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CRE Transactions Expected to Fall 5% Next Year Amid Rising Treasury Yields

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To understand where interest rates might go, watching the actions of the Federal Reserve is important, of course, but so is monitoring yields of Treasury instruments. Whether bonds, notes, or bills, depending on the term, they have great sway.

Treasurys are considered safe investments, and so are one of those practical baselines for calculating risk adjusted returns. As the yields rise, so do interest rates.

But as is true with anything, trying to track every movement can become confusing.

For example, CBRE noted on Thursday, November 3 that the “recent bond market sell off has lifted the 10-year Treasury yield to nearly 5% and further dampened investor sentiment for commercial real estate.”

 

“Rather than inflation, a mix of short- and medium-term economic and political pressures is driving up bond yields,” they continued. “These include a stronger-than-expected economy with robust consumer spending, increasing term premiums, the surging government deficit and reductions in the Fed’s balance sheet (quantitative tightening).”

Based on such data and their analysis, CBRE said that it lowered growth expectations for CRE investment rate volumes in 2024. The projection had been +15%; now they are -5%.

“Our econometric models indicate that the rise in the 10-year Treasury yield to 5% or more, if sustained, will raise cap rates and lower capital values for commercial real estate,” they wrote.

And if they were correct that the 10-year would continue a strong upward pace, maybe the impact of higher interest rates would have such an impact. They might even be correct.

But this is where following short-term data flows can drive people to potentially make mistakes.

On Wednesday November 1, the 10-year dropped from the previous day’s 4.88% yield to 4.77%. Then on Thursday, it hit to 4.67%, and Friday closed out at 4.57%. Similarly, the 2-year yield went from 5.07% on Tuesday to 4.83% on Friday.

Econometric models can be wrong. Then again, they could be correct, look further out, and maybe yields will rebound in the long run.

But then, CBRE wrote that other than office, the “relative health” of CRE property types “makes forward internal rates of return (IRRs) increasingly attractive.”

“If the economy manages a soft landing and long-term bond rates ease, investment activity may surprise on the upside,” they wrote.

This is why solid hedging strategies make a great deal of sense.

 

Source:  GlobeSt.

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A Sale-Leaseback Conundrum: Elevated Valuations Could Mean Later Problems

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The Federal Reserve’s October 2023 Financial Stability Report was not the sort of reading for CRE professionals to quell their fevered concerns about the industry’s immediate future.

As the Fed wrote, “Valuation pressures arise when asset prices are high relative to economic fundamentals or historical norms.” An apt description for commercial real estate. And elevated valuation pressures can “increase the possibility of outsized drops in asset prices.”

The implications might apply to any CRE property, but on reflection, sale-leaseback transactions seem like they might be particularly prone to adverse effects under the current conditions. The problem that appears for both buyer and seller is the potential longevity of the arrangement. Getting caught by an erroneous valuation is bad enough in the short term. Over a longer period, the effect can be magnified, with more to regret over an arrangement that will run years and possibly decades.

Under a sale-leaseback, the initial owner of a property is also the occupant. That owner decides to sell the property to an investor that will become the new owner and landlord.

The initial owner wants to use the property, often over a long period of time because that party prefers to keep control for years at least or perhaps decades. So, as part of the deal, that party agrees to remain a tenant, often on a net lease basis.

It’s a common type of arrangement. The first owner wants the sale to free capital locked in the building that might be put to better use, like R&D, acquiring another business, or expanding into a new sales territory.

In normal times, understanding the true value of the property is fairly straightforward. But currently, that isn’t possible because there is a lack of price discovery. If, as the Fed suggests, properties are overvalued, then the seller might seem to get a premium, assuming that an experienced buyer won’t recognize the danger, which a bit of a stretch.

However, say the transaction happens on that valuation. The buyer will need rents going forward that justified the price it paid, and they would need to be higher than true market rents. Overly high valuation likely means higher taxes that are paid by the seller. It could be that taxes would eventually come down, but it would require the local government to reassess the property.

This doesn’t mean that a sale-leaseback with net lease can’t make sense, but it might require more thought and negotiation for changing conditions.

 

Source:  GlobeSt.

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The Fed Says CRE Valuations Are Still Elevated

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The Federal Reserve’s October 2023 Financial Stability Report reads like a slightly early major Halloween trick for commercial real estate — no treat in the pages. Overly high asset valuations, even after all that’s happened so far, and ongoing high interest rates are flashing warning signs for the central bank.

One aspect is of particular concern to CRE professionals.

First, the overall view, based on a periodic survey the Federal Reserve Bank of New York conducts, the most recent having taken place from August 10 to October 4. Here is the top line:

“The two most frequently cited topics in this survey — the risk of persistent inflationary pressures leading to a more restrictive monetary policy stance and the potential for large losses on commercial real estate and residential real estate — were mentioned by three-fourths of all survey participants, up from one-half of all participants in the previous survey.”

The grim views are all focused on real estate, whether commercial or residential. For a bit of moderation, the survey was of 25 people, “including professionals at broker-dealers, investment funds, research and advisory fi rms, and academics,” the Fed wrote.

Far from a representative sample, but given the expertise, concerning. About 70% of the experts pointed to commercial and residential real estate as among the biggest risks over the next 12 to 18 months. The only other factors gaining that type of attention were a pairing of persistent inflation and monetary tightening. Auspicious company.

The big problem for CRE is valuation. As the Fed wrote, “Valuation pressures arise when asset prices are high relative to economic fundamentals or historical norms.” An apt description for commercial real estate. And elevated valuation pressures can “increase the possibility of outsized drops in asset prices.”

What is an apparent puzzlement in the Fed’s report is that even as prices have continued to decline, real estate valuations have remained elevated.

“Aggregate CRE prices measured in inflation-adjusted terms continued declining through August,” the report said. “Capitalization rates at the time of property purchase, which measure the annual income of commercial properties relative to their prices, have increased modestly from recent historically low levels but have not increased as much as real Treasury yields, suggesting that prices remain high relative to rental income.”

Office sector prices are particularly elevated, “where fundamentals are especially weak for offices in central business districts, with vacancy rates increasing further and rent growth declining since the May report.” But that doesn’t leave other sectors free and clear.

Some part, maybe significant, of this may be the ongoing lack of price discovery. With transactions down and many sellers holding off, waiting for improved pricing, while a lot of buyers look for bargains in distress, it’s hard to tell how much properties should be worth. CRE has the possibility of seeing significant additional drops in valuation, which would then cause even more problems with refinancing.

 

Source:  GlobeSt.

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Commercial Real Estate’s Troubles Offer Opportunities For Investors

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It’s no secret that the commercial real estate industry is struggling.

The Federal Reserve has hiked interest rates to their highest levels since 2007. The collapse of First Republic Bank last week represented the second-largest commercial bank failure in American history.

But, through all the tumult, there may be opportunities for investors looking to take advantage of the distress, panelists said at Commercial Observer’s State of Commercial Real Estate forum, hosted in partnership with L&L Holding Company.

JPMorgan Chase’s decision to buy First Republic, at the behest of federal regulators, certainly weighed on the minds of the public and private sector experts gathered at 222 Broadwaythe morning of May 2. But not so for Andrew Farkas, CEO of Island Capital Group.

“Now that you’re all distressed investors, this is good,” Farkas said during a fireside chat. “Don’t be afraid of defaulting loans. Don’t be afraid of down markets.”

While “a recession is never really good for anything,” Farkas said that tough markets like today’s are when “fortunes are made,” because investors can buy on the cheap. A slowdown in the debt markets also could encourage sellers to provide financing for acquisitions themselves, he added.

Still, the turbulence in the banking sector is another concern in a long list of problems facing New York City’s office market. A “wave of defaults” looms for office property debt, Richard Barkham, CBRE’s global chief economist, said in the opening panel, titled “2023 Economic Outlook: Analyzing Key Stats & Data.”

Office property values have dropped roughly 30 percent since the pre-pandemic peak of the market, and those buildings are unlikely to recover all of their value in the next five years, Barkham added.

But not every office building is in trouble. High-end, trophy properties are still seeing strong attendance, Jamil Lacourt, director of construction at L&L Holding, said in the “Office 2023: Where Occupier Innovations & Workplace Demand Meet” panel. Buildings that offer tenants data on their carbon footprint are more attractive to firms that are required to track their sustainability commitments, said Linda Foggie, CitiGroup’s global head of real estate operations.

Landlords can also use data to measure how tenants use amenities and what types of benefits keep renters coming back to their buildings, said Chase Garbarino, founder of workplace experience software company HqO. Panelists were joined by Colliers’ Michael Cohen and the Rockefeller Group’s Bill Edwards.

“The market environment today is creating a really good opportunity for the larger commercial real estate market to be more data-driven,” Garbarino said. “Commercial real estate does a better job than any industry in assessing the financial viability of their customers. And they probably have the least understanding of how people use their product.”

Buildings that can’t survive as offices could be converted into housing, if the property is the right size, zoned properly and empty of tenants, said Michael Pestronk, co-founder of real estate development firm Post Brothers.

“You need a lot of stars to be aligned in order to convert an office building,” said Shimon Shkury, president and founder of Ariel Property Advisors, in the “Investment Sales, Conversions & The Rise of the Rental Market” panel. “The city and state, if possible, have to think about subsidies and help people that want to come here and convert office buildings.”

Gov. Kathy Hochul proposed a tax incentive to turn office space into housing in her initial budget in February, though most of the governor’s housing agenda was cut during budget negotiations. But Melissa Román Burch, CEO of the New York City Economic Development Corporation, said legislation to support conversions could be passed before the legislative session ends in June.

Not all commercial real estate properties need a complete redesign. Multifamily properties remain a strong asset class as rising rents outpace the impact of higher interest rates on owners’ bottom lines. (Farkas said he was “all-in” on single-family rentals. “Single-family home rental has been unbelievable,” Farkas said. “And 10 years ago, I told everybody they were going to lose their ask. Wrong!”)

Life sciences space and data centers are also still in demand, particularly thanks to the exponential growth in the amount of data collected by companies that utilize artificial intelligence technology, Rob Harper, head of real estate asset management in the Americas at Blackstone (BX), said in the panel “A Deep Dive Into the State of CRE Market: Paving the Road to Stabilization.”

Last, it was on to retail.

Retail leasing activity has started to trend up slightly, said Fred Posniak, senior vice president of leasing at Empire State Realty Trust. That could be because the retailers that survived the pandemic represent a stronger crop of businesses, Andrew Mandell, vice chairman at Ripco Real Estate, said in the “What’s Next for Retail: The Innovative Strategies Driving the Retail Revival” panel.

Still, retail is far from immune to inflation and the higher cost of debt, which can make it more difficult for retailers to raise funds to expand to new locations, Posniak said.

 

Source:  Commercial Observer

 

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Powell’s Congressional Testimony Likely Means More Rate Hikes

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As they say, if you don’t want the answer, don’t ask the question. But Congress did insist that Federal Reserve Chair Jerome Powell talk about the economy and the Fed’s take this morning. His testimony is probably not what most people want to hear, but certainly what businesspeople, especially in CRE, need to.

If, like an economic Dylan Thomas, you were concerned that the Fed’s policies might go gentle into that good night, don’t worry, they aren’t.

In the testimony, Powell quickly invoked the Fed’s dual mandate of promoting maximum employment and stable prices. Notice, there is no direct mention of easing business costs or supporting asset prices. Those are supposed to come as byproducts — boost business to indirectly promote employment and slow it to moderate prices.

“We have covered a lot of ground, and the full effects of our tightening so far are yet to be felt,” Powell said, for those who want a pause to assess progress. “Even so, we have more work to do. Our policy actions are guided by our dual mandate to promote maximum employment and stable prices. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of labor market conditions that benefit all.”

 

Or, as Oxford Economics translated in an emailed note: “Fed Chair Jerome Powell used his semi-annual testimony to push back against financial markets as his comments were hawkish, noting that the terminal rate for the fed funds rate could be higher than previously anticipated. He noted that he isn’t hesitant to increase the pace of rate hikes if the data on employment and inflation continue to come in stronger than anticipated.”

Although inflation had seemed to be slowing, January was a jarring reminder that inexorable progress toward goals is unusual. Jobs, consumer spending, manufacturing numbers, and inflation “reversed the softening trends that we had seen in the data just a month ago.”

It was the “breadth of the reversal” that meant inflation was running hotter than during the last meeting of the Fed’s Federal Open Market Committee. And even then, the underlying message was not to expect immediate lower interest rates.

Inflation “remains well above the FOMC’s longer-run objective of 2 percent,” and Powell was talking not just the overall number, in which housing costs were a major driver. He specifically mentioned core personal consumption expenditures (PCE) inflation without the volatility of food and energy that push upwards, and core services without housing, which discounts that outlier.

“Although nominal wage gains have slowed somewhat in recent months, they remain above what is consistent with 2 percent inflation and current trends in productivity,” said Powell. “Strong wage growth is good for workers but only if it is not eroded by inflation.”

 

Then he got to interest rates. “We continue to anticipate that ongoing increases in the target range for the federal funds rate will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time. In addition, we are continuing the process of significantly reducing the size of our balance sheet.”

So, continuation of maybe 25-basis point increases and also continued scaling down of the balance sheet, which means reducing purchases of bonds that help fuel home mortgages and, so, that entire part of the construction and sales ecosystem.

However, the maybe is not to be ignored.

“While a quarter-point increase in the Federal Funds rate is still the most likely outcome of the Federal Reserve’s March meeting, expect the Fed to adopt a half-point increase in March if data on inflation and labor conditions continue to run hotter than expected,” said Marty Green, a principal with mortgage law firm, Polunsky Beitel Green, in an emailed note.

 

Source:  GlobeSt.

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Miami, South Florida Still Great Place To Invest, Financial Experts Say

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In spite of rising interest rates and an uncertain economy, South Florida’s commercial real estate market is still an attractive place to invest in, finance experts say.

That was the general consensus among those who spoke at Tuesday’s Urban Land Institute’s Florida Summit at the JW Marriott Marquis Miami.

During a panel discussion on capital markets, panelists Acore Capital managing partner and co-CEO Warren de Haan; Morgan Stanley Real Estate Investing co-CEO Lauren Hochfelder; and senior managing director Jonathan Pollack said credit markets have tightened significantly as the Federal Reserve raised rates in an effort to control inflation. As a result, investors and lenders have become more particular with where they put their money.

However, South Florida and the rest of the Sunshine State are still appealing places for investors thanks to its rising population and openness toward business.

“Politicians in both the state and local level [in Florida] are playing to win,” Pollack said. “You want to be where there is growth and there is going to be growth in Florida.”

 

Hochfelder said South Florida has “officially arrived as a gateway primary market.” Within the area, there’s investor appetite for all real estate asset classes, including new Class A “trophy offices.”

Due to remote working trends in most of the U.S., office buildings elsewhere are seen as a risky endeavor. But in South Florida, the return-to-work trend is about 86%, compared to New York and San Francisco which is “half of that,” Hochfelder added,

De Haas, who recently moved from Los Angeles to Miami, said he was struck by the positivity of the people living in South Florida who desire to “do good” and “move the economy forward.”

“I think Miami showed everybody that they are … business-friendly, that the infrastructure is here, and they are open for business,” he said.

Since the pandemic, wealthy individuals, well-paid professionals, and businesses have been migrating to South Florida thanks to the lack of a state income tax, decent weather, and a pro-enterprise atmosphere, brokers and developers have told the Business Journal. This has resulted in rising rents for apartments, industrial, retail, and office.

CBRE’s Director of Research and Analysis Darin Mellott, who moderated the panel discussion, said the post-pandemic migration is part of a broader story across the Sun Belt, a region in the southern U.S. where taxes are generally low. However, he added, the growth that took place in South Florida outperformed other Sun Belt metropolitan areas.

“People coming to Florida are here for the long term,” Mellott said.”They are comfortable with this market.”

Yet, rougher times are coming for South Florida. As the years go by, so, too, will the adverse effects of climate change and sea level rise.

“While the issue is intermittent right now, it’s going to become a regular and bigger problem in the future,” he said.

In the more immediate timeframe, Mellott said the nation as a whole will likely face a mild recession next year with unemployment reaching as high as 5%.

“While we do think things will slow the next couple of quarters, we do see recovery at the end of next year,” Mellott said.

 

Source:  SFBJ

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Construction Starts Continued To Climb, But Slowdown May Be Looming For Specific Sectors

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Construction starts have remained robust this year but certain sectors could begin to see a slowdown in the coming months.

Total construction starts rose 4% in May to a seasonally adjusted annual rate of $979.5 billion, according to data released late last week by Hamilton, New Jersey-based Dodge Data and Analytics LLC. But among the major categories tracked by Dodge, nonresidential building starts was the only one that increased, by 20%, while residential starts fell by 4% and nonbuilding starts dropped 2% during the month.

It’s a signal homebuilders are starting to pull back on what had been an active construction pipeline through the Covid-19 pandemic, as demand for housing wanes amid a rising-interest-rate environment.

Year-to-date, total construction is 6% higher in the first five months of 2022 compared to the same period in 2021. In that period, residential starts have actually grown 3%, suggesting the tide is only starting to change on the homebuilding front.

Nonresidential building starts have increased 17% annually in the first five months of the year, while residential starts are 5% down.

Richard Branch, chief economist at Dodge Construction Network, said in a statement the construction sector has become increasingly bifurcated in the past several months.

“Nonresidential building construction is clearly trending higher with broad-based resilience across the commercial, institutional and manufacturing spaces,” he said. “However, growth in the residential market has been choked off by higher mortgage rates and rapidly falling demand for single-family housing. Nonbuilding starts, meanwhile, have yet to fully realize the dollars authorized by the infrastructure act.”

Branch said while the overall trend in construction starts is positive, the very aggressive stance taken by the Federal Reserve to combat inflation risks slowing momentum in construction.

Ken Simonson, chief economist at the Associated General Contractors of America, said in an interview he felt homebuilders are in much more precarious position right now than multifamily or nonresidential construction.

Ripple effects on construction starts from the passage of the federal $1.2 trillion Infrastructure Investment and Jobs Act late last year hasn’t been felt yet. Simonson said for a while he’s expected contractors wouldn’t go to work on any IIJA-funded projects until late 2022 or early 2023, which he said he continues to expect. When that occurs, that’ll bolster the pipeline for the nonbuilding sector.

Outside of single-family home construction, multifamily and warehouse development — both of which have seen big growth through the pandemic — may be the most vulnerable to a slowdown, Simonson said.

Seattle-based Amazon.com Inc.’s (NASDAQ: AMZN) disclosure this spring that it had excessive warehouse capacity is one signal of slackening demand, he continued.

“Now that there’s doubt about how strong consumer demand is going to be for goods, I think other businesses are going to slacken their buying and building of warehouse space,” Simonson said.

Amid rising costs and interest rates, it’ll become more challenging for multifamily developers to pencil out deals, also making it more vulnerable than other sectors, he added.

One of the sectors likely to boom: manufacturing. New automotive plants, and large-scale facilities to support the burgeoning electric-vehicle industry, will translate to new business for general contractors nationally, Simonson said.

 

Source:  SFBJ

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Are We In A Shifting Market?

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We have been in a Seller’s market for the last several years. Properties have been sold at values that have not been seen since before the great recession of 2007-2008.  The Federal Reserve has artificially kept the interest rates low and the President in 2020 and 2021 pumped billions of dollars into the economy.  Yes, this helped some people during the pandemic, but also prevented the normal cycle we have seen over the last 40+ years.

In South Florida, every 10 to 12 years, we have seen a down swing in property values, adjustments and corrections for a few years.  The downcycle was due to change around 2020, but, instead, the market heated up.  Why? Due to the movement of large corporations, senior level executives and large private investors moving to South Florida.  This was due in part to the pandemic and no personal income tax.  This kept home prices from declining and values dramatically increasing.  They also sold their investment properties in the high tax states such as NY, NJ, California, Pennsylvania, etc. and purchased replacement properties in Florida.

Why is the market starting to shift now?  Because the Fed is looking at multiple rate increases (4) this year of  75 basis points each meeting. We could see interest rates as high as 6% to 7%, before the end of the year.  This means that Capitalization (Cap) rates must also move up, which will cause the pricing to decline.  We have seen this already occurring in other states in recent weeks.  This will make Buyers happy and put Seller’s in a state of reverse sticker shock, and, in some cases, they may even pass on good sale prices because they do not believe prices are declining.  Buyers are already refusing to accept some of the low cap rates on non-credit tenant transactions.  Transactions will slow in the third and fourth quarter of this year except for seller’s that are now trying to complete their 1031 exchanges.  These only will happen on truly all cash sales with no debt as the current rates are in the 4.75% to 5.5% range from banks and you can’t buy a property with leverage at a 4% to 4.75% cap rate.  The returns are breakeven to negative.

So, I believe we are entering a stabilizing market, we will see adjustments in the next 12 to 18 months, but not a crash.  It won’t be a Sellers or a Buyers’ market, but a market at equilibrium.  This means that both sides will walk away giving a little to make a transaction happen.

If you are a seller there is still time to take advantage of this market, but you need to be realistic and move quickly. Properties need to be properly unwritten with management fees (5%), vacancy and collection rates (5%), reserves for replacements, adjustments for increased property taxes based on sale, and a reasonable cap rate.

SperryCGA can help you still take advantage of the market. We have 60 offices throughout the US, with 8 offices here in Florida.

 

To receive more information on available properties and off-market listings, please complete the form below:

 

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