Winter is Coming! Or is it?
It is mid-May, and I am not referring to the 5-10” of snow the foothills and mountains around Boise received recently—and to be honest, I have never watched an episode of Game of Thrones, so I probably shouldn’t use the line!
We could be headed into darker time in commercial real estate in the near future. There are so many factors that are all converging on us at the same time. We have inflationary pressure, extremely high oil prices, labor and material shortages, fed rate increases, quantitative tapering policies, population/demographic shifts (thousands turning 65 and tens of thousands turning 21 every day), nearly full employment, all-time high home prices, all-time high apartment rental prices, little-to-no inventory in any property type for investment, stock market declining rapidly, crypto currencies crashing and following stocks, and many other factors that just seem too insurmountable to have the current real estate market trends continue. With all of these headwinds blowing briskly in the face of investors, how can we not see some pressure on values in commercial real estate?
With inflation over 8% and realistically, mid double digits for consumers, the Federal Reserve recently raised its overnight lending rates by .25% in March and another .5% in May 2022. They are aggressively fighting inflation the only way they have available to them. The problem is that the inflation we are seeing is not solely driven by the supply of money. Don’t get me wrong, there is a LOT of new money in the marketplace from the PPP loans, quantitative easing, and stimulus that happened during the Covid-19 pandemic, but I don’t believe that is the current cause of the drastic uptick in costs across the board.
My feeling is that we are currently experiencing much of the inflation we see right now due to supply chain issues, and reduced supply in nearly every area including lumber and building materials, fuel (gas and diesel) due to Russian oil being banned, supplies and goods produced in China (they have massive shutdowns for Covid-19 resurgence currently), and much, much more. Food processing plants have been mysteriously, blowing up or burning down all across the country. I believe that when the Fed sees that their interest rate hikes are helping in a few areas (housing and vehicle purchases are the most likely), but not doing much in other areas (fuel, building materials, food) that they will have two possible responses.
Federal Reserve option one: double down and increase the rate more rapidly in hopes it will help reduce inflation. Option two: recognize that the inflation we are seeing is not related to their lending rates and back off their current plan and possibly even reduce the rates a bit. If they go with the second option, which is my hope, I think we will see a quick regroup of the markets and we will probably start to feel consumer confidence drift back up. If they go with option one and continue to raise the rates, I think we will see a relatively short, but dire, recessionary period of eighteen months to two years. I find it unlikely that the current administration would look too favorably at the Fed if we had a recession in line with their next election year (2024)—so I believe we will see pressure from the Democrats to leave rates or possibly even drop them a little bit in the 4th quarter of this year. Granted, the administration doesn’t really control monetary policy of the Federal Reserve, but they know how to pull strings.
INFLATION RESISTANT INVESTMENT:
Historically, real estate, and specifically—commercial real estate—has been one of few assets that have held their value in the face of inflation. As inflation increases, so typically, do the rents. In a period of expected higher inflation, investors would be wise to consider the types of real estate that have the least exposure to rising costs and inflation due to the short lease terms. Mini storage, AirBnB type rentals, mobile home parks, and apartments seem to be the most ideal products to invest in when inflation looks like it will be picking up soon. Those shorter lease terms allow you to raise rents more frequently to adjust for inflationary pressure on a monthly, or at minimum, annually. Compare that to corporate lease on a retail building, like a Walgreens or CVS. Those leases typically have longer lease terms (10-20 years and sometimes longer). Usually, they build in annual increases of 2-4% or some will have a 5% increase every fifth year or some variation thereof.
When inflation is in the 8%+ per year range, it doesn’t take a mathematician to realize that you are going backward in comparison to the current market rental rates if you only get 2% for three years when the market is 8% per year. The caveat to this comparison, is that most of the long term retail leases are NNN leases which means that the landlord passes the cost of owning, maintaining, operating and managing the building through to the tenant, so while they take a hit by losing some possible market rent growth by being subject to these long-term leases, they don’t typically get hit with the increased costs associated with owning (taxes/insurance), maintaining (repairs and maintenance), or operating and managing (labor and management fees), whereas investors who buy mini storage, apartments, and short-term rentals will see both sides of the coin of inflation.
Regardless of which property type you invest in, you typically come out ahead owning real estate versus keeping your cash in a savings or money market account during periods of high inflation even before the non-cash benefits of owning real estate are considered (depreciation, appreciation, principal reduction, passive losses on taxes, etc.).
INTEREST RATES AND CAP RATES:
With our current onslaught of multiple market factors working against us, inflation and the cost of funds increasing may have an interesting impact on the values of commercial real estate. As cap rates increase, some of the decreased value may be made up by rents that are rising quicker than the expense/costs are increasing, meaning greater NOI and possibly off setting the effect of the increased upward cap rate pressure. Additionally, there is more cash/savings per household than we have seen ever before, which means that people still have cash to spend to buy investment property. Cash buyers who are not reliant on debt to purchase property can still afford to pay a lower cap rate than the current interest rate level as long as the return is still greater than what they would have received with their cash in savings or money market accounts, so they can somewhat throw off the calculus of cap rates for all investors, making it hard to predict what will actually happen. I do believe cap rates are going to rise, but the cash in the market could slow that slightly in comparison to the increase of interest rates.
One thing that I feel fairly confident will happen is that we will start to see fewer deals being sold “off-market” and we may finally get to see a few deals that actually come to market in a traditional sense. That being said, the trend we have noticed, is that those that do come to market tend to be “unpriced” or have a “call for offers” which will allow the market to price the asset. Some investors do not appreciate this tactic. They do not want to feel like their offers are being “shopped” and may not opt to submit an offer at all in this case. More sellers may begin to consider listing their properties for sale because they feel like the real estate market has finally peaked and they want to try to time the market. As more sellers bring their properties to market, we may see deals start to sit on the market a little bit longer until we reach a more normal equilibrium of supply and demand. As a result, we will likely see prices stabilize for the first time in several years. With higher NOI as mentioned above, and prices stabilizing, cap rates will potentially creep back down for a short period until acted upon by some outside force (further Fed action to increase rates or quantitative tapering).
Graph above shows the spread between cap rates and the 10-year treasury. You can see we are at the smallest spread since 2006. Image courtesy of Marcus & Millichap.
In summary, I believe that we will see some bumps in the near term as the market works out how to price in all of these factors, but the fundamentals of our market supply and demand and the amount of investment dollars that are still sitting in cash on the sidelines makes me comfortable saying that I expect the overall market trend in the next 3 to 4 years to still be positive. I believe it is possible that we could see CRE interest rates up to 6.5% in 2023. I believe cap rates for investment property (except for institutional assets) will likely be forced up to 5.5-7.0% and that will result in a hit to values for those that are not able to keep their NOI growing faster than the pace of inflation. The bottom line is that I don’t believe we are going to see a 2008 level event in the real estate market at this time due to the strength of our underlying fundamentals (jobs, unemployment, cash/savings, demographics, supply and demand, etc.).
If you already own investment property, now more than ever, you need to be vigilant. You need to make sure you are weighing the effects of huge rent increases with increased turnover costs and longer vacancy. You need to do everything you can to maximize your net operating income so you can maintain your value at higher cap rates in the market. Sometimes that can be done most effectively through tenant retention and resident relationships. Make sure you are offering maximum value to your tenants and residents to keep them happily in your space if possible while still keeping rents within striking distance of the market rates.
There is a fine line there and an experienced (and friendly) property manager is your best tool in your toolbox right now. Their market knowledge can help you determine just how much you can push rents while minimizing the risk of pushing a resident/tenant so hard that they find another space for less money resulting in turnover and/or tenant improvement costs and costs of vacancy and re-tenanting the space. Those are costs none of us can afford to absorb right now and they are costs that are avoidable.
If you are an investor that has held your property for a few years and you have been riding the tidal wave of value we have seen building, waiting for the right time in this strangely extended real estate cycle to consider selling your property, PLEASE do not wait. There is a short window of opportunity right now to get your property sold very near the top of the market and then in a short time, you may be able to capitalize on some of the opportunities that may be coming to market during the bumpy period and get a good deal on a newer or larger replacement property.
If you would like to discuss ideas to maximize your property’s value proposition, please don’t hesitate to reach out. I would be happy to discuss ways to ensure your tenants/residents view your property as a better value than the competition.
Please call us at High Ground Commercial Real Estate – KW Commercial at
(208) 344-6275 or email us at email@example.com.