of doing so will take time.”

Want the latest institutional investment industry news and insights? Sign up for CIO newsletters. 

The investment commission’s notes for the meeting included a table that showed a grade of “reasonably off target” for the policy portfolio for four consecutive quarters, citing the private equity allocation. In March, Berg told the commission that the plan was overweight “due to the ongoing strong performance of private assets relative to public markets.” The reported allocation to private equity of 13.6% on June 30 is lower than the 15% on March 31 that was reported in June.

The commission monitors the targets because it “believes that long‐term investors should resist the temptation to adjust their long‐term asset allocation in response to short-term volatility in capital market expectations. The Commission will not depart from [its] asset allocation review schedule,” according to the commission meeting agenda notes. The SCRS is following a trend to take advantage of growth in alternative assets, as public pension funds have been investing more in alternative assets than at any time in history, according to recent research.

The pension fund managed $40.6 billion in assets across the state’s retirement system as of June 30. Public equities made up a majority of the fund’s holding at 44.3%, bonds accounted for 20.6%, and 12.5% is in real assets.

The SCRS also reported it has 12 vacant staff positions, including three investment officer positions, four investment associate positions and five additional vacancies. The fund plans to fill any vacant roles “as best serves the needs of the agency,” according to the meeting minutes.

The fund exceeded its internal benchmarks for public equity, private equity and real assets for the quarter ending June 30. Bonds and private debt did not exceed their benchmarks. The fund’s returns for the last one, three, five and 10 years were 6.83%, 10.79%, 7.19% and 7.11%, respectively, compared with the firm’s respective benchmark returns of 5.49%, 7.83%, 5.98% and 6.46%.

Tags: RSIC, SCRS, South Carolina Retirement System, South Carolina Retirement System Investment Commission