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What to Anticipate in 2024: Outlook for Net Leases

Corporate real estate owners are forced to devise innovative plans for the upcoming year due to rising cap rates and interest rate volatility.

Owners of corporate real estate are navigating uncharted territory. With interest rates and borrowing costs rising due to the Federal Reserve, many are turning to unconventional means of funding their deficits. Additionally, as 2024 approaches, these businesses are curious about what lies ahead.Two major themes will continue to have an impact on the net lease market in 2024, according to Gordon Whiting, managing director and head of net lease real estate at TPG Angelo Gordon.

First, there are high cap rates, which are seen as the “new normal.” Second, he anticipates a rise in the innovative capital raising option, particularly sale-leasebacks, as long as corporate borrowing costs are high.

Raising cap rates is the “new normal.”
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Since cap rates are at a 15-year high, Whiting does not see a notable decline in 2024. According to Real Capital Analytics, US single-tenant cap rates increased to an average of 6.24% in the third quarter of 2023 as a result of cap rate expansion in the industrial and office sectors. Cap rates for sale-leasebacks have been reported to range from 7% to 8%, which is also higher than historical averages.

He goes on to say that the market is beginning to realize that high interest rates are here to stay after a decade of falling cap rates and cheap interest rates. This approval might lead to a rise in sale-leaseback volumes in 2024, enabling building owners to raise money by selling a building to an investor and leasing it back over an extended period of time.

According to Whiting, transaction volume will naturally increase as buyers and sellers feel more certainty about pricing as the markets get clarity around Fed tightening.

Increase in the Volume of Sale-Leaseback Transactions

Mr. Whiting points out that, based on statistics from Real Capital Analytics, the number of single-tenant net lease transactions is expected to reach over $45 billion by 2023. In 2024, he anticipates that figure to approach the historical five-year average of $80 billion. The need to generate funds in an era of costly finance will contribute to the growth.

According to Whiting, sale-leasebacks are a desirable type of funding that lets business owners keep operational control and are typically less expensive than corporate debt.

Sale-leasebacks are an appealing alternative to traditional financing choices because they don’t have as many financial covenants as they used to.

It’s crucial to keep in mind that, according to JP Morgan, high-yield bonds with maturities within the next three to five years make up around one-third of all leverage loans that are now in existence, adds Whiting. As we enter the new year, there will be strong tailwinds for an increase in sale-leasebacks due to the need for creative corporate finance options for firms.

We are ready to assist investors with Santa Ana Commercial Real Estate properties. For questions about Commercial Real Estate Investments, contact your Orange County commercial real estate advisors at SVN Vanguard.

1. CPI INFLATION

2. THANKSGIVING INFLATION

3. COMMERCIAL PROPERTY PRICES

4. GOVERNMENT SHUTDOWN AVERTED

5. FHFA CUTS GSE LENDING CAPS

6. EMERGING TRENDS IN REAL ESTATE: 2024 ISSUES TO WATCH

7. EMERGING TRENDS IN REAL ESTATE: 2024 PROPERTY TYPE OUTLOOK

8. HOUSEHOLD DEBT TRENDS

9. SMALL BUSINESS OPTIMISM

10. NAHB HOUSING MARKET INDEX

 

SUMMARY OF SOURCES

 

 

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In particular, the bank consumer and CRE lending divisions are under close observation by the Fed for possible signs of credit deterioration.

The November 2023 Supervision and Regulation Report states that the Federal Reserve Board of Governors has stated that there are issues even if they believe the “banking sector remains sound overall.” The lending of banks to commercial real estate was one of the problematic areas they identified. Overall, the banking sector is still solid. According to their writing, banking institutions “continue to report capital and liquidity levels above regulatory minimums.” Despite recent pressure on net interest margins, earnings performance has remained strong and consistent with pre-pandemic levels. The decrease in deposits caused by the financial strains in March has abated. Overall, loan delinquency rates continue to be low.

Yet, banks have raised credit loss provisions, and delinquencies for CRE and certain consumer sectors have risen from their low levels. Some banks continue to face elevated liquidity and interest rate concerns, which can be partly related to rising funding costs and large fair-value losses on investment securities. While not the primary problem, CRE is significant enough to be mentioned separately. Delinquency rates for consumer and real estate loans, which “increased slightly during the first half of 2023,” were one culprit, according to the report. It’s hardly shocking that “the CRE office loan segment showed the largest increase in delinquency rates for the largest firms.”

According to the report, S&P and Moody’s have downgraded the bank sector’s credit rating. They both mentioned CRE exposure and rising interest rates, which have caused some banks’ long-term bond holdings to significantly lose value. The Federal Reserve noted that although loan delinquencies are low, larger banks are building up their reserves to protect themselves from lending losses. But that’s not all that’s happening. While larger banks become more cautious and hoard more cash, they are decreasing lending, while smaller banks are increasing their CRE credit activity. Despite the fact that the Fed’s research focuses mostly on large banks, those are the organizations with the resources to more readily endure an issue with CRE loans.

According to estimates, the $33 billion CRE loan portfolio held by Signature Bank would see a fire sale, driving values 15%–40% below face value. In an era of constrained price discovery, this kind of outcome would probably impact loans and property assessments in general. Between 2024 and 2026, waves of maturing office loans are also expected in significant markets. Delinquency rates for CRE bank loans have already reached a 10-year high.
“They wrote that some firms, particularly in the office segment of CRE, have indicated in public earnings releases that they expect increased loan losses.” Supervisors thus keep a careful eye on loan quality and underwriting. A horizontal review has been conducted recently to mitigate exposures to possible declines in CRE markets.

In the end, tighter banking regulations affect all banks, larger ones more so since they attract more attention, but smaller ones eventually close out of prudence or in the event that things go wrong. Recall that following the Global Financial Crisis in 2010, 155 banks closed. 530 closed in 1989 following the savings and loan crisis of the 1980s. There is a chance that banks may become less willing to take on CRE loans, and there isn’t likely to be enough nonbank lending to make up for it, especially because federal regulators are currently preparing to increase their level of oversight of them as well.

We are ready to assist investors with Santa Ana Commercial Real Estate properties. For questions about Commercial Real Estate Investments, contact your Orange County commercial real estate advisors at SVN Vanguard.

1. GROSS DOMESTIC PRODUCT

2. CPI INFLATION

3. 2024 COMMERCIAL REAL ESTATE OUTLOOK

4. INDEPENDENT LANDLORD RENTAL PERFORMANCE

5. MORTGAGE APPLICATIONS

6. UNDERGRADUATE ENROLLMENT RISES FOLLOWING YEARS OF
DECLINE

7. NEW HOME SALES

8. CONSUMER SENTIMENT

9. INDUSTRIAL PRODUCTION

10. US RETAIL SALES

 

SUMMARY OF SOURCES

Time and time, the same crucial errors are committed.
The CRE sector differs from every other sector in that it uses a transaction-based paradigm. Transactions involving the sale, financing, and leasing of goods and services are the industry’s lifeblood. The industry as a whole, its participants, and the firm all profit more as there are more interactions. The year 2021 saw unprecedented transaction volumes and a tremendous CRE boom.

The most prosperous organizations and people in the sector are typically skilled in marketing, financing, and/or leasing CRE property. However, the same crucial errors are consistently made when pursuing these transactions, which typically leads to subpar performance, the loss of equity in a property, or the loss of the property in foreclosure. The following are the top 15 commercial investing blunders that we’ve identified:

    1. Purchasing real estate at a low cap rate. Even if the investor thinks that potential rent increases in the future, which may not materialize, will offset the low initial return, cap rates below 5.0% are not warranted. Purchasing CRE at cap rates under 5.0% is comparable to purchasing a tech stock at a 100 price-to-earnings ratio.
    2. Not varying a nationwide portfolio by region, sector, and type of property. Numerous major funds are diversified by kind and region by national firms, but industry diversity is often overlooked. In Silicon Valley, 70% of apartment tenants and 70% of office tenants, if an investor purchases only flats and offices, are employed by the technology sector. Many apartment residents could lose their jobs and be unable to pay their rent if the IT sector experiences a slump. They could even go back home or share rooms with roommates. The apartment market will suffer as a result of this. The office market will suffer if many of the internet companies fail on their leases or reduce the amount of space they need.
    3. Not carrying out all of the necessary financial and property due diligence before buying a portfolio of properties. Many institutional investors that purchase huge portfolios made up of dozens or hundreds of properties don’t perform enough due diligence at the individual property level. They either employ unskilled third-party organizations to perform the property-level due diligence or they just examine the larger and more expensive homes in the pool.
    4. Purchasing real estate using negative leverage. Negative leverage is a “no-no” in commercial real estate because it happens when the cap rate is lower than the mortgage constant, which means the cash-on-cash return will be lower than the cap rate. Many businesses buy real estate using negative leverage in the hope that rising rents will more than offset the low initial return.
    5. Fund a long-term real estate asset or portfolio with short-term floating-rate financing without the added security of a swap or collar. In the past two years, when the Fed abruptly increased the federal funds rate from 0% to 5.25%, this is what has happened. Due to the sudden surge in interest rates brought on by floating-rate debt and the lack of interest rate protection, many CRE investors are now frantically trying to cut their financing costs and risk.
    6. Using a terminal cap rate that is lower than the going-in cap rate when underwriting an acquisition. To “juice up” the internal rate of return on the equity in a transaction underwriting, this is frequently done by the acquisition team or another internal division within a large CRE business.
    7. Institutional investors who provide funding to sponsors with junior management teams with little expertise. The senior management group should be older, with members having seen at least the two most recent secular CRE downturns, from 1987 to 1992 and 2007 to 2012. Having team members with extensive and long-term expertise and understanding of various property kinds, markets, and economic recessions is one of the most crucial factors in CRE investing success.
    8. Utilizing excessively upbeat rent predictions while underwriting a deal. This frequently happens when an inside group trying to grow or acquire a deal wants to improve the transaction’s appearance.
    9. Not looking into the retail tenants’ sales per square foot, a crucial indicator when purchasing shopping centers. The sales per square foot of the anchor tenants, after the cap rate, is one of the most crucial indicators when purchasing retail complexes. A center with high sales per square foot is in a prime location, will remain fully leased, and is in high demand among tenants and customers.
    10. Utilizing a high leverage of above 75%. High leverage is one of the dangers associated with CRE investing and was one of the factors contributing to the Great Recession from 2007 to 2012.
    11. Not granting top staff members an equity stake in the business, holdings, or fund. The “golden handcuffs” are what are referred to as CRE. Your top personnel will depart if you don’t look after them, joining your competition.
    12. Not including in a real estate firm the 15 CRE hazards. Risks in the firm’s investment strategy include those related to cash flow, value, tenants, the market, the economy, interest rates, inflation, leasing, management, ownership, legal and title issues, construction, entitlement, liquidity, and refinancing.
    13. Investing in real estate segments where the investment firm has no prior experience, such as hotels and senior housing, which are more operational businesses than real estate deals. Senior housing is often 80% to 100% operating business and 0% to 20% real estate deal, while hotels are normally 70% operating business and 30% real estate deal.
    14. When buying a sizable portfolio of CRE assets, not getting the Kmart discount. When a sizable CRE portfolio changes hands, it usually consists of Class A queens, Class B pigs, and average Class B transactions. The buyer needs to receive a discount of at least a 1.0% higher cap rate to account for the risk of the Class C properties.
    15. Not double-checking the formulas in an XL underwriting spreadsheet because every CRE underwriting worksheet contains at least one mathematical inaccuracy. When creating a challenging Excel underwriting workbook, this is a regular occurrence, thus businesses should ensure that all calculations are double-checked by an impartial third party.

We are ready to assist investors with Santa Ana commercial real estate properties. For questions about Property Management, contact your Orange County commercial real estate advisors at SVN Vanguard.

Debt financing is not available to all borrowers or even all industries, but it is not inaccessible either.

According to MSCI’s research on global capital trends for August 2023, CRE investment sales have been declining and disappointing. It has been demonstrating this for months.

The credit ones are linked to the sales ones. There is a widespread belief that obtaining funding is virtually impossible because many banks are exposed to risk from CRE loans, lending requirements are becoming more stringent, and there are concerns that government-sponsored companies may not reach their lending caps.

But MSCI essentially advised holding on. According to the company, “off-the-cuff statements from industry participants might lead one to believe that the commercial real estate markets are in free fall with no debt available.” The reality, however, is more complicated, with certain industries dealing with illiquidity in the debt portion of the capital stack while others are merely dealing with more expensive debt. Each circumstance has unique effects on future investment performance and activity.

When compared to the pace of the first quarter, loan originations tracked by the company increased by 31% in the second quarter. In the second quarter, variables often raise originations, but from 2013 to 2022, the average rise was only 17%. “If the market were viewed through the prism of a typical second quarter, one might conclude that the slide from a time of excessive liquidity in 2021 and 2022 is complete.”

The numbers weren’t consistent; they were drastically dispersed according to category. $51.2 billion in multifamily originations were made in Q2. From 2015 to 2019, the pre-pandemic five-year average was 4% higher. The highest rise was in industrials, which witnessed originations of $17.2 billion, or 45% more than the average for that property type. The total for retail was $14.2 billion, 15% below the five-year average. $10.7 billion was spent on hotels, which was a 17% decrease from the average from 2015 to 2019. Office saw the highest decline, as might be expected: -52% and $15.1 billion.

Taking a look at both industrials and multifamily, it is obvious that funding is available. However, MSCI noted that using debt no longer offers the same advantages as in the past. “LTVs at origination have decreased for both sectors as lenders take precautions against the risks posed by declining real estate values. Apartment LTVs peaked in 2021 at 64.5%, while industrial LTVs reached a maximum of 59.1%. In Q2 2023, these LTVs decreased to 59.4% and 56.1%, respectively. For these areas, it might be preferable to claim that there is no loan available rather than that there is no cheap debt with lenient conditions like there formerly was.

But it is easy to understand how the sales of the category and the availability of credit for it might move together given the decline in the number of offices.

We are ready to assist investors with Santa Ana office properties. For questions about Property Management, contact your Orange County commercial real estate advisors at SVN Vanguard.


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