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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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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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CRE Predictions For 2023: Distress, Opportunity And Another ‘Roller Coaster’ Year

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After the last three years, there are few real estate professionals brave enough to make confident predictions about what will happen in 2023 — other than to say once again to expect the unexpected.

“We expect 2023 to herald a whole lot more of the same relative to 2022, and by that, I mean it’s likely to be a similar roller coaster ride,” Moody’s Analytics Head of Commercial Real Estate Economics Victor Calanog said. “It’s not all downs, it’s a lot of ups and downs.”

Commercial real estate enters 2023 pointing in the opposite direction as it did a year ago. The Federal Reserve has pushed its benchmark rate to 4.5% after starting 2022 near zero, a rapid change in the state of affairs that has ground sales volume to a standstill and killed deals around the country.

Rents at multifamily and industrial properties have soared this year, but amid the Fed’s aggressive campaign to rein in inflation, demand for both has started to come down. More significantly, demand for office space has never approached pre-pandemic levels, and office occupancy is still below 50% of what it was in most large markets.

Meanwhile, predictions of a recession next year — and whether the overheated recovery will end with a hard or soft landing — have intensified. Nothing is predictable these days but something of general consensus is taking place on apartment rents, the U.S. economy, return to office and how the Fed may behave in 2023.

It might not turn into a nightmare year along the lines of 2008 — but it certainly “won’t be pleasant,” CBRE predicted — and it will likely be defined by what doesn’t happen more than what actually does.

“I think we’re in for a tough road,” said Andrew Steiker-Epstein, the vice president of sales, leasing and marketing at New York developer Charney Cos. “I think you are going to see just very low transaction volume, and not a lot of things happening.”

Bisnow spoke to nearly a dozen industry leaders to gather predictions for the year ahead in CRE. Here is what stood out:

The Housing Crisis Won’t Abate, Even As Rents Stabilize

Eye-watering rent increases are expected to keep slowing down this year after posting records in 2021 and the beginning of 2022.

“The last of the Covid-era discounts will expire in 2023, bringing even more inventory to market,” said Diane Ramirez, the chief strategy officer of Berkshire Hathaway HomeServices New York Properties. “I think there’s going to be a lot of turnover of apartments. That’s going to help with supply, and with supply, you might get a little bit of an easing with prices, so I think the rental market is going to just become a little more normalized.”

Shimon Shkury, founder of multifamily sales brokerage Ariel Property Advisors, saidrental growth will no longer see a rapid ascent, but he doesn’t expect it to start coming down because “there’s not a tremendous amount of new product that is opening up.”

That spells bad news for the tens of millions of Americans who are paying more than 30% of their income on rent. The housing crisis isn’t going away next year — and it will likely get worse, Nuveen Impact Investing Senior Portfolio Manager Pamela West said.

“I’ve seen a ton of numbers quoted from different sources, but we’re somewhere between 6 and 7 million units in deficit of housing,” West said. “If we were to build 100,000 units per year of affordable housing, it would still take us 20 years to catch up to what we need. It’s just a ridiculous statistic and the needle moves every year, and so in 2023, it’s going to move again, and it’s going to move away from us.”

She said housing is a “purple” political issue and is on governments’ agendas more than in previous years, but the required urgency is not yet there, and it’s unlikely to show up in 2023.

“I don’t think we’ll go backwards on any policies, but my concern is that we’re not really going to move forward either,” West said.

Recession? Maybe. But Distress Is Coming

The predictions on the style of recession vary wildly, from deep to shallow to not coming at all.

“The market really hasn’t given up on the possibility that there will be a soft landing, that we’re going to avoid a recession,” Calanog said. “We think that the probability of a recession in the United States now lies between 55% to 65% over the next 12 months.”

Goldman Sachs, for its part, has put the chances of a recession at 35%. Almost uniformly, real estate players have arrived at the conclusion that some form of correction will come next year, particularly for deals made at the top of the market last year.

“We’re heading to what you refer to as a liquid recession,” said Ran Eliasaf, the founder of real estate private equity firm Northwind Group, which has $3B in assets under management. “It’s hard to say if we’re gonna hit a full-blown recession, or it’s just gonna be a milder one, but there’s definitely a big correction in pricing as well as valuation. That has to happen.”

Marx Realty CEO Craig Deitelzweig is predicting a “shallow” recession, characterized by companies shedding employees following the hiring spree in 2021. His company has been lying in wait for opportunities to pounce on assets whose owners aren’t able to withstand the current market conditions.

“Those opportunities have presented themselves in Washington, D.C., but in New York, the come to Jesus moment hasn’t yet arrived,” Deitelzweig said. “I thought we would see more in New York, but I’m hearing quarter one is when we’ll really start to see more of those opportunities. The firm will continue to look for assets in New York, and in other parts of the country like Atlanta and Austin. A lot of debt comes due in 2023, 2024,” he said. “They have debt coming due, and they either don’t have the capital to improve the buildings or they don’t have the wherewithal to do it.”

 “The bank pullback from CRE lending has already led to some borrowers seeking out debt funds like his for products like condominium inventory loans in New York,” Northwind’s Eliasaf said. “The quality of borrowers that need financing solutions increased, because they would usually get the solution from the bank and that doesn’t exist. I think we’re going to be very busy 2023 as well.”

A sluggish market makes for a tough time for appraisers, said Grant Norling, a co-founder at Valcre, a software company for appraisal firms, but next year is set to bring more activity for the industry as owners, and their lenders, face challenges with their assets.

“There’ll be other aspects of the other sectors of the appraisal industry that start picking up quite a bit,” Norling said. “Any bank that has troubled assets, or they’re looking at pre-foreclosures … they’ll want to be appraising their assets for loan monitoring purposes. So that portion of the industry we anticipate will fire back up.”

Office Usage Will Rise With The Threat Of Layoffs

Office usage is top of mind for 2023 across the board, with some predicting workers will try to ease their fears about the state of the economy by heading into the office more frequently next year.

“I think part of the reason why the sentiment has been weak on office is because a lot of companies have had challenges in fully mobilizing their employees back to the office,” Empire State Realty Trust Chief Operating Officer and Chief Financial Officer Christina Chiu said. “Tech layoffs, maybe some of the financial firms’ layoffs and how that rolls through the system, especially in light of rising interest rates and economic uncertainty … I think some of that will make it easier for companies to bring people back and get people more confident about the use of office.”

Deitelzweig predicted office occupancy will jump by 10%, while Shkury said he thinks usage “absolutely” is going to go higher. Steiker-Epstein of Charney Cos. said 2023 is more likely the year office owners accept the workplace is fundamentally altered.

“I think there’s going to be a slow trend of people coming back,” Deitelzweig said. “It’s never going to be near where it was.”

Calanog took another viewpoint: While employers might demand more workers back at their desks — and some are already doing so — that phenomenon might proved short-lived.

“Would you really feel good about working for an employer that uses the potential threat of layoffs to get you to go back?” Calanog asked. “Yeah, you might comply in the short run, and then guess who’s gonna be stepping up their résumé?”

Interest Rates Could Start Coming Down Before Year-End

Last week, the Federal Reserve hiked the benchmark interest rate half a percentage point, hitting its highest rate in 15 years. The targeted range reached between 4.25% and 4.5% — and Fed officials are now forecasting raises to be around 5.25% by the end of 2023. Real estate has a more optimistic take, however.

“I think that we peaked in terms of interest rate growth — I hope so at least –—and I think that there is some likelihood that we’ll see a lower interest rate environment in a year from now,” said Shkury, though he said he can’t predict that with any certainty.

“I think we’ll see a pause in March and they start dipping in June,” Marx’s Deitelzweig added.

“There are some who are talking about the possibility of rates coming down next year … There’s a number of folks in the last few weeks who are entertaining that possibility, giving a greater probability to that happening than they were weeks before,” Trinity Place Holdings CEO Matt Messinger said. “I am certainly more optimistic about the possibility of potentially opportunistically being able to refinance certain debt obligations at the tail end of ‘23.”

Industrial Down, Retail Up

Industrial real estate, long the darling of the industry, could be facing a challenging 2023.

 “The sector is suffering from lack of available space and limited new construction coming online,” said Turnbridge Equities Managing Principal Ryan Nelson. “This stagnation can be attributed to the current and impending capital market dislocation we are seeing and this will further exacerbate supply chain delays as industry players navigate finding space,” he wrote in an email. “From a developer’s standpoint, higher interest rate and the potential for a recession will threaten prospective industrial developments.”

Speculative construction has been the norm — of the record 700M SF of industrial space under construction in the middle of 2022, just 26% was pre-leased, according to Cushman & Wakefield.

“But while future development is still needed, construction will be limited due to capital market dislocation and distress,” Nelson said.

But in a complete reversal of fortune, there is a growing sense that the worst is over for the embattled retail market.

“The pessimists all said it would take years for the New York retail market to recover from the pandemic, but the numbers don’t lie,” Patrick Smith, who is vice chairman of retail brokerage at JLL in New York, wrote in an email. “By the close of 2022, we expect the number of retail leasing transactions this year to surpass that of 2019 and mark a return to normalcy as we go into the new year.”

Sublease space dropped nearly 11% last quarter and leasing velocity was up 7.4% year-over-year in Manhattan, per the brokerage.

“It seems that lenders have become more positive on retail, along with some buyers, under the notion that they’ve been downside-tested on multiple fronts: Covid-tested, internet-tested, e-commerce tested,” Chiu said.

 

Source: Bisnow

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Ready Your Business For Recession

Mark Hinkins

By Mark Hinkins, CCIM, FRICS | President-SperryCGA 

 

Recessions always seem to catch people by surprise — even though lots of supporting evidence indicates they’re forming and proves they’re cyclical. This time around, with the pandemic’s work-from-home routine adopted by many companies, commercial real estate is being deeply tested.

The post-COVID-19 recession may already be here, though it may only become more clearly visible by the middle of next year. Commercial real estate values will start falling as liquidity goes out of the market. In preparation, brokers and agents must adapt their business today, so they can stay profitable during the next 18 to 36 months. Here are seven time-tested approaches for recession-proofing your real estate business and a glimpse into the future of our industry.

Pick a Winning Side

Any real estate market contains these four pillars: sellers, buyers, tenants, and landlords. You’re trained to think how to represent one of these factions as best you can, but during economic downturns, it’s a matter of who you represent, because knowing which side to represent amid changing market conditions is how the agile brokerage adapts, follows the money, survives, and flourishes.

If you represent sellers, show them how commercial real estate values historically dropped following stock market corrections. If it’s buyers, shift their mindset to see a recession as a friend — an opportunity, as growth happens, paradoxically, when buying and not selling. If it’s tenants, assess the impact of the lease based on your clients’ expenses and work policies. Finally, if it’s landlords, take stock of their expenses and exposure to lease defaults.

If you’re a real estate investor, stock up on cash and be prepared to buy. It’s true that prime rates aren’t favorable right now, due to the federal government’s desire to combat a 40-year high in inflation. But remember that you can always renegotiate and refinance down the road. Having something to refinance is better than having nothing — and it’s better to have a tenant to renegotiate with later than having empty space.

Finally, lenders must avoid dealing with empty spaces. Some buyers see this as an opportunity, others as a problem. Look at the reserve budget because the costs of services, construction, and material go down during recessions — and it might just be the best time for the borrower to fix the building. Shifting your perspective on repairs in the dip — when labor and materials are cheap and selling or refinancing at peaks is a game-changer — because you’ll ultimately enjoy better-term refinancing or high-profit sales.

Having something to refinance is better than having nothing — and it’s better to have a tenant to renegotiate with later than having empty space.

Accountability, Ethics, and Community Outreach

We live in a deeply divided nation. During this time, take responsibility for your actions; define your approach to ethics, honesty, and transparency; and seek to foster a culture where it’s safe to share and voice opinions. Providing knowledge or income isn’t enough in today’s market because clients pick those whose values align the most with their own. This also means staying connected and giving back to your community during hardships, not only in monetary ways, but also with empathy and education.

Discipline and Education

Professional agents adapt and lead in times of change, and entrepreneurial agents excel at this, especially those who own and operate their own brokerage firms. Slowing markets require commitment and perseverance, and it’s in times of foggy terrain when people look for seasoned navigators. Helm your vessel by demonstrating that your agents are the most trained, educated, and knowledgeable in the industry. Help them brand themselves, because client relationships endure throughout all market cycles.

Fiscal Accountability

Be nimble and control your operating cost — but never cut your services or marketing spend during recessions. Ensure your company structure leverages the value of investment and technology, while providing your affiliates access to tools, training, education, and technology. A value-based affiliation allows agents to operate with higher profit margins, keep more money in their pocket, and access more capital to invest in their businesses and household.

Collaboration and Affiliations

The 1991 and 2008 recessions proved that agents stranded without affiliations are by themselves as lone rangers with low chances of survival, let alone success. Clients are unlikely to go with generic brokerages when compared to recognized and trusted names. It’s imperative to them, when market conditions are challenging, that they’re following someone who can successfully liquidate their assets at a fair price, if need be. Often, it’s not even a question of dollars and cents — they’re looking for peace of mind and certainty, two priceless commodities in uncertain times.

During recessions, when the buy-side goes away, is when you’ll need to be affiliated to win listings. When choosing a branded name, seek a regional or national platform providing a collaborative environment that fosters goodwill, a cooperative spirit, and strong alliances, yielding more recognition, increased leads, and more income. As the proverb says, “If you want to go fast, go alone; if you want to go far, go together.”

Diversification of Services

Putting all your eggs in one basket is like building your own guillotine with a recession being the executioner. It’s important to expose your client’s portfolio to all asset classes, including to Class A properties in prime areas. Additionally, you can diversify your income by offering specialty products like consulting services on debt restructuring, exit strategies, and acquisition formulas.

Technology

Commercial real estate has gone through a catching-up period after lagging behind other industries more open to tech adoption. But, if a decade ago, you bent your ear to the ground, you might’ve heard the train of digital innovation coming toward CRE. Today, even with earplugs in, you can feel the gravel beneath your feet vibrating and see the smoke coming out of the prop-tech locomotive.

A decade ago, approximately 75 proptech startups raised $220 million in venture capital. Fast forward to 1Q2022, and VC poured $4 billion into the sector. In 1H2022, VC investments in private real estate tech companies topped $13.1 billion, outperforming the global venture capital market, according to GlobeSt.

Putting all your eggs in one basket is like building your own guillotine with a recession being the executioner.

Looking forward, the quality and ease of 3D scanning and augmented reality in the sector will skyrocket, while attaining such services will cost drastically less. These trends will enable medium-sized brokerages to pierce the veil of exclusivity and reach clients from outside their limited ZIP code. Proptech will also greatly enhance an agent’s ability to represent a client’s best interests in marketing the property, while also giving the buyer or the tenant unique insight into the property, allowing them to make an informed decision before ever stepping through the front door.

But proptech will extend beyond photos and aerial videos for marketing and sales teams. It’ll rectify the construction, property management, and insurance sub-sectors, with its advantages mostly felt in the property inspections sector. It’ll allow property managers and owners to seamlessly track, record, and weave the condition of the property into stats readily available and accessible for limited partners, bankers, and insurance agencies.

Recessions aren’t easy. Learning how to leverage such times will be crucial for you and your team. Pick the winning side, be ethical when you do so, give back to your community, and educate your agents. Diversify your services, portfolio, and technology offerings. And remember: While technology changes the world, the commercial real estate market is, and always will be, about developing personal relationships across the board.

Source:  CCIM

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Small Investor Opportunities Surface For Industrial

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Despite strong overall demand, rising interest rates are changing the fundamentals of industrial sales deals with retrading becoming ubiquitous.

Lately, 100% of the retrading activity has been for that reason, according to NAI Global brokers during the July Logistics Conference Call.

One broker said that institutional investors are putting everything on hold for 5 to 6 weeks to see how interest rates shake out, according to NAI Global.

However, the group noted that there is upside to some of the retrading activity. According to some of the broker comments, sales that are dropped during the due diligence period—and most often to institutional investors—is allowing local and usually smaller regional investors who have been “boxed out” the opportunity to buy in what has been one of the most competitive environments for industrial property sales in history.

BJ Turner, founder of Dunleer, a Los Angeles-based private real estate investment and development firm that focuses on industrial and multifamily sectors, tells GlobeSt.com that there are definitely more and more re-trades happening in the marketplace.

“Deals that were put together 45 to 60 days ago have wrapped up due diligence and now it is time to remove contingencies,” Turner said. “Their lenders are either pencils down or telling them the rate for debt financing is 100 bps to 150 bps higher, so something has to give—and in most cases, it’s the buyer saying to the seller they still like the deal, but due to the cost financing, they can’t afford to pay the same price they did before. In many cases, there is some form of a meet-in-the-middle solution that works for both the buyer and seller and deals get done. In the deals that don’t get done, there are opportunities for users to put deals into escrow they couldn’t compete on three to six months ago.”

Demand, No Less, Remains Robust

Doug Ressler of Yardi’s Commercial Edge said despite those growing weary of a possible recession around the corner, demand for industrial space remains as high as ever.

He said that in June, the average in place rents grew 4.9% year-over-year, the vacancy rate fell to 4.6% and the average cost of a new lease signed in the past 12 months was 88 cents higher per foot than the overall average.

“Supply of new industrial space cannot maintain pace with demand, a problem more pronounced in areas where geography limits the amount of land available for development,” Ressler tells GlobeSt.com.

 

Source: GlobeSt.

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What CRE Investors Should Consider When Contemplating A Recession

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Investors “shouldn’t be afraid of an impending recession” and should instead consider what the economic picture will look like over hold times of three, five and ten years, according to one industry watcher.

“It’s hard to say if or when the next recession will be because there’s a wide range of economic crosscurrents in play. That makes it very difficult to predict,” says Marcus & Millichap’s John Chang, adding that while “the risks are rising, a recession is not a foregone conclusion.”

On one hand, Chang says, job creation is robust, with an average of 488,000 jobs added per month this year. Unemployment remains low at 3.6% and wage growth strong at 5.2%. And while retail sales have flattened recently they are still up nearly 8% over last year.

“Those are all positive economic readings pointing to a steady growth outlook,” Chang notes. “On the other hand, we have exceptionally high 8.5% inflation, rising interest rates, a falling stock market and falling confidence levels. In many ways there’s a fear factor coming into play that could cause people to slow their spending, and that could induce a recession.”

So does it really matter if the US undergoes a recession? That depends, according to Chang.

The Great Financial Crisis involved a liquidity crunch that curtailed real estate investment, which Chang says is unlikely in the current scenario. And while there are a variety of causes and effects for recession periods, Chang predicts the US is likely looking at a recession along the lines of the 1981 or 1990 downturns. Both periods were preceded by strong growth and rising inflation that pushed the Fed toward the same types of aggressive rate hikes we’re seeing today. Yields softened in both recessions, but nothing like the 2009 decline, and Chang noted considerable variation among property types, with apartments, for example holding up well in the 1980s and dipping mildly negative in 1991 – though “nothing like the hit the sector took in 2009,” he says.

Much of the risk to CRE investors will depend on asset and location.

But “in general, real estate has delivered positive returns through most recessions,” Chang says. “And even when returns dipped, it was usually followed by strong steady growth. So yes, recessions matter to commercial real estate – but not nearly as much as people may think.”

 

Source: GlobeSt.

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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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