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Industrial Cap Rates Expected To Rise But Outlook For Seasoned Investors Remains Strong

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Industrial has been on quite a tear over the past few years, as changes in consumer behavior have driven demand for more logistics and fulfillment facilities in key markets.

And according to one industry expert, the sector should stay a favored asset class for experienced investors, despite rising capital costs.

“Post-pandemic consumer behavior has changed and the rate of growth in ecommerce has slowed which has already led to pullbacks by some companies,” says Greg Burns, Managing Director at Stonebriar Commercial Finance, noting Amazon’s recent announcements regarding its industrial portfolio. “Demand for industrial though was driven by other factors as well including a move toward onshoring and the disruption of just in time supply chains.”

With that said, however, Burns said “depending on the what and the where, I would not be surprised to see cap rates widen another 50 to 100 basis points.”

“The cost of debt and equity capital have increased and cap rate hurdles have increased for institutional buyers,” Burns says, adding that he recently saw an increase of 100 basis points in an appraisal for a property in a market where his firm closed a deal six months ago.

Burns will discuss what’s happening in the capital markets in a session at next month’s GlobeSt Industrial conference in Scottsdale, Ariz. He says Stonebriar’s definition of industrial includes not just warehouse and distribution facilities, but manufacturing, life sciences, cold storage and data centers as well, and notes that “each of those sub-categories have their own dynamic and, broadly, all are growing.”

“We prefer properties with multi-modal access, especially those near ports, with most opportunities we’ve seen recently being to the southeast of a line drawn from Baltimore to Phoenix,” Burns says. “We also pay attention to outdoor storage capacity as that has become a greater consideration for tenants. There have been several announcements of new manufacturing sites relating to microchip and electric vehicles which should lead to demand for new logistics properties nearby.”

As the costs of debt capital rise, Burns says Stonebriar’s underwriting will continue to focus on the sponsor, asset and market and “that won’t change.”

“We do few spec development deals and will likely be more granular on understanding the demand/supply side of a respective market,” Burns says.

Ultimately, a recession seems likely and Burns says the changing economic landscape will have “varying impacts” on investors and individual markets alike.

“From our perspective, there will be a premium on a sponsor’s experience and capacity,” Burns says. “I anticipate industrial will remain a favored asset class for investors although those with less experience in the sector could pull back until the economy recovers.”

 

Source: GlobeSt.

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How Commercial Real Estate Can Hedge Against Inflation

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Whether inflation first entered your adult life in the 1980s, the late 2000s or the first few years of the 2020s, the aftermath is more or less the same: emptied wallets and angry consumers.

And while some inflation is good (like the Federal Reserve’s annual target of 2%), too much is obviously not.

Amidst all the commentary that usually accompanies inflated economies, you may hear the word “hedge” thrown around quite a few times. And while many asset classes can help you provide a hedge against inflation, how can you utilize commercial real estate specifically as a hedge?

How Inflation Degrades National Currencies

In inflated economies, your average consumer ends up having to pay more for everyday items and conveniences than what may be considered average due to decreased purchasing power. Purchasing power, in this regard, refers to how much value of something you can extract with a single unit of currency (such as a single US dollar). In inflated economies, this decreases, and vice versa for deflation.

Illustrating Decreased Purchasing Power

This fall in purchasing power can be simply illustrated with a simplified example. Let’s say John Doe usually pays $100 a month for groceries in a regular economy. And let’s say that a large-scale financial crisis has just crippled that economy. As a result, consumers, now driven by fear of the unknown, start spending less and saving more.

Businesses in John Doe’s country, however, still need to make a profit, but this decrease in consumer demand is ultimately shrinking profit margins. So, these businesses start raising their prices to compensate. And these price increases accelerate even more when those businesses start paying more for raw materials and labor as a result of this financial crisis, creating a domino effect.

All of this creates an inflation rate of, say, 9%. This means that, if something cost $1 last year, it now costs $1.09 today. Each unit of that economy’s currency has lost 9% of its purchasing power, and John Doe will now pay $109 a month for groceries for the very same things.

What Does Inflation Leave Behind?

Ultimately, what inflation leaves behind is your average consumer having to pay more for everyday goods and services at no fault of their own. And while inflation can come about as a direct result of high employment and strong economic growth, there are a myriad of things to factor in a large, complex economy like price gouging or consumers getting higher-paying jobs. More impactfully are the consequences of macroeconomic factors such as global conflicts, financial crises and large-scale natural disasters.

Hedging Against Inflation

To hedge against inflation, you store your money in assets that appreciate in value over a certain period of time. Store here is a synonym for purchase. Gold is probably the most popular example of a hedge against inflation. As the purchasing power of the U.S. dollar falls, an ounce of gold tends to become more expensive as more investors buy it.

As such, the owner of that gold has successfully hedged against inflation. They can sell off that asset and receive more dollars in compensation than they originally invested, compensating for the drop in that currency’s purchasing power.

How Commercial Real Estate Can Hedge Against Inflation

Commercial real estate operates in a similar way to gold in inflationary environments. As the purchasing power of a currency drops, average property values tend to increase alongside new and existing commercial rentals as lease renewal rates increase. This is largely the case with properties that are already developed and have been around for some time. It’s likely that the interest rates on any loans taken out to purchase those properties were lower before inflation hit.

Once the Federal Reserve begins raising interest rates to combat inflation, the cost of owning the property for the owner stays the same while its value grows. This is not so much so, however, for properties currently or planning to be under development. Inflation often leads to increased costs for labor and materials, slowing down property development as a result. This means that demand for existing properties rises while demand for new ones falls, placing the odds all the more in favor of existing commercial real estate property owners.

Timing Matters

Commercial real estate as a short-term hedge against inflation usually doesn’t bode as well as its long-term alternative. Your investment needs time to mature, and purchasing CRE when it’s too late will not protect your portfolio in the same way.

This is largely due to the rising costs of goods, services and labor that come with inflation, most especially when it rapidly accelerates. By the time you start considering putting some cash in CRE in an inflated economy, not only will it be more expensive, it’s usually too late.

Instead, you should approach investing in CRE as a long-term hedge. As we get out of these inflationary times, now is a good time, as soon as you’re able to, to look into investment strategies and talk to the right professionals to help you get started; the last thing you want to do is wait too long.

Selecting The Best Property Type

Selecting the best commercial property types as a hedge is where market specifics really come into account. Take the Covid-19 pandemic, for example; the virus put many retail outlets out of business but led to a flaming hot housing market. Those invested in retail felt the aftershocks of the pandemic as retail values plummeted, while those invested in multifamily and industrial real estate saw quite the opposite.

This is extraordinarily important information to keep in mind moving forward into a post-pandemic economy. The retail market has forever changed, and while consumers still enjoy shopping in person, there is no denying the cold lessons the pandemic taught us about e-commerce. In the end, do your research and stay diligent when investing in CRE.

 

Source: Forbes

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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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