The prolonged high-interest-rate environment has left few sectors untouched. For individuals, it has manifested in higher living costs and more expensive mortgage debt. For real estate borrowers, however, the impact has been particularly acute. The increase in benchmark rates has raised the cost of floating-rate debt, while inflation has simultaneously driven up operating expenses—including personnel, utilities and maintenance. These pressures have translated into reduced earnings and compressed net operating income margins.
Compounding the challenge is concurrent capitalization rate expansion. Since valuations are determined by the formula NOI ÷ Capitalization Rate, the double impact of declining NOI and rising cap rates—driven by market dynamics and investor expectations—has led to significant erosion of borrower equity. There are a lot of properties in the market where the borrowers now struggle to maintain breakeven occupancy, resulting in negative operating margins after accounting for debt service. This has forced some to subsidize properties directly from personal liquidity or equity infusion, a practice that might not be sustainable over the long term. Once liquidity is exhausted, or confidence in equity recovery diminishes, borrowers may cease supporting the property altogether.
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In this inflationary environment, prudent portfolio oversight and disciplined asset management are critical to ensure rent growth is sufficient to compensate for increase in expenses. Investors must not only monitor operational performance but also anticipate distress and act decisively. Key considerations include the following.
Maintaining operational excellence
Strong property operations remain the cornerstone of investment performance. High occupancy and stable rent collections should be achievable through capable management. Investors should ensure that property managers possess both local market knowledge and experience with the specific asset class. Managing a Class A property, for example, requires a very different operational approach than managing a Class C property. It is critical that property managers conduct regular site visits to monitor conditions firsthand and ensure proper upkeep at the properties. Additionally, property managers should ensure accurate financial reporting and ensure that essential maintenance is not neglected, allowing for additional capital to be allocated toward property renovations.
Implementing rigorous tenant screening
Inadequate tenant screening can be highly disruptive as it can potentially increase delinquencies, undermining occupancy rates and reducing income stability. Furthermore, local landlord-tenant regulations often make the removal of delinquent tenants a lengthy and costly process. Accordingly, investors should confirm that property managers employ robust screening processes designed to evaluate tenants’ creditworthiness and capacity to meet rental obligations to avoid delinquencies. Depending on the property jurisdiction, the eviction process of delinquent tenants may prove to be lengthy and challenging.
Assessing borrower liquidity
Liquidity serves as a critical buffer in the event of operational shortfalls. Investors should evaluate whether borrowers can maintain adequate reserves to support properties when cash flows prove insufficient to cover expenses. Insufficient liquidity heightens the probability of default, borrower disengagement and eventual property abandonment. Insufficient reserves can lead to deferred maintenance issues which can quickly devolve into costly deterioration of property condition.
Dual importance of portfolio and asset management
While operational, tenant and liquidity metrics are essential to monitor, the ultimate success of real estate investments depends heavily on the strength and coordination of portfolio management and asset management teams. Each plays a distinct but interdependent role:
- Portfolio management provides a macro-level perspective, tracking performance trends, monitoring credit risk, and determining strategic courses of action when properties underperform.
- Asset management operates at the micro level, engaging directly with properties through site visits, evaluating management practices, and ensuring adherence to business plans.
The interplay between these teams becomes most critical in distressed scenarios. Consider a hypothetical example: A property has experienced declining operations, the borrower is in default and liquidity support is no longer available. At this juncture, portfolio management must determine whether to pursue a distressed sale or assume ownership with a view to repositioning the property.
Asset management’s local intelligence is vital in shaping this decision. If the property possesses strong fundamentals—such as favorable location, market demand and solid structural characteristics—the asset management team may recommend ownership transfer and operational improvement, thereby preserving value for a later, more favorable sale. Conversely, if the property faces insurmountable challenges such as high crime rates or reputational risks, an expedited sale may be the more prudent course.
In sum, portfolio management maintains a strategic, portfolio-wide perspective, while asset management provides granular, asset-specific insights. Effective coordination between the two functions, in my view, is essential for protecting investor capital and maximizing long-term outcomes.
The combination of elevated interest rates, persistent inflation, and capitalization expansion has created a challenging operating environment for real estate borrowers and, by extension, their investors. Compressed margins, eroding valuations, and liquidity pressures demand a heightened level of discipline in monitoring and managing investments.
By focusing on operational quality, tenant stability, borrower liquidity and the collaborative engagement of seasoned portfolio and asset management teams, investors can mitigate risk and navigate volatility more effectively. In doing so, they would be able to position their portfolios not only for resilience in the current cycle but also for enhanced value creation when market conditions ultimately improve.
Bhavna Goyal is senior director of credit risk management at ORIX USA.
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