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What CRE Industry Insiders Are Thinking Might Happen In 2024

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Commercial real estate professionals agreed in the Fall of 2022 that 2023 would have a healthy serving of uncertainty, with falling transaction volumes leading to a lack of price discovery and rising interest rates putting pressure on financing.

Still, people thought that by the second quarter of 2023, things would be getting back to normal. No one had a clue how long inflation would hang in, how high interest rates would go, and how much macroeconomic trouble there would be with banks being closed, many lenders pulling back, falling valuations, the ongoing impact of higher interest rates, major strikes by unions, political division, and more.

CRE pros are being much more careful and circumspect now.

As Jeff Klotz, founder and CEO of The Klotz Group of Companies, says, “The only certainty we’ve added is that it’s more uncertain.”

Welcome to the future. Here’s what industry insiders are thinking might happen this year in key areas.

PRICE DISCOVERY AND VALUATIONS

With all other problems, discovery of many types is maybe the biggest, because it holds important answers, if only that discovery gets to happen.

“For the next 12 months, the theme will be a discovery of the result of all the mistakes made over the last several years,” Klotz says. On the transaction level, he thinks that “the divide between buyer and seller is larger and wider today,” and “it hasn’t shrunk as we had expected at this time last year,” Klotz says. His company buys, sells, owns, operates, consults, borrows, lends, and develops with 12 different wholly owned subsidiaries.

Klotz gets excited over the potential for buying “some discounted and cheap real estate.” His big worry is his own portfolio.

“Let’s face it, I can’t control the market. I can’t control what it’s worth because the market does that.”

PRIVATE MARKETS HAVE YET TO PRICE IN CHANGES

Going hand-in-hand with a lack of price discovery is the opacity and potential over-valuation of private real estate values.

“The public REIT markets have already priced in the impact of higher debt caps and are trading at the 6% cap rate,” says Uma Moriarity, senior investment strategist and global ESG lead for CenterSquare. “For core private real estate funds, we look at the NCREIF ODCE Index. The valuation across those funds is still close to a 4.2% cap rate. If you don’t have transactions, you don’t have comps and you don’t have the right data feed appraisers need. In terms of the 4.2 cap rate, those ODCE funds are doing transactions in the 5% cap range. We think the public REITs are on the slightly cheap side of fair because the private market is still overpriced.”

According to research from CenterSquare Investment Management, REITs historically outperform private real estate and equities in the periods of time after rate hiking cycles end. If the Fed does stop the upward march of its rate hiking cycle, 2024 could see REIT outperformance.

INTEREST RATES

If there is any single number that is a meaningful metric for the industry, it’s the federal funds rate, the benchmark interest set by the Federal Reserve, with its enormous impact on financing costs.

“I think you could argue very convincingly that the 30-year bull run is over,” Nancy Lashine, managing partner of Park Madison Partners, says. “I don’t think I’m ever going to see a 2% Treasury rate again. I don’t think we’ll ever see a 3% or 4% mortgage rate again. You could argue there’s no good deal. There’s plenty of capital but no good deal.”

 

“I would say we’ve enjoyed cheap money for a very long time, but it’s led us to a lot of pricing perhaps that was reliant on that cheap financing,” says Tess Gruenstein, senior vice president, acquisitions and portfolio management, real estate at Bailard. “When it goes away, things shift. We’re back to a more normalized environment and people won’t do deals because they’re optimized for leverage.”

That means a lot of real estate — and not just office — is going to be underwater.

“We have a lot of groups coming to us because we raise private equity capital. The best thing anybody can say to us is we have no legacy assets,” says Lashine. “If you were in this business over the last 15 years and you heard someone say, ‘I sold everything in 2005, 2006, and 2007,’ not only is he a good operator, but he has good timing. That was the best story anyone could tell and you’re going to hear those stories again.”

LENDERS PULL BACK

“This is kind of a doom and gloom moment,” says Stephen Bittel, chairman and CEO of Terranova Corporation. “The real challenge is that, whether they admit it or not, most banks are pretty much out of the lending business. There are a handful that will continue to dip their toes in the water for best customers with good equity and balance sheets.”

Many banks are worried about depositors seeing some assets, whether long-term Treasuries and mortgage-backed securities, or CRE-backed loans, as suspect, as happened with bank closings in 2023. Depositors pulled their money. For the first time, bank deposits contracted, by 4.8%, in the first half of 2023. Banks are worried that CRE loan values could drop in the face of falling property valuations, cutting asset values and making it harder to cover further worried withdrawals.

“If the small and mid-sized banks stop lending, which they effectively have — they’re pushing deals with high rates — businesses will shrink and cause a recession,” Bittel adds. “Banks are nervous about the future because it’s uncertain.”

 

Adam Fishkind, a member of law firm Dykema Gossett, says his “loan origination practice has definitely fallen off a cliff” — not just with banks, but other sources. “When I do borrower representation, I don’t see a lot of CMBS deals coming through these days.

“A lot of that has been replaced by private equity lending” with “the overall loan transaction is more akin to hard money lending.” Rates are higher and generally include points on the front and back ends, with larger spreads, shorter terms, and higher interest rate floors.

 

“Our expectations is that we’re not going to see an early improvement in 2024,” says David Cocanougher, president of multifamily at Leon Multifamily, part of Leon Capital Group. “I think there’s a tendency to want to be optimistic, but the longer this continues, the more down to earth everybody becomes.”

OFFICE SPECIAL SERVICING AND DEFAULTS

Ongoing data from multiple sources have shown that defaults, workouts, and special servicing are all on the rise, especially for office.

“We’re seeing some large office product defaults in the CMBS special servicing stuff that I do,” says Fishkind. “A lot of these buildings, they have a couple of major tenants that have left. If you have an A property and a great location, you probably still have a pretty good asset. But if you have suburban office or older office, you might have trouble again. It’s one of those opportunities where people are probably reducing space and putting the money in their pocket because they’re nervous about the possible recession, or they’re reducing space and going to a better environment.”

 

DISTRESS

“There are more distressed situations and transactions happening because of the way projects were structured because of floating rate debt or even pressure from equity partners to get a faster exit,” Cocanougher says.

 

“A lot of people say things because they want to move the market,” Jason Aster, vice president at KBA Lease Services, says. “The truth of the matter is my business exclusively relies on tenants taking office, but other than highly liquid companies poised to take advantage of distress, I don’t see anyone jumping in to invest in office assets, or any commercial assets.”

GlobeSt.com has previously reported signs of a secret distress market — increased bank CRE charge-offs and higher levels of distressed CRE loans — largely being handled privately and that has not broken out into a fully obvious run on distressed properties.

“What you’re seeing in leases is a focus on how a landlord or owner could apportion reinvestment,” Cocanougher adds. “What you’re seeing in leases are ways for the landlord to take back space originally designed for tenants, but then” charge back the costs or possibly even the lost rents. “While super high quality, trophy office assets will be fully booked and retain their value, landlords will hand the keys of distressed assets back to the lenders at a greater frequency in 2024. This will be particularly prevalent in the older Class A and Class B office product in dense cities like NYC and San Francisco.”

Klotz refers to the current distressed market as “private” and “embarrassing.” No one wants to talk about it publicly because they don’t want to draw attention to having made a mistake and losing money. Or, on the other hand, they don’t want others to realize that they bought some distressed properties and got a good deal. And the data lags because these events are in real time.

But it’s also attractive. “If you’re a core buyer, you can look around and say, ‘Would I take a 7% interest rate on a core investment?’ I think so,” Gruenstein says. “If you have a long-term perspective and patient capital, it’s very easy to make a case that now is the time to be out in the market, picking up some of these great pieces of real estate.”

Many with capital in their back pockets may still be waiting, though.

“I think there’s possibly a lot of equity being kept out,” says Tere Blanca, chairman and CEO of Blanca Commercial Real Estate. “It’s eroding if you had any, with values being hit as much as they have been. You wake up to higher interest rates and to much higher costs of operating your property and values are getting impacted. It’s a difficult time to navigate.”

 

“We’re still being patient, for sure, especially when it comes to investing in hard assets,” says Matt Windisch, executive vice president at Kennedy Wilson, which bought PacWest’s CRE loan portfolio for $2.4 billion back in June. “We continue to think that the construction lending space is extremely interesting. We have committed capital partners to fund an expansion.”

CONSUMERS PULL BACK

While consumer spending has appeared to continue strongly, it may not be all it seems. When the Census Bureau reports on consumer spending, it doesn’t take price differences into account. In other words, these are nominal and not real changes in spending behavior. To top it, the changes in spending are to only a 90% confidence interval that generally includes zero, so there is no way to tell if there’s been an actual change.

“I think part of why the pickup in transaction volumes didn’t happen this year is the Fed kept raising rates,” says Moriarty.

The translation from monetary strategy to the rest of the economy isn’t working as it has in the past.

Moriarty says she’s seen a rolling recession across the economy, but that it hasn’t hit the consumer. “That lasted a lot longer than any of us anticipated,” she says. “If you listen to what we saw from a lot of the consumer-oriented earnings this past earnings season, listening to what the hospitality REITs were telling you or the apartment REITs were telling you, you were seeing a pullback from the consumers.”

Credit card debt is at an all-time high and credit card and auto loan delinquencies are on the rise.

“The other new big thing to watch relates to student debt payments coming back online,” she adds “It seems difficult with the lack of credit availability overall to see that level of tightening without an impact.”

Consumers had built-up liquidity from Covid, but estimates, including from the Federal Reserve Bank of San Francisco, suggest that is likely gone. Not what you want to see when you’re hoping to avoid a recession, but consumer spending is 68% of GDP.

 

Source:  GlobeSt.

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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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How Interest Rates, Debt Coverage Ratios And Loan-To-Value Ratios Affect The Value Of Commercial Property

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By Ron Osborne, Managing Director

Sperry Commercial Global Affilates | RJ Realty

 

Interest rates, debt coverage ratios (DCR), and loan-to-value (LTV) ratios are important factors that can significantly impact the value of commercial property. These factors are closely related to the financing and income potential of a commercial property, and they are often considered by investors and lenders when assessing the value and risk associated with a property. Here’s how each of these factors can affect the value of commercial property:

Interest Rates

  • Interest rates set by central banks and financial institutions have a direct impact on the cost of financing for commercial property buyers. When interest rates are low, borrowing costs are reduced, making it more attractive for investors to purchase and finance commercial properties. This can drive up property values as demand increases.
  • Conversely, when interest rates are high, borrowing becomes more expensive, which can reduce the affordability of commercial properties. This can lead to a decrease in property values as demand weakens.

Debt Coverage Ratios (DCR)

  • DCR is a measure of a property’s ability to generate enough income to cover its debt service (i.e., mortgage payments). It is calculated as the property’s net operating income (NOI) divided by the annual debt service.
  • A higher DCR indicates a property’s ability to comfortably service its debt, which can increase the property’s value. Lenders typically prefer to see a DCR of 1.2 or higher, as it provides a margin of safety.
  • A lower DCR can be a red flag for lenders and investors, as it suggests that the property may struggle to meet its financial obligations. This can result in a lower property valuation or difficulties in securing financing.

Loan-to-Value (LTV) Ratios

  • LTV is a measure of the loan amount compared to the property’s appraised value. For example, an LTV of 80% means that the loan covers 80% of the property’s value, and the buyer must provide a 20% down payment.
  • Lower LTV ratios, such as 60% or 70%, can reduce the risk for lenders and investors, as there is more equity in the property. This can lead to more favorable financing terms and possibly a higher property value.

In summary, interest rates, debt coverage ratios, and loan-to-value ratios are interrelated and play critical roles in determining the value of commercial properties. Lower interest rates, higher DCRs, and lower LTV ratios typically support higher property values, while the opposite conditions may have the opposite effect. It’s essential for investors and lenders to carefully consider these factors when assessing the attractiveness and risk associated with a commercial property investment.

 

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The Ripple Effect: How Interest Rates Impact Insurance Premiums For Commercial Properties In Florida

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Commercial property owners in Florida are no strangers to the unique challenges posed by the state’s unpredictable weather patterns and natural disasters. To safeguard their investments, property owners often rely on insurance coverage. However, what many may not realize is that insurance premiums for commercial properties in Florida can be significantly influenced by another factor – interest rates. In this article, we will explore how interest rates affect insurance premiums for commercial properties in the Sunshine State.

The Link between Interest Rates and Insurance Premiums

Interest rates play a crucial role in shaping insurance premiums. These rates, set by central banks, impact the overall financial climate. When interest rates rise, insurance companies will incur higher costs for re-insurance and investment returns and maintaining reserves. Consequently, they may adjust their premium rates to compensate for these increased expenses.

In Florida, where hurricanes, floods, and other natural disasters (World Wide) are a constant threat, insurance premiums can already be substantial. When interest rates rise, insurance companies may increase premiums further to mitigate financial risks, as they may need to pay out larger claims due to more frequent and severe weather events.

Mitigating the Impact

While property owners may not have control over interest rate fluctuations, they can take steps to mitigate the impact of rising interest rates on insurance premiums:

  1. Risk Mitigation: Implementing risk management strategies such as building upgrades, hurricane-resistant materials, and flood mitigation measures can help reduce insurance costs.
  2. Insurance Shopping: Periodically reviewing insurance policies and shopping around for competitive rates can help property owners find the best deals, even in a changing interest rate environment.

Conclusion

Interest rates are a hidden variable that can significantly influence insurance premiums for commercial properties in Florida. As property owners brace themselves for the unpredictable weather patterns of the region, they should also keep an eye on interest rate trends and consider strategies to manage the impact on their insurance costs. By staying informed and taking proactive measures, property owners can better protect their investments and ensure their businesses thrive, come rain or shine.

 

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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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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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Our Sales Were Up In Q4. Let Us Help You.

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It was a rough fourth quarter for commercial real estate brokers in South Florida, as property sales plunged 55% compared to a year ago, according to property data firm Vizzda.

There were $5.2 billion in commercial real estate sales of at least $1 million each in the tri-county region, down from $11.6 billion in the same quarter a year ago. The number of transactions fell 40% to 631. The average price of each deal also fell.

The two main factors that led to a dramatic drop in sales were the reluctance of buyers and sellers to agree on a price and the lack of bank financing, said Paul Tanner, founding partner of Fort Lauderdale-based Las Olas Capital, which invests in commercial real estate. Lenders have started asking for much more equity in deals, often making them unfeasible, he said.

“We started feeling it [the slowdown] in late August and by Sept. 15 it was pencil’s down,” Tanner said. “The lending institutions wanted to see how interest rates would play out, how the recession would play out and no one was willing to be bold.”

Rising interest rates impact commercial real estate prices because they make debt more expensive, which reduces profit margins for buyers. It also increases the expenses for development, which was already impacted by rising construction costs. Tanner said many developers were slow-rolling their projects rather than moving forward aggressively to close on land and obtain a construction loan.

“Capital markets are currently in a period of price discovery largely driven by debt markets, not underlying fundamentals,” said CBRE Executive Managing Director Josh Bank, who oversees Florida. “And although U.S. commercial real estate investment volume fell from 2021’s record levels, 2022 was still the second-highest year on record with South Florida ranked in the top five markets for annual investment volume.”

Ryan Nee, senior VP for Marcus & Millichap in Fort Lauderdale, said there’s a price gap between buyers and sellers that has slowed transactions. Sellers want the prices of early 2022, but they’re largely no longer available. Buyers are seeking significant discounts, as not only have interest rates increased, but a dramatic spike in insurance costs for commercial real estate in recent months has eroded their profit margins, he said.

“The brakes have been put on and it’s hard to bridge the gap,” Nee said. “The Fed tapering rate hikes has added some calm to the market, but buyers want transparency on what the cost of debt is going to be.”

Multifamily

Vizzda broke down the transaction volume by category. The largest decline was in multifamily, plunging 72% to $1.2 billion. Despite the dramatic increase in rent in South Florida, fewer buyers were able to snag an apartment complex.

Nee said the fundamentals for multifamily in South Florida remain strong, with rising rents, a growing population and relatively low vacancy rates. Yet, the market is still impacted by interest rates and insurance costs, as well as higher property taxes.

Office

The second-largest decline was in the office market, with sales falling 65% to $455 million, according to Vizzda.

Tanner, of Las Olas Capital, said it’s virtually impossible to get a term sheet from a bank for an office acquisition. Many lenders feel the sector is too risky because many companies are permitting remote work and may downsize their office space.

Nee said Class A office space has been performing well in South Florida, because for every company that downsizes there’s another one moving into the market to occupy more space. Yet, buyers and lenders are still uncertain about the future of office and that has slowed transactions.

Retail

Sales of retail property dropped 31% to $1.1 billion. Nee said vacancy rates remain low for retail in South Florida and the population growth will continue to drive demand for space in that sector.

The retail market has done very well in South Florida, as sales are up for many stores and restaurants, said Barry M. Wolfe, senior managing director of retail in South Florida for Marcus & Millichap. However, rising interest rates still put a damper on the number of deals.

Industrial

The industrial market was the least impacted by the slowdown, as sales declined only 11% to $1.14 billion. Nee said vacancy rates are near record low for industrial in the region, there’s tremendous demand from tenants such as e-commerce firms and there’s a limited supply of new development. Those strong fundamentals kept industrial deals going, despite the economic headwinds.

Outlook for 2023

Nee said he expects the number of deals to pick up in the second half of 2023, but prices won’t return to the peaks from early 2022. The first wave of deals will probably be properties with maturing debt, as the owners may decide it makes more sense to sell than to refinance with a higher rate, he said.

“Debt maturing will be the number one catalyst for sales in the first half of this year,” Nee said.

Tanner, of Las Olas Capital, said more deals will take place once the Federal Reserve stops raising rates. After all, banks need to lend to make money.

“Everybody is sticking their head out of the cave and checking the weather out there and looking for a thaw,” Tanner said. “By the second half of this year, we will be back to fully ramped up.”

 

Source: SFBJ

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Expiring Interest Rates To Fuel Distressed Property Sales

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An exponential increase in the cost of interest-rate caps—insurance that CRE borrowers with floating rates purchase to hedge against rate increases—may soon spawn a wave of property sales in an increasingly distressed market.

In 2019, the Mortgage Bankers Association estimated that up to one-third of all commercial property debt was floating rate, with most lenders requiring that borrowers hedge against an increase in the borrowing costs.

When interest rates were low, derivative contracts offering hedges on multimillion-dollar mortgages could be purchased for as low as $10K. Now—as the lion’s share of these insurance contracts are expiring—the cost of rate-cap hedges is as much as 10 times higher that it was a year ago, according to a report in the Wall Street Journal.

Few buyers who opted for floating-rate loans when borrowing costs were low anticipated they were going to have to rebuy a cap at the same time interest rates are peaking, the report said.

According to Michael Gigliotti, co-head of JLL Capital Markets NYC office, many property owners may not have the liquidity to pay the increased insurance costs. Gigliotti told WSJ he expects a surge in property sales this year from owners who chose to unload their assets rather than spend millions on a new rate cap.

“This is the margin call on the real estate industry,” Gigliotti said, warning that a flood of properties going on the block to avoid increased rate cap costs could turn into what he called a “first trigger” pushing down real estate values.

Interest rate caps typically enable a borrower to avoid paying additional interest rates beyond a fixed threshold. According to the WSJ report, speculative ventures, where investors acquire short-term, floating-rate debt to finance building renovations aimed at raising rents have the most exposure to the increased cost of rate-cap hedges.

Apartment owner Investors Management Group was cited as an example of the rate-cap conundrum facing property owners: in 2020, the firm took out a $24.4M loan on a 300-unit multifamily in San Antonio. The firm bought insurance that capped interest at 5%, with the hedge contract costing $22K.

The cap on the San Antonio apartment campus expires in September. The company estimates that purchasing a new two-year hedge will cost $1M—40% of the property’s annual net income.

Floating-rate mortgages on apartment buildings insured by Fannie Mae or Freddie Mac can require borrowers to put money into an escrow account to pay for a new rate cap when the old one expires.

A wave of property sales spawned by spiraling rate-cap costs would magnify an already intensifying credit crisis in commercial real estate. According to a new report from Bloomberg, almost $175B of global real estate debt already is distressed, four time more than any other sector in the global economy.

Rising interest rates and the accompanying economic downturn, which appears to be the overture of a looming recession, have created an expanding pipeline of potentially defaulting loans in an environment where property values and cash flows are under pressure in all global markets, Bloomberg reported.

 

Source: GlobeSt.

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Why Sale-Leasebacks Are Especially Important Now

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The current economic climate has been difficult, with Federal Reserve interest rate hikes chasing inflation. Even as some of the pressures might be reaching a plateau, the Fed has made clear that further rate increases are still planned. That has led corporate lenders to become more cautious. They’ve been tightening their standards and lowering the amount of leverage available.

“Typically, a mortgage lender will provide 75% to 80% of the loan-to-value of the property,” says Gordon J. Whiting, managing director and head of net lease real estate at Angelo Gordon. “In today’s macroeconomic conditions, it’s much harder to get access to capital, it’s harder to get a loan, and you’re only getting 60%.”

Even as the corporate lending market has become less liquid and more expensive, capital remains available for sale-leasebacks at very attractive terms. Even as property values have been dropping — though they’re still largely at or above pre-pandemic valuations — the return to a company is still better. “They’re able to get 100% of the value today,” says Whiting.

The Advantage of Renting

There’s rent to pay, yes, but unlike interest on a loan, it’s completely deductible as an operating expense. The seller can also typically negotiate control for 20 years with options to extend.

“The rental will be lower than what they’d have to pay in financing,” Whiting adds.

And the longer the lease term, the better the value to both the buyer and the seller, making negotiation of that point easier.

With the future uncertain and rates potentially going higher, there is also value in locking down a strategy with certainty.

“You’re better off doing a sale-leaseback and paying off some of the more expensive or floating rate debt,” notes Whiting. “Cash is king.”

The more liquidity on hand, the easier it is to deal with unforeseen circumstances.

Why Working Capital Now Is King

Sale-leasebacks are also a great source of acquisition financing, particularly in the current market environment, where distress may drive opportunities for strategic add-on acquisitions. Companies can use sale-leaseback proceeds to help fund new acquisitions or expand upon existing platforms. A vertically integrated company might decide to buy a supplier. Sponsors can do the same, using proceeds of a sale-leaseback done at the time of an acquisition to lower their capital costs for the deal.

“Now sale-leasebacks are another arrow in a CFO’s quiver,” Whiting says.

From Whiting’s view, the market uncertainty and potential for ongoing rate increases are also a source of danger, with a sale-leaseback being an option to consider sooner, not later.

“Time is not your friend,” he says. “In our view, we’re headed into an environment where you’re going to be glad you did it the day before and not the day after.”

 

Source:  GlobeSt.

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6 Things Investors Should Consider With CRE Market In Flux

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South Florida’s commercial real estate market is certainly in flux. Owners, buyers and sellers are adjusting to higher interest rates, continued supply chain challenges and an uncertain economic outlook.

Deals are still being done and space is still being leased. But in this inflationary environment, deals have to make sense, with a cushion to account for the unpredictability of 2023 and beyond.

With all this in mind, here are some points to consider for companies and individual investors who are involved in the commercial real estate market or are looking to get into it.

1. With more properties now getting less attractive cash flows, sellers are often grouping assets together for sales.

This can make sales transactions more complicated, and buyers need to work with their banking partner to make sure the overall risk-reward equation works for them.

2. The demise of the office market seems to be overstated. Office is still a good niche to consider.

Certainly, more people are working from home, and many companies are adjusting with new hybrid models involving employees coming in for one to two days a week instead of every day. Smart owners are adjusting by being more flexible and offering smaller floorplans. That said, leases and sales are still being done and there are some real bargains available for opportunistic buyers.

3. Higher interest rates are slowing the market, but there are still plenty of opportunities to find favorable deals.

Deals are now more expensive, and as rates have increased, a buyer’s margin for error has significantly shrunk. So smart planning is more important than ever. But there is still significant liquidity in the market and buyers and sellers are still making deals work, so we predict a healthy CRE market in South Florida for the coming year.

4. South Florida can be expected to fare better than much of the country as the economy faces an unpredictable 2023.

The reason is simple — population growth. That means more companies are looking for office space here. It means there’s more need for distribution centers and other industrial real estate. And it means people are continuing to buy houses and condos.

5. In an uncertain market, a long-term relationship with a CRE banker is more important than ever.

To get a favorable deal, owners and buyers alike need an advocate who takes the time to make sure a transaction will work for their client for the long term. This is best accomplished by having a long-term relationship with a banker who has significant commercial real estate experience. The more you can share about your business plan and the more you can talk about both opportunities and challenges, the more successful that relationship will be.

For the client, it’s important to take the time to build a relationship based on trust and consistency versus finding a different partner for every deal. And for the bank, finding ways to help the client in a wide variety of ways will make the relationship even more impactful.

 

Source:  SFBJ

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