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3 Multifamily Trends CRE Investors Should Monitor

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Multifamily properties are still going strong in the commercial real estate (CRE) sector. But it’s not business as usual. Coming off record growth in 2021, the industry is recalibrating, which creates dynamic investment, valuation and risk environments for multifamily property investors.

Heading into 2023, inflation and rising interest rates prompted forecasts for a slight slowing of growth in the multifamily property sector. Through the first quarter, overall occupancy rates held steady, with a modest increase in vacancy rates to 6.7%, up from 5% one year ago. Rent income is still growing, but month-over-month increases are returning to pre-pandemic norms. Nationwide, demand for multifamily units remains strong, with plenty of inventory in the construction pipeline.

Looking ahead, multifamily properties continue to offer appealing and profitable opportunities for commercial real estate investors. However, today’s evolving market can’t be predicted based on past performance. For investors, keeping a pulse on key demographic, economic and risk-related trends is more important than ever.

 

1. Demographics and Demand

Demographic trends are favorable for increasing demand. Forty-five million Gen Z-ers, born between 1997 and 2013, will be in their peak years as renters by 2025. At the opposite end of the generational spectrum, an increasing number of Boomers are expected to opt for multifamily properties as they retire and downsize their homes.

Beyond the population numbers, other factors come into play. Inflation and rising interest rates may prompt Gen Z to live at home longer and Boomers to push back their timelines for downsizing from their single-family homes. At the same time, many Millennials are renting longer, having been priced out of the housing market due to a smaller inventory of starter homes and higher levels of personal debt compared to previous generations.

 

2. Inflation and Valuation

Inflation and higher interest rates have created a challenging near-term capital market environment for the multifamily sector. Capital is available but at a higher cost. With narrowing margins, lenders are taking a more cautious approach and loan-to-value ratios are down. With higher cap rates, the value of a stable multifamily property is lower. Similarly, value depreciation accelerates with slower rent growth and increased operating costs.

Inflation creates uncertainty about how much a property is worth, how much rental income will — or will not — grow and how much operating costs may increase. Digging into the details within a property’s valuation is critical in the current evolving market. An independent third-party valuation analyzes the historical performance of the property, comparable rental rates in the local market and expected operational expenses. The valuation projects the net operating income (NOI) and provides a benchmark of the property’s value over time.

 

3. Risk and Insurance

Insurance costs for multifamily properties are also on the rise. Over the past three years, property owners have seen double-digit increases in premium costs. Extreme weather events, such as wildfires, hurricanes and flooding, are a primary reason, with losses exceeding the premium collected. As a result, insurers are reducing their risk exposure in high-risk areas, which means property owners must often seek partial coverage from multiple carriers.

Inflation is also driving increased insurance costs. The cost of construction materials and labor has risen sharply since the start of the pandemic, with multifamily construction costs up 8% in 2023. An up-to-date valuation, which is required by many insurers at renewal, helps property owners to ensure their insurance covers the cost of rebuilding at current prices.

Liability insurance premiums have also increased in recent years, as several carriers exited the excess liability insurance business. Primary liability insurers are mitigating rising costs by increasing premium rates, deductibles and self-insurance limits. Many insurers are managing costs by implementing policy exclusions that may save property owners money in the short term but increase financial risk in the long term.

Insurance advisors can help property owners take a proactive approach to monitoring policy changes, conducting regular property assessments and calculating maximum probable losses in the event of a catastrophic event.

The dedicated commercial real estate team at CBIZ can help you optimize the valuation, insurance and tax strategies for your multifamily investment. Explore more resources and connect with a member of our team today.

 

This article includes input from John Rimar, Managing Director of CBIZ Valuation Group’s Real Estate Practice, and Greg Cryan, President of Southeast CBIZ Insurance Services, Inc. Their teams provide the initial and ongoing services needed to accurately assess and insure your real estate investments. 

 

Source:  CBiz

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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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7 Investment Tips To Keep In Mind Investing In 2023 Commercial Real Estate

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There’s no denying that uncertain financial times lie ahead. A recent poll by Bloomberg cited that 70% of economists predict a mild recession in 2023, following moderate growth the previous year. The U.S. economy faces the headwinds of increasing interest rates, stubborn inflation, a stagnant job market, and weak market exports abroad.

Despite these troubling signs, however, those in commercial real estate enjoy a unique position. There’s far less leverage in the consumer and financial sectors than during the Great Financial Crisis, and plenty of liquidity remains ready and able to deploy in long-term vehicles. The overall uncertainty will lessen demand and potentially unearth value-add opportunities, and different asset types will experience different momentary signs of distress while others will experience boosted demand.

Overall, prices and demand are shifting, and the time may be nigh for those looking to invest in real estate, whether for the first time or for those who make their livelihood. These seven ideas to keep in mind will keep the investor prepared to face 2023 with awareness and agility, well-positioned to strike opportunities when the iron is hot.

1. Trouble Unearths Opportunity

In times of distress, opportunities usually arise. Assets or markets facing headwinds today may eventually develop into solid, long-term holding investments. Good real estate fundamentals (location, location, location) remain essential even in challenging economic cycles. Those who can shore up their capital nicely will be best prepared to take advantage of opportunities as they arise. If you’re in a position to take advantage of low prices in well-positioned asset types or markets, next year may be the time to invest and many great investors often say the outcome is won at acquisition.

2. Capital Costs will Likely Stabilize Soon

This last year, the Fed’s continual interest rate hikes increased overall cost of capital, making debt and equity much more expensive. These hikes resulted in lower leverage, higher debt service, and greater discount rates, which lowered net present values or created higher yield requirements. Additionally, fixed income yields increased and, when adding in the risk premiums associated with CRE, added to required property yields (or cap rates).

Number shifts like these aren’t so bad when they’re infrequent, but the Fed’s aggressive measures to curb inflation have made deal-making much more expensive. However, the latest increase to between 4.25 and 4.5% in mid-December points to a deceleration (the last increase was 75 basis points), a trend that will hopefully continue into 2023.

The cost of capital will likely stabilize as rate hikes taper off – encouraging stakeholders to start investing again. Additionally, a massive supply of capital seeking placement means plenty of liquidity. We’re still seeing demand continue to bid up deals to healthy values, particularly for good buys in good markets. Now’s the time to get your ducks in a row and prepare for quick action if you want to access good deals ahead of the competition.

3. Real Estate Buffers Against Stubborn Inflation

Real estate, as an inherently longer-hold investment vehicle, remains a haven that better buffers against stubborn inflation than other capital markets, thanks to its predictable cash flow. Lease terms that allow for underlying rent increases connected with rising costs or annual/regular rate increases in both long-term and short-term leases (e.g., in offices and multifamily) allow landlords to adapt more quickly to rising costs and keep up with inflationary changes.

Even though inflation is finally (hopefully) tapering, commercial property represents an excellent long-term option. But don’t forget: operational expenditure also inflates, so lease structures where tenant covers all or a portion of expenses can be important.

4. Now’s the Time to Lean on Your Broker

Partnership and expertise are more important than ever. Your broker is your partner in deal-making and serves as an essential business partner as you navigate changing valuations and asset performance. Brokers provide detailed in-market knowledge and economic cycle experience and make it their business to know what’s happening in the sector – so why go it alone?

In an uncertain market, now is the crucial time to partner with someone who can find you the best comps, source the best data, and find the best buyers for your listing or next investment option. Additionally, in times like these, brokers often are better at finding off-market opportunities, which can be acquired at opportunistic pricing if buyer can navigate unique circumstances.

5. Assess Tech Stacks and Optimize for the Best Tools

In a lean market, businesses need to cut overhead spending to focus on managing costs and optimizing the best possible tools and headcount for task efficiency. Running your business affordably is essential before venturing into the market. A lean, efficient tech stack can empower you to manage business operations while minimizing spending successfully. Prioritize technology that saves time, determine what’s essential and what’s fluff, and if you can find one software that solves multiple business needs, all the better.

6. Solidify Relationships with Capital Sources and Financial Partners

Now’s the time to foster closer relationships with your capital sources, lenders, and financing partners. It’s essential to maintain these connections – they will allow you to collectively stay more agile and make smarter, faster decisions as the economic climate changes.

Open communication with these parties will position you to act fast when the time is right, ready to strike on value-add opportunities as soon as they emerge.

7. Back to Basics: Understand Your Brick-and-Mortar

This may seem like a no-brainer, but it’s even more essential to understand your tenants’ day-to-day realities. Get to know their business operations, keep a pulse on market happenings, and maintain a steady flow of communication with your operators.

A clear understanding of the present and fundamentals of your tenants’ businesses will open your eyes to potential changes and allow you to make strategic moves or adapt as needed. Additionally, clear communication is more likely to set your tenants at ease and make them more likely to renegotiate and continue their leases with you.

The Bottom Line

We’re long-term bullish on commercial real estate. With open eyes and an agile, ready-to-act team, we’re confident that the savvy investor will discover valuable ROI diamonds in the rough. These tenets are, at their core, essential elements of well-run commercial real estate operations, even in prosperous economic times. However, in turbulence, it’s all the more important to stick to your investment principles and – as always – consider the long-term while resisting short-term distractions.

 

Source:  Global Banking & Finance Review

 

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Here’s What CRE Investors Are Thinking As Inflation Ticks Up

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A recent investor survey by Marcus & Millichap reveals that while CRE transactions may level out this year, investor sentiment remains strong.

The mid-year survey’s headline index value of 159 is “somewhat reminiscent of the trend we saw in 2016,”in which sentiment declined a bit as higher interest rates bit into the market, says Marcus & Millichap’s John Chang.

”But they’re not down by as much as people might expect,” he says.

In 2016, the index declined 12 points and the number of CRE transactions flattened. This year, the index has declined 11 points and that could deliver relatively similar results, in what Chang calls a “relatively modest softening.”

“Yes, the market is going through a recalibration as investors rework numbers based on the rising costs of capital, but the survey respondents aren’t telegraphing a significant market change,” he says.

According to the survey, the top two investor concerns are interest rates and inflation. About two-thirds said interest rate increases aren’t affecting their investment plans, and almost 9% said they’d buy more commercial real estate because of rising interest rates. On the sell side, 77% said the rate increases haven’t caused them to change plans and 11% said they plan to sell more.

Respondents were even more dismissive of inflation, according to the survey. Twenty-four percent of respondents said they’d buy less CRE but almost 12% said they’d buy more. The buying intentions with respect to more inflation-resistant property types like apartments, hotels and self-storage indexed higher, with about 14.4% of investors overall saying they’d buy more of those assets because of elevated inflation.

Cap rates are expected to rise as a result of rising interest rates as well, with 14% of investors surveyed saying they think cap rates will rise by 50 basis points or more over the next year. About 35% think they’ll go up by less than that, and 27% expect no change. And Chang says  since there’s still a lot of capital coming into CRE, yields and stability look compelling.

“Consider that the last 12 months ending in the second quarter of 2022 was by far the most active commercial real estate investment transaction year on record,” Chang says. “Even if activity steps back a bit over the next 12 months, it will still likely rank as the second most active year.”

 

Source:  GlobeSt.

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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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Commercial Real Estate—Buy, Sell Or Hold?

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The commercial real estate market was beaten, broken and left for dead by Covid-19 in 2020.

It roared back to life in 2021 with record-breaking sales of $809 billion, but like cops pulling up to a rowdy frat house all-nighter, the arrival of unrestrained inflation and soaring interest rates may signal the party’s over. That has many real estate investors at a strategic crossroads wondering, “do I buy, sell or hold?”

Privately owned commercial real estate has historically offered a strong hedge against inflation. The owners of properties with short-term leases such as apartments, self-storage, and manufactured home communities can quickly raise rents to match inflation, as measured by the Consumer Price Index. That’s a significant advantage as the CPI topped 8% in March and April, reaching 8.6% in May, the highest rate since 1981. Then, like today, inflation was driven by a dramatic spike in oil and gas prices and an unrestrained Treasury flooding the economy with money.

In 1980, newly installed Federal Reserve Chairman Paul Volcker responded by strangling the flow of currency to such an extent that in December 1981, mortgage rates hit 20%. Inflation quickly declined, but at a cost of 10.8% unemployment, a decline of 3% in GDP, and not one but two recessions. While inflation is the friend of many landlords, recession is not, and the commercial real estate business began a decade-long decline.

A recession has followed every sharp increase in inflation over the past 75 years, and the current gravity-defying trend shows no sign of fading. The Producer Index – what manufacturers pay for raw materials – rose .08% in May, doubling the .04% increase in April, for an annual rate of 10.8%. Those costs will be passed on to the consumer, driving the CPI yet higher. Gas is over five dollars, and diesel is flirting with six. Given that sudden spikes in energy costs preceded six of the last seven recessions, and the Commerce Department reporting an unexpected decline in retail sales in May, another recession seems inevitable.

Investment real estate performance and GDP rise and fall together. A weak economy creates a decline in business and consumer spending, limiting the ability of landlords to raise rents. Pandemic resistant, “essential businesses” like Dollar General and Walgreens have been highly favored by investors. However, with leases holding their rents flat for 10-15 years, landlords will be losing money every year, as will big-box retail and office building owners with long-term leases not indexed to CPI. The Fed’s more aggressive monetary policy will create higher long-term interest rates, provoking a recession and stricter commercial lending requirements. Higher rates and loan equity requirements result in lower returns, causing investors to retreat and property values to fall. For investors with such assets who are alarmed by a disintegrating economy and contemplating a sale, it may be best to hold and wait for the inevitable recovery.

The cycle of decline and recovery often occurs over a decade or more. Property owners under 50 can afford to wait for the next upcycle if the market sees a significant correction. Commercial real estate always trends up over decades, and for 25 years has outperformed the S&P 500 Index, with average annualized returns of 10.3% and 9.6%, respectively. And, unlike stocks, bonds, and cryptocurrency, real estate has never been worth zero. For those younger investors, this may be the right time to buy.

“While rates are being managed higher as a deterrent to inflation, they are still historically low. Buyers who can lock in fixed rate debt on income property at current rates of 5.5% to 5.6% today will be winners as these rates are likely to be the lowest they may ever see,” said TowneBank Commercial Mortgage President, David Beatty.

Named a “Top Ten US Bank” by Forbes in 2022, TowneBank is a leading commercial real estate lender in Virginia and North Carolina.

What’s the case for selling in the current market? Few people doubt that commercial real estate values have reached a cyclical peak after a 12-year bull run. Secretary of the Treasury Janet Yellen recently expressed concern to the US Senate Banking committee that banks and non-bank lenders such as insurance companies and hedge funds maybe be overleveraged at a time of rising interest rates. Knowing cash is king, there is anecdotal evidence that portfolio owners are choosing to boost liquidity with strategic dispositions at apex pricing. In what may be a record-breaking sale for a single such property, an Arizona company paid $363 million for Jamaica Bay, a manufactured home community in Fort Myers, Florida.

Many investors anticipate a wave of defaults when acquisitions at aggressive pre-COVID prices can’t cover the debt service when their loans soon reset at higher rates. When real estate crashed in 1973, legendary investor Sam “Gravedancer” Zell, the father of the modern REIT, picked up dozens of high-quality apartment buildings at a fraction of replacement cost. Zell used the massive cash flow from those assets to buy office buildings at 50 cents on the dollar when the real estate market crashed again in the 1980s, becoming a billionaire. Today, the post-COVID “hybrid working” trend is driving tenants from center city office buildings to the more affordable suburbs. Those tenants who remain are demanding aggressive rent concessions to stay.

Foreshadowing a coming market correction are dozens of “distressed” real estate funds, amassing billions of dollars. Global investment firm Angelo, Gordon & Co. L.P. has in 36 months attracted $11billion in investment to its “distressed debt and special situations” platform. Investors are betting on a spike in real estate loan defaults, with banks forced to sell their debt at deep discounts to maintain FDIC liquidity requirements.

What about the smaller investor or owner/user? If you’re a doctor over 60 wanting to cash out the equity in your medical office building to facilitate a more comfortable retirement, now may be the time to sell and lease back. The demand for these properties is ceaseless due to their resilience during economic slumps. Montecito Medical is one of the nation’s largest privately held companies specializing in healthcare-related real estate acquisitions and a leader in sale and leaseback transactions. Since inception in 2004, Montecito has closed healthcare real estate transactions of over $5 billion.

“With the population of Americans over 65 projected to more than double by 2040, medical office real estate fundamentals are highly secure. That makes this category recession-resistant and a haven for capital at times when other commercial real estate sectors may be struggling. This was proven in both the Great Recession of 2008 and again during the Covid-19 pandemic,” said Chip Conk, chief executive officer of Montecito. “We built our entire business around medical office and the market has validated that strategy over and over. We remain as bullish as ever on this sector.”

Sale-leasebacks are increasingly common in other asset categories such as industrial real estate, perhaps the hottest commercial real estate category of all.

Owners with management-intensive assets like single-family rentals, manufactured home communities, and small apartment buildings may want to relax, travel, and otherwise enjoy the result of decades of hard work. They can use IRS Code Section 1031 to trade into management-free “absolute net,” single-tenant retail, enjoying historically low interest rates, avoiding capital gains and pocketing tax-free cash.

Being sensitive to economic cycles when buying, selling or hanging on is essential for success in commercial real estate.

 

Source: Forbes

 

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The Impact Of Interest And Inflation On Industrial Real Estate

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The Good News

Industrial leasing fundamentals are still positive after a banner 2021. Despite a hearty influx of new deliveries, national vacancy rates fell for the sixth straight quarter to 3.4 percent as occupiers absorbed 110.8 million square feet in first quarter 2022.

As such, the average national asking rent climbed to $7.62 per square foot, marking a 7 percent increase over fourth quarter 2021 and becoming the largest quarter-over-quarter increase since at least 2000.

In addition, investor transaction volume for the first quarter 2022 was strong, reaching $33.2 billion, the second-highest total ever for a first quarter showing and a notable achievement following a year that saw a record amount of capital pour into the industrial sector. There is still record levels of liquidity in the domestic markets, and overseas capital has an even longer runway.

In first quarter 2022, developers delivered 90 million square feet of new inventory, effectively equal to first quarter 2021. While strong by historical standards, this influx of new space barely moved the needle on vacancy for most markets. According to JLL research, the pipeline of under-construction space grew to 531 million square feet, of which more than a quarter is in the mega-box size category of 1 million square feet and larger.

There appears to be a bifurcating of markets between the coastal/port markets and non-port markets. Port markets have seen year-over-year rent growth eclipse 23 percent, compared to 16 percent in non-port markets. Further, despite a near 40-basis-point pricing premium, these coastal cities represent an attractive opportunity for investors looking to secure long-term net operating income growth.

The (Less) Good News

While projects continue to be mired in delays due to materials and labor shortages, the volatility in material pricing itself has started to calm. However, prices are still going up for these materials, thanks to inflationary pressures. Tight labor and housing markets, supply chain constraints, growing production and energy costs, and surging consumer demand are all key contributing factors to our rising inflation, which in May reached the highest levels since 1981 at 8.6 percent.

Real concerns surrounding inflation and rising interest rates are causing investors to assess their underwriting. Negative leverage is beginning to be the primary driver of capitalization rates due to the cost of capital. It’s possible to mitigate some of this negative leverage with the exponential rent growth that is still occurring in many markets. However, if and when rent growth moderates, there will likely be some downward pressure on values.

The Overall Outlook

JLL anticipates that vacancy will continue to decline for industrial product, likely bottoming out at sub-3.0 percent. From a landlord perspective, any shifts in rates have not impacted the need for space. The supply chain is still not right-sided, which means that tenants are not at pre-pandemic supply levels in their warehouses. Even if there were to be a pull-back in consumer spending, there would still be a significant shortage of warehouse space throughout the country.

Businesses are also still shell-shocked from the massive disruption to their supply chains that occurred during the pandemic and are re-thinking their distribution models. “Just in time” delivery used to drive decisions. There’s since been a pivot to “just in case”, both in terms of product and in terms of space-banking due to rental rates increasing quickly.

Workforce considerations are also driving these locational decisions, as are rising fuel costs due to inflation. Tenants are approaching expansions, especially to non-gateway markets more carefully, as the rent savings from moving to tertiary locations is likely offset by higher transportation costs.

However, real estate is only a fractional part of overall cost for these businesses (estimated at 3 to 6 percent). The inflationary pressures in terms of real estate costs likely pale in comparison to the inflationary and interest rate impacts on the rest of their business.

Given these factors, it is anticipated that market rents will continue to increase across the industrial sector. Most investors are underwriting 7.0 percent or higher in most markets and anticipate rising rents through 2023.

Speculative development will likely continue, though will be impacted by supply chain and regulatory restrictions. Capital is virtually non-existent for non-permitted and phased development (two to three years until completion). Upfront due diligence for construction debt is becoming far more robust, with more focus on appraisals and underwriting assumptions.

Capital markets underwriting has changed significantly in second quarter 2022. There has been re-pricing of many assets, which was initially driven by changes to the debt market but are now more driven by overall risk assessment. The most attractive type of industrial property has become value-add product with near-term roll or vacancy.

The buyer pool has also decreased for industrial assets, as investors are pivoting away from asset classes that aren’t near the peak of pricing (ie. retail). Most investors are now underwriting slightly higher investment rates, particularly at the end of their projected holding period.

Overall, the entire real estate class could benefit from this period of economic volatility and continue to outperform the broader equity markets. Some market participants are assuming that this volatility is short term. Others believe that a slowdown in the economy could create arbitrage opportunities. Investors are stress testing for an inflationary environment, rate increases and a potential recession. It’s likely that this will continue for the second half of 2022 until the direction of the economy becomes clearer.

 

Source:  CPE

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Here Come The Multifamily Headwinds

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There are usually multiple ways to look at anything. In the case of the Yardi Matrix National Multifamily Report for March 2022, you could emulate the late lyricist Johnny Mercer: accentuate the positive, eliminate the negative, and don’t mess with Mister In-Between.

But what works for an upbeat song isn’t necessarily good for business planning. There is ample good news of increased asking rents and occupancy rates, but in a sense, that’s all in the past. The question investors and operators must ask is what might be coming.

One big consideration is rent growth. “Asking rents increased by $34 nationally, up 2.1%, in the first three months of 2022, which is record growth for a first quarter,” the report said. However, that’s unlikely to continue for a few reasons. One is slowing economic growth as inflation continues to take a toll on activity. Slower growth will affect incomes, meaning the likelihood of fewer gains to cover costs of higher rents. The war in Ukraine is also an issue, according to Yardi because that could help sustain inflation, especially with the effect on energy prices.

Inflation means higher interest rates as the Fed tries to cool the economy. But multifamily acquisition yields are low, at a 4.5% average and down into the threes for prime locations. “Low cap rates caused little concern when the risk-free rate was 1% and the typical mortgage coupon was 2.5% to 3.5%, but when the cost of capital gets more expensive, low yields can complicate transactions and refinancings,” the report says.

Then there’s household formation.

“Although official numbers for 2021 have not been released, some estimates put the number of new households formed in 2021 in the two million range, which makes sense given record multifamily absorption of nearly 500,000,” the report says. “Household growth and absorption are likely to slow to more normal levels in 2022, to about half of last year. That would presage healthy—albeit more moderate—gains in multifamily fundamentals.”

Also, rent growth is not at all nationally even. Migrations to the southeast and west are a big force in rent growth, presumably because there’s a lot of new construction happening, which means higher costs given rising building materials and labor expenses and a steady stream of asking rents not tied to previous occupancy.

Occupancy is cooling in some high-growth metros—that is, the very west and southeast that has led growth because of demographic migration.

“Occupancy rates in several markets have decreased over the last year as demand hasn’t kept pace with deliveries,” the report says. “Phoenix showed the largest decrease in occupancy (-0.5%) in March, followed by the Inland Empire and Las Vegas (-0.4%) and Sacramento (-0.3%).”

 

Source:  GlobeSt.

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These Are The Asset Classes Most Resistant To Inflation

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Inflation is the risk factor investors are watching the most closely this year—but each property type has unique nuances in terms of how it interacts with inflation.

That’s according to John Chang, senior vice president and director of research services at Marcus & Millichap. He says office properties have general inflation resistance because their values tend to align with replacement costs and they mark to market upon tenant turnover. Some properties may also have inflation escalators built into lease agreements.  On a scale of 1 to 10, with one meaning little to no inflationary risk, Chang ranks the office sector risk at a three to a five.

Multi-tenant retail falls in the same category, he says, thanks to long-term lease agreements that could have escalators tied to sales. Single-tenant properties typically don’t have such escalators, but the risk depends on the tenant he says; Chang ranks them in the three to five range as well.

Seniors housing market-rate units can recalibrate on turnover, and government programs like Medicare or Medicaid also typically adjust to inflation. The sector has the ability to mark to market so the inflation risk rating is in the three to four range.

Medical office inflation risk is low, Chang says, in the two to four range. Meanwhile, the multifamily and self-storage sectors have tremendous inflation resistance since their rents mark to market frequently.

The most inflation resistant CRE property type—with the ability to change rates every day—is hotels, at the one to two range.

“Periods of high inflation tend to be relatively short—a few years or less,” Chang says. “This shouldn’t be a primary commercial real estate investment driver but it could nudge investor decisions a bit. Real estate is generally a long term investment with multi-year hold periods, so while you factor in inflation and other short term risk, investors need to keep their eyes on the horizon.” 

 

Source:  GlobeSt.

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Higher Inflation Means More Competition For CRE Assets

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Supply chain problems, labor shortages, and the housing shortage are all fueling inflation to eye-popping levels – and for CRE investors, that will mean greater competition for assets.

Headline inflation is up 7.1% from last year, the biggest uptick since 1982. And that rising inflationary pressure is forcing the Fed to switch gears and tighten policy. This will in turn put upward pressure on interest rates, raising the cost of capital for CRE investors, says Marcus & Millichap’s John Chang.

Supply chain is the first contributing factor to inflationary pressures: “It’s hard to move products from the manufacturers to the customers,” he says, pointing to shortages in raw materials, limitations on foreign port capacity, shipping container shortages, backlogs at domestic ports like those in Los Angeles and Long Beach, and a shortage of trucks.

“Basically, people want to buy more stuff than our supply chain can handle right now, so there are shortages and that means prices go up,” he says.

Retail sales are up 16% over 2019 numbers, while the amount of product moved by trucks in the US is down 5.1% over the same period.

The second issue? Labor shortages, which continue to stoke inflation.

Quite simply, “the US has never experienced a labor shortage like this,” Chang says, “at least not in the last 22 years, when records have been kept. As a result, companies are competing for personnel, and that’s driving up wages.”

Average hourly earnings are up 5% over last year, and sectors like accommodations and food services have seen labor cost increases of more than 15%. And “rising wages create broad-based long-term inflation,” Chang says.

The third challenge is the housing shortage: there are not enough houses to buy or apartments to rent right now, and the problem will likely continue at least in the near term. There are currently about 1 million houses for sale in the US right now, about two months’ worth of supply; typically, four to six months’ worth of supply is required to maintain stability in the market.  Housing prices shot up 14.9% last year in response to the shortage.

In addition, there are only about 480,000 apartments available for rent, a vacancy rate of 2.6%, the lowest on record. Rents rose 15.5% last year.

“The Fed will be taking action to curtail the rising costs,” Chang says.

He notes that Fed Chairman Jerome Powell has already announced plans to accelerate the end of quantitative easing that was put in place during the pandemic, and says this will likely put upward pressure on long-term interest rates. The overnight rate is also on track to increase three times or more this year, which will put upward pressure on short term interest rates.

As a result, Chang says, interest rates are likely to continue to rise. The ten-year Treasury rate is already up about 30 basis points from the beginning of December to a little over 1.7%.

For investors, this will equate to more competition.

“Commercial real estate is viewed as one of the best places to invest money during periods of high inflation, especially properties that can increase rents with the market, like apartments, hotels, and self-storage properties,” Chang says. “Rising interest rates, and increased investor demand, implies that levered yields will compress this year. Basically, more commercial real estate buyer competition will push cap rates lower while the cost of capital, or interest rates, rise. That means CRE levered returns may tighten.”

But several property types still offer higher yields, like well-positioned office assets, retail assets, medical office buildings and some hotels, he says – and properties in softer markets harder-hit by COVID restrictions could also offer higher yields and stronger multi-year returns.

 

Source:  GlobeSt.

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