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

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

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

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

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

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

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

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

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

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

 

Source:  GlobeSt.

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The Fed Says CRE Valuations Are Still Elevated

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

One aspect is of particular concern to CRE professionals.

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

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

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

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

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

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

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

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

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

 

Source:  GlobeSt.

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3 Multifamily Trends CRE Investors Should Monitor

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

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

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

 

1. Demographics and Demand

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

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

 

2. Inflation and Valuation

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

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

 

3. Risk and Insurance

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

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

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

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

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

 

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

 

Source:  CBiz

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