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Net Lease’s Meteoric Rise In Inventory And What It Means For Cap Rates

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The net lease market has witnessed an astounding transformation in the last two years. From May 2022 to May 2024, the total supply of net lease available assets has increased from $9.05 billion to $24.3 billion. That represents a 168% jump in inventory in only 24 months despite average cap rates rising 88 basis points during that same period.

Many participants in the net lease market are overlooking the major storm brewing on the horizon. Despite rising cap rates, inventory levels continue to swell, signaling that cap rates will almost certainly climb much higher to restore market equilibrium. Here, we explore the reasons behind this trend, analyze the underlying data and discuss implications for the future so you can stay ahead of the market.

 

The Cap Rate Pendulum Swings

Coming off historically hot market conditions in 2021, with cap rates at all-time lows, the market experienced a dramatic shift. Inflation and interest rates quickly skyrocketed, leading to a far higher cost of financing with an ensuing slowdown of buy-side activity. By late 2022, market transaction velocity was plummeting despite a steady influx of assets hitting the marketplace. Sellers have been holding onto “hope certificates” for the past 18 months, anticipating that cooling inflation and potential Federal Reserve interest rate cuts would lure investors back to buying at aggressive cap rates. However, none of that has come to pass, and the supply/demand imbalance has reached its breaking point.

 

The Current Marketplace in Four Tenants

Market transaction and cap rate data on four specific, highly traded retail net lease tenants provide an incredible snapshot of the broader marketplace dynamics. Chipotle, Starbucks, 7-Eleven and Walgreens are some of the most commonly traded net lease brands, and these tenants provide a fascinating illustration of how the landscape has radically shifted. Over the past two years, cap rates for these tenants have steadily increased, mirroring the overall market shift.

In 2022, the average cap rate for 7-Eleven was 4.51%. By 2023, it had risen to 5.38%. For Chipotle, the average cap rate increased from 4.26% in 2022 to 4.88% in 2023, reaching 5.08% in early 2024. Starbucks saw its cap rate go from 4.75% in 2022 to 5.29% in 2023, and it currently sits at 5.47% in 2024. Walgreens experienced the most dramatic rise, with cap rates moving from 5.60% in 2022 to 6.25% in 2023 and a significant jump to 7.19% in 2024.

These increases in cap rates have been accompanied by a sharp decline in the number of closed transactions. For instance, 7-Eleven saw 148 closed comps in 2022, dropping to 114 in 2023 and just 24 so far in 2024. Similar trends are evident across the other tenants, with Starbucks seeing a drop from 158 closed comps in 2022 to 124 in 2023 and 47 in 2024.

These market conditions and numbers tell a sobering story. Despite cap rates rising substantially over the past two years, on-market inventory has exploded, and transactions have collapsed. This implies that cap rates still have far to go to find market-clearing buyer demand. Let’s look forward and consider how this will play out in the coming months.

 

The Tipping Point: Motivated Sellers and Accelerating Cap Rates

Within the current on-market inventory, there are both motivated sellers and those with lower eagerness to sell. Motivated sellers, who must make deals due to factors such as loan maturities and financial pressures, make up a large percentage of the market. Therefore, the crux of the pressure within the market lies in the decisions these highly motivated sellers will make and to what extent they will loosen up their pricing. In turn, as the inventory of motivated sellers grows, we can anticipate a notable shift.

As time passes, the urgency for motivated sellers will intensify as loan maturities and financial pressures draw nearer. With a glut of inventory in the marketplace, these sellers will feel compelled to price their assets more aggressively, lowering prices and increasing cap rates to more quickly attract buyer engagement. These highly motivated sellers will have an outsized impact on the market comp data – particularly when transactions are at a relatively low point – setting lower ceiling benchmarks on valuations.

This shift is likely to have a snowball effect. As more sellers observe transactions closing at higher cap rates, fear of further increases will set in. This will drive a sense of urgency, prompting even more motivated sellers to enter the market and accept the new pricing reality. Highly motivated sellers, however, are not the only ones who may want to change their game plan. Conversely, fewer may choose to withdraw their assets from the market and hold onto them if cap rates rise too much. We believe that given the glut of supply of those tenants mentioned earlier, as well as many other household name net lease credit tenants, the result could be a rapid upward adjustment in cap rates, potentially climbing 50 to 75 basis points from current levels through 2024 and well into 2025.

The cycle will then repeat itself as more highly motivated sellers need to transact and “leapfrog” the cap rates from prior sales, until such time the new crop of buyers take notice of the attractive pricing levels in the net lease market and flood in. This process will continue until a happy medium is found where transaction volume consistency and cap rate fluctuation will stabilize in cohesion with one another.

 

Navigating the New Landscape

For brokers and investors alike, this evolving landscape presents challenges, but where there is a challenge, there is an opportunity. Understanding the motivations behind current inventory levels and anticipating the likely shifts in cap rates can inform strategic decision-making. Sellers who recognize the changing tide and adjust their expectations proactively may find themselves better positioned to navigate the market effectively ahead of time, rather than being forced to react more drastically as the pattern continues.

On the buyer side, the coming months may present unique opportunities. Higher cap rates can translate into more attractive yields, drawing in investors who have been on the sidelines. As the market finds its new equilibrium, savvy buyers will look to capitalize on the evolving conditions, securing desirable assets at favorable pricing.

The current logjam in the net lease marketplace is a complex phenomenon driven by rising cap rates and shifting economic conditions, and the breaking of this logjam will be marked by a period of rapid adjustment. Sellers, driven by necessity, will set new cap rate benchmarks, accelerating the market’s recalibration. While the near-term outlook suggests further upward pressure on cap rates, the market’s ability to adapt will ultimately determine the trajectory. By staying informed and responsive to these dynamics, stakeholders can navigate the challenges and uncover opportunities in this evolving landscape.

 

Source:  GlobeSt.

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Have Cap Rates Peaked?

Cap rate expansion may have very well peaked, but uncertainty will delay sales volume recovery until 2025, according to CBRE’s cap rates survey for the first half of the year.

cap rates graphTreasury yields remained volatile during the first half of 2024, reacting to economic data that sent mixed signals about the outlook for inflation, Federal Reserve policy and long-term interest rates. The 10-Year Treasury yield started 2024 below 4 percent and peaked at 4.7 percent in late April.

Ultimately, continued disinflation and expectations for a Fed rate cut held the 10-year Treasury yield to 4.2 percent as of June.

“Interestingly, different property types did not move in unison but rather reacted uniquely to changing fundamentals and capital markets drivers. For instance, industrial cap rates fell on average and office yields continued their climb,” according to the report.

More than 250 CBRE real estate professionals completed the survey with their real-time market estimates between May and June. The report captured 3,600 cap rate estimates across more than 50 geographic markets to generate key insights.

Every one of CBRE’s reports in the series asked respondents to estimate the direction of cap rates and the magnitude of the expected change during the next six months. This quarter, the most common response across all categories was “no change.” Fewer respondents believe cap rates will increase during the next six months compared to the previous two publications.

“This improved sentiment is likely driven by more accommodative signals from the Fed and the decline in bond yields from their October 2023 peak,” the survey revealed.

The share of respondents expecting further devaluations was highest within the office sector, reflecting the uncertainty around market fundamentals.

Buyers coming off the sidelines

Doug Ressler, manager of business intelligence at Yardi Matrix, told Commercial Property Executive that it appears that cap rates have indeed peaked but ongoing uncertainty is expected to delay sales volume recovery until 2025.

“During the first half of 2024, cap rates held steady despite fluctuations in Treasury yields,” Ressler said. “Different property types reacted uniquely to changing market conditions, with industrial cap rates decreasing and office yields continuing to rise. Most respondents in the survey believe that cap rates will remain stable in the near term.”

Peaking will differ by market and property type, Ryan Severino, chief economist at BGO, told CPE.

“There has been tentative evidence of peaking broadly, and that looks almost certain with the Fed set to start cutting rates,” Severino said. “The first-order effect of a rate cut won’t have much impact. But the second-order effect, decreasing the risk premia embedded in cap rates, should be more meaningful—especially with the record amounts of dry powder sitting on the sidelines like Pavlov’s dogs waiting for the Fed to ring the bell.”

Matthew Lawton, executive managing director at JLL, mentioned cap rates peaked in the second quarter and have a downward trend based on some recent transactions, including the KKR portfolio acquisition and other recent one-off transactions in the multifamily space.

“We are seeing a significant number of buyers coming off the sidelines due to several factors, including discount-to-replacement costs, lack of new starts that will lead to outsized rent growth and bringing in residual cap rates due to treasuries stabilizing and coming in more recently,” Lawton pointed out.

Equilibrium must avoid negative leverage

Recent data suggests there is uncertainty in office cap rates in some major markets, according to Jeff Holzmann, COO at RREAF Holdings.

He further added, “But that peak assumption is only a short-term observation since the cap rates are closely related to interest rates. The equilibrium can only survive long term as long as we are not in the zone referred to as negative leverage. This occurs when the effective cap rate is lower than the interest rate of the debt, which means that even a functioning property that is producing cash flow can’t service its own debt, not to mention profits. That’s when properties fail, loans stop, and a new equilibrium must emerge.”

“Hence the future trajectory of the cap rates in the industry will depend on what the Federal Reserve does with the interest rates in the coming months. The consensus seems to be that rates will remain steady or possibly even decrease for the first time in a long time. This suggests we may see peak cap rates for quite some time,” Holzmann concluded.

Neil Schimmel, Investors Management Group founder & CEO, noted that with inflation and debt pricing falling, cap rates are poised to follow suit.

“Loan rates have dropped 50 basis points in the past few weeks. Today’s underwhelming jobs report confirms the Fed’s success in cooling inflation. As a result, cap rates have likely peaked and will decline, though not to the lows of 2021 and 2022.”

 

David Camins, principal at Xroads Real Estate Advisors, told CPE that the argument could be made that cap rates have peaked in the office sector; however, they may be “the least of the worries for a potential buyer,” considering the number of lenders still not lending to the office sector.

“Anyone underwriting a loan or investment in the sector is not solely focused on a cap rate, as underwriting the cash flow for a multi-tenant office property is not as linear as it once was,” Camins said. “These days, it’s more akin to how hotel cash flows used to be underwritten.”

“Even if lease rates are relatively the same, they are materially different given the ‘new’ creativity within the concession packages. These all contribute to challenging cash flow projections, regardless of what economic factors are under consideration,” he concluded.

 

Source:  CPE

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Single-Tenant Net Lease Cap Rates Rise

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While 2023 was not kind to net lease, things have been improving so far in 2024, particularly for single-tenant.

A new report from the Boulder Group says that in the second quarter of 2024, single-tenant net lease saw cap rates increase for the ninth consecutive quarter. That was for all three sectors, with retail hitting 6.47% (up five basis points), office up 7.67% (an increase of seven basis points), and industrial at 7.10% (eight basis points up).

Things have been improving since the middle of Q2. In May, Marcus & Millichap said single-tenant net lease was in good shape. They pointed to the continued strength of the labor market and says that has supported increases in retail spending beyond inflation for real growth. Real increases in wages also helped by giving people on average more money to spend after price inflation.

The Boulder Group also noted that property supply had increased by 8.7% over the first quarter. Q2 also saw the largest number of properties on the market since 2021 Q4. For retail, the amount of inventory increased quarter over quarter by 8.1%. Office was up 11.4% and industrial, 9.5%.

Investors have shifted their positions. They largely think that the market currently favors buyers, which would fit with the ongoing increases in cap rates. That is particularly true for commoditized properties. Buyers have little competition and, as a result, are largely focused on either tax-free states or regions with strong demographic drivers. They’re also looking for CRE fundamentals and tenants with good credits. Stronger brands — Olive Garden and Texas Roadhouse, Boulder gave as examples — haven’t seen increases in cap rates.

Breaking results down even further, the auto sector has seen a five-point increase in cap rate. Median asking cap rates vary by lease term remaining. So, an auto service location with 16 to 20 years left has a 5.50% cap rate, but a 7.15% one for five years or less.

Casual dining saw an eight-basis point increase in general. But the rates varied from 5.25% for a Texas Roadhouse ground lease to 7.25% for either a Buffalo Wild Wings or an iHOP. Median asking cap rates ran from 6.05% for 16 to 20 years left on the lease to 7.30% for five years or less.

Dollar stores ran from 6.75% for Dollar General to 7.80% for Family Dollar. Net lease drug stores have seen some tough times for Walmart, Ride Aid, and Walgreens. The overall sector saw asking cap rates of 6.67%. But even if particular locations are threatened, the quality of the real estate that drug stores have accumulated is good, meaning owners should be in good shape, even if a store pulled out, as there will be plenty of other opportunities.

 

Source: GlobeSt.

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STNL Cap Rates Won’t Be Coming Down Soon

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Cap rates for the single-tenant net-lease sector increased for the eighth consecutive quarter in Q1 2024, jumping to an average of 6.64% across all major asset types.

STNL asking cap rates for office properties hit 7.6% in Q1, followed by industrial, which averaged 7.02%, and retail, which jumped to 6.42%, according to the latest market report from The Boulder Group.

According to The Boulder Group’s Jimmy Goodman, the current cycle of STNL cap rate increases is the longest since 2014. In an interview at GlobeSt.’s Net Lease conference in NYC this week, Goodman said STNL cap rates will remain elevated until the Fed starts cutting interest rates.

“I think we’re at status quo, this is the new normal until the Fed moves to cut rates,” Goodman said. “Everyone had this level of hope last year that we would have rate cuts this year, but 2024 is looking a lot like 2023.”

“Now, people are hoping for a rate cut in Q3, but it probably won’t be a large cut,” he added. “Until then, nothing will change. Cap rates will increase or plateau. I don’t see them decreasing any time soon.”

The new status quo also is likely to keep transaction volume at a minimum — one description we heard is “flatlining” — as buyers are few and far between and sellers refuse to reprice their deals to higher cap rates.

Most of the players in the STNL market are in it for the long-term, typically with 10- or 20-year leases, and they can wait out the down cycle, Goodman noted.

“It’s a steady cash flow. The lenders, the equity, they know they’re going to get a check from the tenant,” he said. “If a $2M Starbucks just got built, it’s got a 10-year lease and they know they’re going to get paid.”

Sellers are still in denial about bringing their pricing in line with the new status quo on cap rates, Goodman suggested.

“If you’re a developer, you still want to make money off your merchant developer deals. The public REITs and people that are subject to financing can’t pay the cap rates the developer wants, and the developer doesn’t want to be upside down,” he said.

“Everyone is staring at each other and nobody is blinking,” Goodman added.

 

Source:  GlobeSt.

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Triple Net Lease Cap Rates Still On The Rise

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You might know that Sound of Music sing-a-longs are a thing in live theater and online. You can bet that one of the favorites is Climb Every Mountain. If only triple net lease could step out of the spotlight.

Unfortunately, the sector seems to be providing encore performances as average closing cap rates keep their upward inclination, according to the Lomuto Report out of Northmarq.

“[The] indicators are saying we’re probably not done with rising cap rates just yet,” Chris Lomuto wrote. “Lots of existing inventory to burn off, maturing loans that may be difficult to roll over, developers needing to recycle capital, tight spreads, and a dearth of 1031 buyers. These are not traditionally a recipe for stable or falling cap rates.”

The mechanisms at work seem clear. In short, there’s more supply and less demand, squeezing out the value owners can claim and lowering the willingness of buyers to pay higher prices. As long as the conditions continue, there’s upward pressure on closing cap rates.

Though Lomuto notes some trends that could eventually head things off and restore a more dynamic market. For example, the average asking cap rate trend for all NNN started to rise in May 2022, when they were about 5.25%. With some minor ups and downs, it’s continued to rise and has gained roughly 100 basis points to 6.25%. Owners are recognizing that they can no longer expect as much as they could have in the near past when markets were at a high and the full impact of higher interest rates hadn’t yet been felt.

With the rise in asking cap rates had been compression of the gap between them and benchmark yields from, in the case of the federal funds rate, 587 basis points in January 2021 to 91 basis points in December 2023. The gap to the 10-year Treasury had been 488 basis points in that same January and now are 222. The S&P 500 earnings were spaced out by 295 and now that gap is 239. All in all, the biggest gap is within under 240 basis points.

Where things can get a little odd is looking at cap rates by product type. Lomuto shows a number of categories: auto and car wash, convenience and gas, dollar stores, grocery, industrial, office, pharmacy, and QSR. Measured from peak pricing, pharmacy is up by only 75 basis points (he points out that issues with Rite Aid and Walgreens should have had more effect). Grocery, one of the die-hard categories, has seen cap rates up over dollar stores. And office seems up only by 50 basis points — okay, more than odd, more like crazy.

When transactions are thinner than usual, “it’s very important to look critically at individual comps, including a thoughtful survey of what else is on the market now, when quoting a cap rate.”

 

Source:  GlobeSt.

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Maturing Loans Will Bring More Clarity To Capital Markets

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Even the experts appear reluctant to predict what 2024 holds for the commercial and multifamily mortgage markets, though they hope the year will bring more clarity.

The just-released Mortgage Bankers Association’s 2024 Commercial Real Estate Finance Outlook Survey describes an unsettled market for borrowing and lending – but anticipates conditions will stabilize in the new year.

One thing is clear. Even though borrowing has declined, the level of outstanding mortgage debt has continued to rise. “A decline in sales transaction and refinance volumes has meant less new debt being extended, but it also means that fewer loans are paying off than in many earlier periods. The result is that debt levels continue to rise, but at a pace that is roughly half of what was seen last year,” the report stated.

“The level of commercial/multifamily mortgage debt outstanding increased by $37.1 billion (0.8 percent) in the third quarter of 2023 to $4.63 trillion. Multifamily mortgage debt alone increased $26.8 billion (1.3 percent) to $2.05 trillion from the second quarter of 2023.”

Virtually every type of lender increased the dollar volume of its holdings of commercial/multifamily debt.

This has happened even though CRE mortgage borrowing plummeted 53% in the year to date. Loan originations fell 7% between 2Q 2023 and 3Q 2023 and 49% year over year – a slump that affected all major property types.

Mortgages that mature in 2024 could bring more clarity to the prospects for the CRE market – “and could force the issue for many owners,” the report stated.

“Many maturing loans have and will refinance easily – providing new ‘marks’ for the market. Maturing loans that have difficulty refinancing at terms the borrower hopes for, as well as loans that are facing challenges during their terms, may end up being another key to unsticking the markets.”

Underlying these problems are questions about property fundamentals, uncertainty about property values, and higher and volatile interest rates. “Greater certainty around these conditions is a key prerequisite to breaking the logjam of transaction activity” that has left many participants on the sidelines, the report commented, noting that the recent drop in long-term interest rates could bring relief to both cap rates and financing costs. At the same time, it pointed out that the Fed’s tight money policy could still have impacts in the future and tightening of credit is also possible.

Meanwhile, different analysts produce different conclusions on how property values are being affected.

“Most series show cap rates increasing but the pace lags the growth in broader interest rates that many look to as a base comparison,” the report said.

RCA found apartment cap rates rose to 5.2% in 3Q 2023, industrial cap rates to 5.9%, retail to 6.6% and office to 6.9%. MBA’s own models predicted a more substantial rise but said market uncertainty makes the situation unclear.

Each sector of CRE faces difficulties. Offices are grappling with how hybrid work will affect demand for office space, leaving owners to figure out which properties will be most affected. Quality of buildings rather than age, is said to be most important. Industrial and multifamily properties are facing a supply glut that outstrips demand and slows rent growth, though industrial vacancy rates remain low and rent growth remains positive. Retail, especially general purpose buildings, is seeing demand but some malls are experiencing negative net absorption.

As CRE markets confront these challenges, there has been a slow and steady uptick in delinquency rates, the report found. The share of properties with outstanding loan balances that were current or less than 30 days late fell from 97.7% at the end of 2Q 2023 to 97.3% at the end of 3Q 2023. Loans backed by office properties were largely responsible, with delinquent loans up from 4% to 5.1%. However, all sectors saw delinquencies rise, though for multifamily and industrial property the hike was less than one percent. And every capital source saw an uptick in unpaid principal balances.

The findings are based on a survey sent to leaders at 60 of the top commercial and multifamily mortgage origination firms, with a 40% response rate.

“CRE markets are entering the new year relatively stuck,” summed up Jamie Woodwell, MBA’s head of CRE Research. “Leaders of top CRE finance firms believe that a host of factors may continue to act as a drag – rather than a boost – to the markets. However, they do believe that overall uncertainty will dissipate over the year, helping to boost borrowing and lending above 2023 levels.”

 

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Is A Sale-Leaseback Strategy A Viable Alternative For Your Business?

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By Ron Osborne, Managing Director, Sperry Commercial Global Affiliates | RJ Realty

 

As a financing method, a sale-leaseback holds more advantages for businesses compared to leveraging their balance sheets. With today’s escalated interest rates, a scenario has emerged where the sale-leaseback option outweighs borrowing avenues for companies. If a business’s borrowing rate for a leaseback (or cap rate) is significantly lower than its corporate borrowing rate, redirecting equity tied up in a building becomes a viable alternative, particularly for business expansion.

Often, businesses encounter opportunities to broaden their reach or enhance their current facilities. Capitalizing on these prospects sometimes demands more funds than readily available. In such cases, selling the property, unlocking the tied-up equity, and reinvesting it into business expansion or improvements becomes a more cost-effective solution than traditional borrowing options.

Consider this: if the borrowing rate stands at 9% to 10%, but the business can sell and lease back the property at 6% to 7%, there exists a substantial 200 to 300 basis point spread. Undoubtedly, this presents a far more advantageous financing route than leveraging the balance sheet.

This strategy empowers the company to retain control over the asset by becoming a tenant for a specified duration—a 5-year, 10-year, 15-year term, or as outlined in the agreement.  Sometime the buyer will give the ownership the First Right of Refusal or Option to buy back the property at some future time and price.

Sale-leasebacks have served companies, regardless of their size, for numerous years, facilitating business expansion, debt reduction, or other alternative uses made possible by the equity in their properties. They’re  an excellent method for companies to unlock dormant equity and channel it toward paying off debts, acting as a debt substitute, or funding crucial business-related upgrades.

Given the recent substantial rise in interest rates over the past couple of years, businesses eyeing property purchases or refinancing endeavors to expand could view a sale-leaseback as a viable alternative to an SBA loan.

 

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Top 15 CRE Investing Mistakes

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The CRE industry is different than all other industries in that it is a transaction-based model. The lifeblood of the industry is dependent on sale, financing, and lease transactions. The more transactions there are, the more money the industry and everyone in it makes and the more successful the business. 2021 was a record year for transaction volumes and a phenomenal boom year for CRE.

The most successful companies and individuals in the industry are usually adept at selling, financing and/or leasing CRE property. However, in pursuing these transactions the same key mistakes are made over and over again which usually results in poor performance, the loss of equity in a property or the loss of the property in foreclosure. Below are the 15 biggest investing mistakes in CRE that are the root cause of bad deals, according to Joseph J. Ori, Executive Managing Director at Paramount Capital Corporation, a CRE Advisory Firm.

  1. Acquiring properties at low cap rates. Cap rates below 5.0% are not justified even if the investor believes that future rent increases, which may not happen, will make up for the low initial return. Buying CRE at sub-5.0% cap rates is like buying a tech stock at a 100-price-to-earnings ratio.
  1. Not diversifying a national portfolio by property type, location, and industry. Many national firms diversify a large fund by type and location but forget about industry diversification. If an investor buys only apartments and offices in Silicon Valley, 70% of the apartment tenants work in the tech industry and 70% of the office tenants are technology or related companies. If the tech industry retracts in a downturn, many of the apartment tenants may be laid off and unable to pay their rent or may move home or double up with roommates. This will negatively affect the apartment market. Many of the office tech firms may default on their leases or shrink their space requirements, which will negatively affect the office market.
  1. Not performing property level and financial due diligence on all properties in a portfolio acquisition. Many institutional investors that acquire large portfolios consisting of dozens or hundreds of properties do not do sufficient property-level due diligence. They only look at the larger and more valuable properties in the pool or hire inexperienced third-party firms to do the property-level due diligence.
  1. Acquiring properties with negative leverage. Negative leverage occurs when the cap rate is less than the mortgage constant, which means the cash-on-cash return will be lower than the cap rate, which is a “no-no” in CRE. Many firms acquire properties with negative leverage believing that future rent increases will more than make up for the low initial return.
  1. Using short-term floating rate debt without the protection of a swap or collar to finance a long-term real estate asset or portfolio. This is what has occurred during the last two years as the Fed abruptly raised the federal funds rate from 0.0% to 5.25%. Many CRE investors were caught flat-footed by the quick increase in interest rates from floating rate debt and no interest rate protection and are now scrambling to lower their financing costs and risk.
  1. In underwriting an acquisition, using a terminal cap rate that is less than the going-in cap rate. This is often done by the acquisition or other internal group within a large CRE firm to “juice up” the internal rate of return on the equity in a deal underwriting.
  1. Institutional investors who commit capital to sponsors who have inexperienced senior management teams. The senior management team should have gray hair and have been through at least the last two secular CRE downturns of 1987-1992 and 2007-2012. One of the most important drivers of success in CRE investment is having individuals on the team with significant and long-term experience and knowledge in all property types, markets, and economic recessions.
  1. Using overly optimistic rent projections in underwriting a deal. This often occurs when  the acquisition or other internal group wants to make the deal look better and the deal to be developed or acquired.
  1. Not analyzing the sales volumes per square foot of retail tenants, a key metric when buying shopping centers. One of the most important metrics when buying shopping centers after the cap rate, is the sales per square foot of the anchor tenants. High sales per square foot means the center is in an A location, will remain fully leased and in high demand from tenants and shoppers.
  1. Using high leverage of more than 75%. One of the highest risks in CRE investment is using high leverage and this was one of the causes of the Great Recession from 2007 to 2012.
  1. Not giving senior-level employees an equity interest in the company, portfolio, or fund. This is what is known as the “golden handcuffs” in CRE. If you don’t take care of your key people, they will leave and become your competitors.
  1. Not incorporating the 15 risks of CRE in a real estate firm. The risks include cash flow, value, tenant, market, economic, interest rate, inflation, leasing, management, ownership, legal and title, construction, entitlement, liquidity, and refinancing into the firm’s investment strategy.
  1. Investing in property sectors like hotels and senior housing, which are more operating businesses than real estate deals, in which the investment firm has no experience. Hotels are typically 70% operating business, and 30% real estate deal and senior housing is 80% to 100% operating business and 0% to 20% real estate.
  1. Not obtaining the Kmart discount when acquiring a large portfolio of CRE assets. Whenever a large CRE portfolio trades it is typically made up of Class A queens, Class B pigs and average Class B deals, and the buyer needs a discount of at least a 1.0% higher cap rate for the risk of the Class C properties.
  1. Not checking the formulas in an XL underwriting workbook, as there is at least one formula error in every CRE underwriting worksheet. This is a common occurrence when preparing a complicated Excel underwriting workbook and firms should make sure that  all formulas are rechecked by an independent party.

 

Source:  GlobeSt.

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Capital Markets Forecast Calls For Cap Rate Stabilization, More Transactions

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Forecasts are helpful, but how accurate they are is what ultimately counts.

CBRE undertook a review of the forecasts it made at the beginning of the year and updated its outlook through year-end and into 2024.  For the most part, the company has nailed the trends that have been occurring in the CRE capital markets, with a few exceptions.

Namely, it has altered its prediction about the timing of a recession due to the resilient economy and persistent inflation. It now predicts if one happens it will occur in late 2023 or in the first quarter of 2024, one quarter later than it originally thought. A recession may bring a mild increase in unemployment to about 5%. Other headwinds of higher interest rates may affect growth negatively in this year’s second half and the restart of student loan payments may pare consumer spending. CBRE has adjusted its 2023 GDP growth forecast upward to 0.6% and 2024 growth forecast downward to 1.3%.

Investors have been cautious so far this year in their transactions, with volume down by 60% year-over-year in the second quarter. Uncertainty about interest rates and the outlook and tighter credit conditions are expected to continue to be hurdles to deal flow, but more stable conditions are coming, it predicts, before year-end. That should bring pick-up in investment activity, CBRE says.

Cap rates have increased by about 125 basis points for most property types but variations occur by market and are closer to 200 bps for office assets. By early 2024 there should be cap rate stabilization for all property types, except offices, which won’t stabilize until next mid-year.

Investment volume is forecast to decline by 37% year-over-year this year and increase by 15% next year due to greater certainty about interest rates and as the economic outlook supports stronger purchasing activity.

Finally, an interest rate cut is not expected until early 2024 and the 10-year Treasury rate will end this year at 3.8% before falling closer to 3% late next year.

 

Source:  GlobeSt.

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$626B In CRE Debt Maturing In The Next Two Years Is Potentially Troubled

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A somber portrait of the state of U.S. capital markets and their impact on CRE has emerged from Newmark’s second quarter Capital Report.

It depicts a landscape of low loan originations, fewer lenders, underwater loans, troubled debt about to mature, and rising cap rates across a wide swath of the CRE spectrum.

Loans are hard to get in this new world. CRE debt origination is down 52% in 1H 2023 compared to the prior year and 31% compared to before the pandemic. Equally concerning, there are 32% fewer active lenders in the market today compared to a year ago.

“The small and regional bank lending engine that has driven the CRE market is rapidly slowing with no clear replacement,” the report noted. 

And this is affecting the entire banking industry, not just regional banks. All property types and lending sectors are affected, “though office, debt funds and CMBS/CRE CLOs (commercial real estate collateralized loan obligations) are negative outliers.” Loan originations are down most dramatically for multifamily.

Furthermore, banks are being more restrictive about whom they lend to and the assets they are willing to consider.

And if loans are hard to get, some of those that were made in the good times and are coming due will create new headaches. Newmark predicts that $1.4 trillion in debt will mature in 2023-2025 — but with significantly higher debt costs than when the loans were originated. On top of that, many loans are actually or nearly underwater, especially recently issued property and office debt.

The report also identified clear increases in transaction cap rates, “which now appear distinctly unattractive relative to the cost of debt capital, possibly excepting office REITs.”

 

Source:  GlobeSt.

 

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