Are we there yet? Unfortunately, whether this question pertains to reaching a road trip destination or the end of the Federal Reserve’s interest rate hikes, the answer is “No”. Much like the feeling of being sandwiched in the middle seat on a long drive with too little A/C and too many beverages, investors are eager and anxious for the journey of steadily climbing interest rates to end as soon as possible. As evidenced in the chart below, the pace and magnitude of the Fed’s increases to the target rate over the past year has been unprecedented. As I write this, the current target rate sits at a range of 4.25%-4.50%, up from 0.0%-0.25% nearly a year ago.
It goes without saying, higher interest rates affect the commercial real estate industry. I could stop there, but we are likely headed into a mild recession and I do care about job security so let’s dig in and examine how these rapidly elevated rates impact commercial real estate in order to better understand the risks and opportunities investors will face.
First things first, a higher federal funds target rate means higher benchmark rates (SOFR and WSJ Prime, for example) which in turn means higher rates for loans and mortgages of all types. Higher borrowing costs eat into deal economics and can lead many property investments that may have penciled a year ago to now seem unattractive from a return standpoint. These higher borrowing costs also affect a property’s ability to meet Lenders’ debt service coverage ratios (typically operating income of 1.2x debt service) and thus result in either lower LTV (loan to value) funding amounts or the need for more equity to be contributed to a deal in the case of a “cash-in” refinance.
As the Fed continues to raise interest rates in order to tamp down inflation, Lenders are also left with a great deal of uncertainty as to where the Fed’s terminal rate will end up. This uncertainty has caused many Lenders to tighten their terms and willingness to lend, effectively constraining the financing environment that greases the wheels of transaction activity.
In addition to constrained credit availability and borrowing costs we must also consider commercial real estate investing in the context of record sales activity over the past several years. Cheap debt and an abundance of undeployed capital , or dry powder, led asset values to increase significantly and capitalization rates to compress across asset types. These lower cap rates were supported by strong growth in rental and lease rates, and in tenant demand, however, an oversupply of new development and weaker consumer confidence have greatly reduced these tailwinds. We now face an environment in which the gap between Seller prices and Buyers’ underwritten property valuations is increasing, leading to a dramatic slowdown in sales activity. Furthermore, weakness in rent growth and a looming supply glut for some markets are not factors we expect to quickly reverse, at least not for the next 18-24 months.
So has the acquisition environment for commercial property investors become a waiting game where everyone sits on their hands and transaction volume grinds to a halt? Yes and no. While good deals always exist if the right price and terms can be transacted upon, they are likely to be significantly harder to find while Sellers cling tightly to overly optimistic values based H1 2022 pricing. For true price discovery to occur and deals to begin transacting at reasonable valuations the market needs a “first trigger” event to increase liquidity. With rates remaining high and Lenders continuing to tighten the credit spigot we’re left to rely on a Minsky Moment in commercial real estate.
As alluded to earlier, this first trigger could likely come from a wave of loans and rate caps set to mature this year. If scenarios start playing out in which owners are faced with a decision between coughing up additional cash to refinance at lower LTVs in order to maintain acceptable DSCRs or selling their properties, we could see properties begin to trade at a discount. In a market with low transaction volume these discounted property sales could begin to form a new downwardly revised comp set that will further drag down valuations. From an investor’s perspective this would help narrow the Buyer-Seller gap in pricing and present a viable acquisition environment. This same scenario could be reinforced by the expiration of rate caps as these hedges are now exponentially more expensive, forcing owners into the same “cash-in” refinance position.
Understanding that there is serious potential for widespread repricing in commercial assets as 2023 marches on, investors would be smart to wait for more attractive valuations to arise. However, there are a few instances in which investors may benefit from deploying capital on a shorter time horizon. As a result of higher interest rates and construction costs, many development projects, especially warehouse or flex industrial projects, have been paused or cancelled. This creates a kink in the supply of industrial square footage expected to be completed in 2024 and 2025. Warning: the stats ahead may come across as concerning, but the takeaway here is the numbers paint a very optimistic picture of industrial demand over the coming years despite a relatively short hiccup in supply. Prologis recently reported 60% of industrial projects slated to break ground in 2023 will fall out of the pipeline. While supply may be kinked, demand for industrial assets remains strong as evidenced by the fact only 26% of industrial square footage brought online in 2022 remains available and unleased. Further supporting this point on demand is the fact that industrial leasing activity in Q4 of 2022 was only 8% off the higher watermark set in Q4 of 2021. This dynamic presents risk tolerant investors with the opportunity to step in and build industrial product that will enter the market when demand is set to far outpace a temporarily limited supply. Development does, however, carry its own unique set of risks and finding opportunities to develop projects with feasible economics is certainly not easy.
In closing, let’s sum up where we stand currently and how investors may think about approaching acquisitions or investment in 2023. Yes, the meteoric rise in interest rates has created an environment where many deals simply do not pencil at current asking prices. The answer, however, is not to bury one’s head in the sand, but to remain vigilant and wait for “DSCRmaggedon” to take affect and for discounts to reverberate through the commercial real estate market. Investors should be aware of the first trigger events that could contribute to this wave of repricing and recognize the opportunity this presents. On the other hand, those investors open to the risk of development should also understand that the forces of demand for several asset types are still very strong and there is significant upside to be captured by building now in order to deliver assets into an environment with constrained supply. At Axia we are pursuing both of these investment strategies in our current Value Development Fund in a “barbell” approach wherein our portfolio consists of industrial development projects and a patient eye towards multi-family acquisitions later in the year.
Portfolio Manager - Director of Investment
Before joining Axia, David developed real estate experience at Everbank/ TIAA CREF in the distressed MBS trading unit and on one of Colliers market-leading investment brokerage teams. David brings a decade of financial services experience, working at Credit Suisse and Goldman Sachs within their Wealth Management and Hedge Fund Strategies groups, and an MBA from Vanderbilt.