Higher cost of capital begins to erode CRE asset prices
Commercial real estate prices that have been hovering near record highs are beginning to decline, and with further interest rate hikes looming, this could prove to be a slippery slope for some sellers.
“The higher cost of capital is driving a repricing of risk across the economy, and real estate assets sit in the middle of that,” says Bryan Koop, vice president of the Boston Capital Markets team at Colliers International. . “Asset values have already taken a hit with the cost of capital raises.”
Although the 10-year Treasury yield has fallen since hitting a high of 3.5% in June, it is still around 130 basis points higher at the start of the year at around 2.9% from mid-July. “At current interest rate levels, those who borrow money cannot earn any return based on the cap rates that existed nine months ago, because this leads to negative leverage,” says Koop.
Cap rates are climbing and the market is still in the early days of asset repricing with more interest rate hikes to come. Markets expect the Fed to raise interest rates further 75 or 100 basis points at its next meeting scheduled for July 26 and 27. The Fed should act aggressively to rein in the acceleration of inflation, which has reached a four decades high an annual increase of 9.1% in June.
Periods of price revisions typically bring about gaps between bids and asks that can slow down trading activity and alter the strategies of buyers and sellers, and today’s market is no different. “Sellers want yesterday’s prices and buyers want better prices tomorrow, and the gap between supply and demand is really fueled by how quickly the market has moved,” says Barbara Perriervice president of capital markets at CBRE specializing in industrial and logistics assets.
The gap between supply and demand varies
The gap between supply and demand that is emerging is by no means unique. Many sellers are well aware of the new market realities and are adjusting their expectations accordingly. “My perception right now is that sellers are in tune with what’s happening with interest rates going up, and we haven’t seen a tremendous amount of sellers stubbornly saying, ‘my price is the only price,” says Lee Shapiro, executive vice president and director of retail brokerage at Kennedy Wilson Brokerage in Beverly Hills, Calif. “If they’re genuine and want to negotiate, they’re willing to change the price.
Several months ago, well-located commercial properties in the Los Angeles market were selling at cap rates between 3% and 4%. There was also a narrow delta of perhaps 50 basis points for tertiary market assets relative to higher quality markets, Shapiro notes. Rising interest rates coupled with uncertainty about the direction of the economy is putting upward pressure on cap rates in the Los Angeles market. Major sub-markets, such as Rodeo Drive, saw prices remain very flat, while commercial property cap rates in the broader market moved 25 to 50 basis points. “So there hasn’t been a huge leap in the higher quality product on the market yet,” he says.
The expectations of sellers are very different depending on their situation and their financing structure. For example, if someone has owned a property for the past decade and built up good appreciation in value, they are rushing to sell now before their gains erode. Some might already be too late as properties that are on the market or coming to market are being re-evaluated with lower values almost everywhere. Everyone is well aware of the rate hike, and many sellers are accepting the price revision because they think the situation will only get worse, says Koop. “I wouldn’t say everyone has taken care of it, but we tend to reset seller expectations because headlines are on everyone’s radar and you can’t deny them,” he says.
There aren’t many motivated sellers hanging around for what properties were worth six to nine months ago, agrees Erik Foster, director and head of industrial capital markets at Avison Young in Chicago. Sellers hoping to trade at prices that existed months ago are unlikely to list assets in the current market unless they have to for some reason. “I think there could be a bit of a rush to make deals in the third and fourth quarters of this year given the potential anticipated interest rate hikes which could further impact debt markets. and erode buyers’ indebtedness,” he adds.
Ceiling rates are changing
Anecdotally, there are many stories of assets in the sell market that were taken off the market because bids failed to meet expectations or sells failed because buyers gave up or funding has not been as expected. In many cases, the price a seller could have gotten 90 days ago no longer exists. That being said, the revaluation that occurs varies by market and ownership, with some assets seeing little to no movement, while others have seen larger jumps.
In the industrial and logistics sector, interest rate increases had more impact on the revaluation of assets with longer leases. “On shorter-term leases, we’ve seen less of an impact because the mark-to-market history is strong, and if investors can see a big increase in NOI, they’ll still be aggressive. on prices,” says Perrier. According to Perrier, capitalization rates for industrial and logistics facilities increased by 25 to 125 basis points on average, with increases depending on the weighted average lease duration.
The industry continues to have a bit of “favored nation” status, Foster adds. Industrial fundamentals are still at historically low vacancy rates in nearly all markets and properties are seeing healthy rental growth. The price gap widened on industrial assets as interest rates started to move. However, it widened more precipitously with B buildings and secondary locations, while the gap didn’t move as much for central buildings in primary locations, he says. “We didn’t see a lack of buyer demand for the assets, just a revaluation to a different level,” he notes.
According to CBRE, cap rates for multifamily assets have increased by as much as 50 basis points, depending on asset quality and the specific market. “We are in a period of price discovery and the bid/ask spreads for multi-family assets are specific to each transaction,” says Brian McAuliffe, President, Multifamily Capital Markets for CBRE. According to McAuliffe, any discrepancy that exists appears to be related to two things: 1) Buyers recognize that sellers are unwilling to accept requests for deep discounts. 2) Sellers recognize that there are significant built-in gains over the past few years that allow them to accept discounts.
According to the last MSCI RCA CPPI Index, house prices in May were up 18.8% year-on-year. Industrials led all sectors with gains of 28.6%, but even office prices recovered with a gain of 12.2%. One-month gains were more moderate at 1.1% for all property types.
Decreasing pools of bidders
Although properties are still trading, rising debt costs are shrinking bidder pools. “Instead of having 15 to 20 offers on a deal, we only have maybe five or six,” says Perrier. Small transactions are easier to sell than larger ones, due to the need for financing for larger transactions. The 1031 exchange buyer with cash has a strategic advantage and is able to win deals that might not have been possible a few months ago as private equity groups and other more debt-sensitive buying groups are having a tougher time in today’s market, she says. .
“We’re seeing executions and good deals right now, but the depth in terms of the number of buyers showing up is day and night compared to last year,” agrees Koop. High leverage buyers who traded based on their ability to financially generate leveraged returns are on the sidelines. Buyers who have the money or sit on dry powder are in control, and they are selective and dictate the terms, he says.
During recent cycles of rising rates over the past decade, investors have been able to adopt a floating rate debt strategy. However, in the current environment, floating rate strategies don’t offer the same level of benefits as they have in recent years, McAuliffe notes. However, rising debt costs are not the only factor contributing to shrinking bidder pools. “While we saw a decline in average LTV which certainly favors buyers with lower debt requirements, there is not enough data to conclude that rising borrowing costs are the primary driver,” he said. Uncertainty surrounding the global economic outlook is weighing on both investors and lenders, and the recent inversion of the yield curve has created additional stress on market conditions.
Despite the headwinds, market participants remain optimistic that the second half of the year will be active, with both buyers and sellers eager to close deals before the end of the year. “We are busier than ever,” says Koop. “Right now we have people who are motivated and want to trade and get their trades across the finish line, but it will be interesting to see what happens three months from now with the withdrawal of cash that will be interesting.”