What Not To Do As A Commercial Property Owner

Maintaining control over loans enables lenders, investors, and real estate experts to recognize possible dangers and take quicker action.

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1. AI AND COMMERCIAL REAL ESTATE

• A recent article by MSCI Real Capital Analytics suggests that despite the growing concern about AI’s potential impact on commercial real estate, a balanced view should be taken that considers both the economic risks of AI and its potential positive impact on productivity.
• The authors argue that AI could advance economic productivity, leading to higher incomes and increased CRE demand over the long run. Data from MSCI RCA shows that, generally, as a country’s economic output per worker (a standard measure of productivity) increases, so does the value of a country’s
  commercial real estate assets.
• Like earlier periods of technological advancement, the dawn of AI may increase structural unemployment in the short term but create demand for new knowledge and skills, which effective federal education and training policies can aid.

2. RETAIL THEFT HITS MARGINS, FOOT TRAFFIC RISES

• In its Q2 earnings report, Dick’s Sporting Goods’ cited retail theft as a critical factor compressing profit margins, shaking equities in the sector this week. While not cited as a primary factor, the report highlights a widespread issue facing many retailers as some US cities see a spike in thefts.
• It is yet to be determined how this may affect Retail real estate. Still, falling investor confidence in the consumer sector could trickle down to commercial activity if businesses delay expansion plans as a result.
• So far, however, retail foot traffic continues to increase and serve as a positive force for valuations, helping offset the impact of rising “shrink” rates.

3. MULTIFAMILY, A BRIGHT SPOT FOR CRE

• Multifamily has continued to be a bright spot for commercial real estate even in the face of higher interest rates and falling home affordability, as detailed in a recent Mortgage Professional America (MPA) analysis.
• While new supply has hit apartment rents, from a loan perspective, the piece argues, the sector continues to perform well compared to when they were initially financed.
• According to data cited in the analysis, the average 10-year increase in value of a multifamily asset stands at roughly 160% and was underwritten in a lower interest rate environment, amplifying returns.
• Contrarily, more recently purchased assets haven’t seen the same levels of appreciation as rates climb. While this is a downside risk for the sector, it represents a smaller share of total assets than those last transacted before the Fed’s tightening cycle, tempering the risk.

4. WARNING SIGNALS FOR CONSUMER DEMAND

• Demand for manufactured goods and services weakened in August, according to the latest data from S&P Global’s US Composite PMI Index. From July to August, business activity saw its most significant drop since November 2022 despite growing for the seventh consecutive month.
• Consumer spending has largely shaken off the effects of inflation and falling sentiment, which has catalyzed the recent quelling of recession fears. However, August’s data registered worse than expected and could be a leading indicator of an upcoming fall in consumption. New business and orders fell across all sectors, while new business in the service sector fell for the first time since February.
• Standing out in the survey was a fall in service demand, which has recently propped up consumption and, by extension, economic growth, as goods consumption has fallen from pandemic highs. The fading impact of service-led growth may hamper GDP. Still, it would be a welcomed sign for the Federal Reserve, which has frequently cited services inflation as a persistent barrier to reducing economy-wide price pressures.

5. NEW HOME SALES CLIMB

• Sales of new single-family homes in the US increased 4.4% annually to a seasonally adjusted annualized rate of 714,000 in July, according to the US Census Bureau.
• July’s increase was the largest year-over-year increase since February of last year and beat consensus market expectations.
• Sales in the US Midwest region saw the highest year-over-year growth rate during the month, climbing by 74.4% to 84,000. Meanwhile, the West region saw the largest overall total transactions over the past 12 months, registering 181,000 sales while climbing 21.5% year-over-year.
• Sales in the South declined by 6.3% year-over-year, while sales in the Northeast dropped by 2.9%.
• The median price of a new single-family home sold was $436,700 in July compared to $478,200 one year ago.

6. CRE’S IMPACT ON BIG CITY BUDGETS

• Diverging trends in the commercial real estate industry make it challenging to forecast fiscal consequences for local governments, but a recent analysis by the Tax Policy Center notes that most US cities saw an increase in their property tax base between 2019 and 2022, though this may be a lagging indicator.
• A separate analysis by GreenStreet estimates that, on average, CRE values, while down over the past year, are roughly on par with those registered in early 2018. While falling valuations present a risk to city budgets, pandemic-era value increases provide many cities a fiscal floor for impending falls in tax revenues. However, how this translates into fiscal health largely depends on local policies and priorities.
• According to analysis, Boston maintains the highest reliance on commercial property tax revenue, which accounts for close to 36% of its total general revenues. Dallas is second, with property taxes accounting for 26% of revenues, and Atlanta is third, with 19%.
• Conversely, Phoenix relies the least of any large metro on property tax revenues, accounting for just 3% of total general revenue, with Chicago second at 7% and Charlotte at 3rd with 8%.

7. US ECONOMY LIKELY INSULATED FROM CHINA CRE TROUBLE

• The recent bankruptcy filing by China Evergrande, a property giant in China, has raised concerns about potential economic stagnation in America’s third-largest trading partner and how it may affect the economy at home. However, the US economy will likely be insulated from the worst effects of the crisis.
• For starters, one consequence of the US/China trade imbalance is that Chinese purchases of US goods and services account for less than 1% of US GDP. If Chinese commercial real estate markets falter and the nation’s growth declines, it will likely have a muted impact on US business activity.
• For further context, consider the potential trouble brewing in US CRE markets. The office sector, which has been the focus of increasing concern in recent months, is currently valued at $2.5 trillion, according to the Bureau of Economic Analysis. In comparison, total US investment in China (including Hong Kong) stands at just $515 billion. Therefore, domestic concerns should weigh heavier for US investors than China-based ones.
• However, if the Chinese economy tips into an extended period of deflation, a weaker yuan may lower the relative costs of Chinese goods abroad, a potential counterweight to US inflation.

8. JACKSON HOLE SUMMIT

• As the world’s top economists and policymakers descend on Jackson Hole, WY, for its annual summit, Federal Reserve officials are expected to express a more dovish tone compared to 2022 when Fed Chair Powell warned that a recession may be needed to calm post-pandemic inflation.
• In recent days, some officials have signaled that the central bank may be close to finished with its tightening cycle, with Philadelphia Fed President Patrick Harker referring to current rate levels as “restrictive,” a more pointed term than typically used in recent statements by officials.
• Still, as put by Jason Furman, an economist at Harvard, Powell is not expected to boast in a “mission accomplished” tone as he speaks to his peers this week and may suggest that there is more work ahead. However, many expect Powell to refrain from the spookier language compared to 2022, when officials aimed to realign Wall Street expectations on the inflation fight.
• A new point of intrigue for Jackson Hole watchers will be economists’ reaction to an unexpected rise in US economic growth and a fall in recession fears. Particularly, onlookers will look to gauge whether the latest data signals that policymakers will keep interest rates higher for longer.

9. RETAIL SALES CLIMB

•  According to the latest data from the Census Bureau, US retail sales were up 0.7% month-over-month in July.
• Retail sales beat the market consensus forecast of a 0.4% increase and followed an upward revision of June’s data. This is the fourth consecutive month where sales have increased.
• Amazon Prime Day may have boosted July sales, with nonstore retailers recording the largest monthly increase across all subtypes, up 1.9%. The category of sporting goods, hobbies, musical instruments, and books rose by 1.5% in the month, followed by food services and drinking places (1.4%).
• The most significant monthly decreases in sales were seen in furniture stores, falling 0.8%; health and personal care, falling 0.7%; and building materials and garden equipment, falling 0.7%.

10. JOBLESS CLAIMS FALL

• Initial unemployment claims fell by 10,000 to a seasonally adjusted 230,000 during the week ending on August 19th, the latest data available from the US Labor Department.
• While jobless claims rose to start the year as the Fed’s monetary tightening began to raise costs for businesses, leading to some layoffs, the labor market has so far avoided a major shock.
• The number of continuing unemployment claims, which represent those receiving benefits for more than one week and a valuable barometer for hiring levels, also fell by 9,000 during the week, landing at 1.70 million.
• The simultaneous forces of a strong labor market, falling inflation, and a recent increase in capital spending have prompted many economists to revise upward their GDP expectations for the year, according to comments by Reuters.

SUMMARY OF SOURCES

• (1) https://www.msci.com/www/blog-posts/do-not-fear-the-impact-of-ai-on/04017862827
• (2) https://www.marketwatch.com/story/dicks-sporting-goods-said-retail-theft-hit-margins-this-issuehit-them-harder-a6634d50
• (3) https://www.mpamag.com/us/specialty/commercial/why-the-commercial-real-estate-landscapeis-both-bright-and-dark/457374
• (4) https://www.pmi.spglobal.com/
• (5) https://www.census.gov/construction/nrs/current/index.html
• (6) https://www.taxpolicycenter.org/taxvox/future-commercial-real-estate-and-big-city-budgets
• (7) https://www.nytimes.com/2023/08/21/opinion/columnists/china-financial-crisis-economy.html
• (8) https://www.bloomberg.com/news/articles/2023-08-24/bullard-says-reaccelerating-us-economycould-prompt-higher-rates#xj4y7vzkg
• (9) https://www.census.gov/retail/sales.html
• (10) https://www.dol.gov/ui/data.pdf

The industrial sector is the least impacted.

Leonardo is a California-raised professional who currently resides in Irvine, California and serves as an advisor for SVN Vanguard Commercial Real Estate. He has a keen interest in SoCal living and boasts extensive experience and expertise in the commercial real estate (CRE) industry, with a focus on property management, sales, and investments. He is particularly adept at dealing with distressed multi-family properties, leasing retail spaces, and providing full-service brokerage.
Leonardo’s skills and experience have led him to successfully manage and enhance the value of a complex portfolio of both residential and commercial properties.

As a multilingual individual, Leonardo has leveraged his language skills to expand his career opportunities beyond the United States. He has successfully worked internationally, selling beach investment properties in Tulum, Mexico, and collaborating with land developers to purchase land, promote pre-sales of developments, and oversee property management.

Prior to his current role, Leonardo managed a portfolio of real estate-owned (REO) properties in California for a major nationwide lender. In this capacity, he was responsible for bringing assets up to city code, dealing with REAP, tenant management, rent collection monitoring, occupancy and property inspections, lease negotiation and enforcement, rent control, and city code violation management. His efforts earned him the Bronze Award of Sales from the Downey Association of Realtors on three separate occasions.

Specialties

1. INTEREST RATE OUTLOOK

• Despite the Federal Reserve’s decision to hold rates constant at their June meeting, current market forecasts project an 81.8% chance that the FOMC will move forward with a 25-basis point hike in July, according to the Chicago Mercantile Exchange’s Fed Watch Tool.
• In June, officials placed their year-plus hiking cycle on pause in an effort to evaluate the success of their tightening effort thus far. Earlier in the month, national employment data registered stronger than expected, while annualized inflation continued to trend downwards.
• With recession concerns still pertinent, the Fed opted to pause and digest incoming data. At the same time, some officials have signaled a preference for further rate hikes to anchor longer-term inflation expectations. Notwithstanding recent deceleration, Real PCE, the Fed’s preferred inflation gauge, remains
  well above the central bank’s 2.0% target.
• In recent days, Fed Chair Jerome Powell indicated that “there’s more restriction coming,” acknowledging that despite the committee’s decision to pause last month, he and other members “expect the moderate pace of interest rate decisions to continue.” While not outright saying that they expect rate hikes to continue, the statement signals the Fed won’t hesitate to move forward with a hike if the data warrants it.

2. HOME PRICES

• Home prices fell annually for the first time since April 2012, declining 1.7% year-over-year in April, according to the S&P/Core Logic Case-Shiller Home Price Index.
• Market forecasts for the Case-Shiller projected a 2.6% annual decline during the month. Despite the steepest annual drop in over a decade, monthly data suggest that home value declines may have hit a cyclical nadir in recent months, as home prices were up 1.27% from March. Between June 2022 and January 2023, home prices fell in each month before turning positive again in February.
• Seattle and San Francisco continue to experience deep year-over-year declines, while several other markets, including Miami, Chicago, Atlanta, and Charlotte, are experiencing modest single-digit growth.
• The southeast continues to be the strongest region for home price growth, averaging 3.6% year-overyear. The west remains the weakest, falling -6.9% over the past 12 months.

3. INDEPENDENT LANDLORD RENTAL PERFORMANCE

• The on-time payment rate in independently operated rental units declined for the third consecutive month in June, falling to 82.5%. Despite the recent retreat in on-time rates, compared to one year ago, the on-time payment rate remains up by 118 basis points compared to a year earlier.
• These data underscore how the rental housing sector has fended off widespread distress while headwinds mount elsewhere in the market. According to MSCI Real Capital Analytics, through May 2023, apartment prices are down 13.8% from their 2022 peak. Additionally, borrowing terms remain stringent as banking sector volatility and high-interest rates impact the attainability and feasibility of debt financing.
• Nevertheless, the continued performance of rental units amid a still resilient labor market is allowing independent operating landlords to withstand the economic malaise. As units maintain their monthly rental payments, the cash flow ecosystem between tenants, operators, and lenders stays intact.
• The June 2023 forecast full payment rate is 91.6% — just 44 bps below its post-covid peak.

4. REGULATORS SOUND THE ALARM ON CRE

• In recent weeks, US regulators have asked major lenders to work with credit-worthy borrowers facing stress in the commercial real estate market.
• The statement arrived from the Federal Reserve, the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, and the National Credit Union Administration, who urged them to work “prudently and constructively” with good clients.
• The outreach comes amid rising concerns about the stability of commercial real estate as lending standards tighten and property values absorb a testing demand outlook.

5. SELLOFF IN CRE STOCKS MAY PRESENT OPPORTUNITIES

• Portfolio manager Jeffrey Kolitch of Baron Funds, a publicly traded fund that manages close to $1.5 in real estate assets, recently expressed his belief that recent stock selloffs in the sector present investors a “gift,” proving some an opportunity to acquire high-quality companies at “attractive” prices.
• At a recent talk, Koltich expressed his disagreement that we are on the cusp of a CRE crisis and his belief that setup for real estate in public markets is bullish. He emphasized the flurry of headwinds that the industry has faced in recent years, including the pandemic and generational shifts in consumer preferences, and how the industry has proven to remain innovative and efficient in the face of them.
• Further, he believes the rising fears surrounding the industry have caused stocks in the sector to fall steeper relative to the broader market, presenting attractive pricing to looking for upside in the public markets.

6. MEASURING UP OFFICE DEVALUATIONS

• A recent CRE Moody’s Analytics analysis explored some of the worst-case scenarios for the office sector by setting out to answer the question: what does it take to see a peak-to-trough Office value decline of 40%?
• The analysis notes that a 40% peak-to-trough decline would require current levels of distress to worsen and sustain. Between Q1 2022 and Q1 2023, office property values have declined nationally by an average of 12.7%. Prices would need to fall by another 31.3% from current levels to reach the 40% aggregate devaluation threshold.
• According to the authors’ calculations, to see office valuations drop by another 31.3% nationally, it would require that occupancy rates fall by an average of 3.8% from current levels and an NOI drop-off of 24.5% from current levels.
• The analysis notes that while the above scenario will likely play out in some properties, “the chances we see broad office declines at this level is on the tail end of the distribution of possibilities, as opposed to the expected case.”

7. RENTS DECLINE

• According to Realtor, May rents on 0–2-bedroom apartments fell -0.5% year-over-year through May, marking the first decline since they began tracking the segment in 2020, signaling a potential shift in the market cycle.
• Smaller units saw rents increase over the year, with studio apartments up 2.0% in the past 12 months and one bedroom up by 0.4%. The retreat in rents was driven by two-bedroom units, which have declined by 0.5% year-over-year.
• The median asking rent in the 50 largest US metros rose by $3 from April but is down $38 from its July 2022 peak.
• Rents in the West are falling steeply, down -3.0% year-over-year, while markets in the South have seen an average decline of -0.7%. Rents in the Midwest continue to climb but are slowing, rising 4.5% in the past 12 months.

8. THE FIVE TIGHTEST RENTAL MARKETS IN THE US

• According to recent research from Chandan Economics and Arbor Realty Trust, the five tightest rental housing markets in the US today are Cape Coral, Louisville, Boston, Knoxville, and Worcester. The scoring matrix relied on two factors: rent growth and occupancy.
• Cape Coral, FL, which had the country’s most intense rent growth pressures through April, has seen its profile rise as a retiree destination. Meanwhile, Louisville and Knoxville have gained in recent years as their combinations of urbanized downtowns and housing affordability have attracted new residents.
• In Massachusetts, Boston’s market tightness appears primarily due to supply-side factors, including the market response to the municipal government’s push to implement rent control. At the same time, Worcester is gaining from demand-side factors as its downtown revival attracts residents away from Boston.

9. MIXED USE MALLS

• Some developers are turning to a mixed-use approach to salvage the value of struggling big-box retail space, specifically by combining a variety of smaller retail tenants with residential properties mixed in.
• For instance, many investors owning property at former Sears locations are now converting them into experimental “live, work, and play” environments, reflecting a trend to revitalize malls and adapt to changing consumer preferences.
• Sears, a retailer with a formerly sizeable national footprint, has just 12 department stores remaining nationwide following a Chapter 11 bankruptcy filing and the effects of the pandemic’s “retail apocalypse.” During the proliferation of malls in the 1960s, Sears positioned its auto center adjacent to mall parking lots where their department stores were typically located.
• As a result, properties that formerly housed these connected retail sites are in a unique position to accommodate such a mixed-use approach and may serve as a template for investors looking to implement such a strategy. The new strategy focuses on residential, retail, and other amenities.

10. NET LEASE INVESTING

• For net lease investors, the recent pause in rate-hikes may signal an easing of cap rate expansion, but the likelihood of additional rate increases in the coming months means that investors should brace for further cap rate increases before normalizing in 2024.
• Even if the Fed’s tightening cycle halts and rates remain neutral for the foreseeable future, lending conditions and risk appetites will likely remain restrictive in the near term.
• Those with cash-on-hand, who can secure long-term lease deals with creditworthy tenants—alongside the proper due diligence processes to execute those deals—should be able to proceed with investment plans despite the lending pullback.
• However, smaller deals will have an advantage in this environment, as larger players with more significant targets may be forced to stay in wait-and-see mode until demand unsticks.

SUMMARY OF SOURCES

• (1) https://www.cmegroup.com/markets/interest-rates/cme-fedwatch-tool.html
• (2) https://bit.ly/44unGBr
• (3) https://www.chandan.com/independent-landlord-rental-performance-report
• (4) https://www.bloomberg.com/news/articles/2023-06-29/us-asks-lenders-to-help-firms-withcommercial-real-estate-stress?srnd=markets-vp#xj4y7vzkg
• (5) https://www.barrons.com/articles/real-estate-stocks-selloff-ac3cb792
• (6) https://cre.moodysanalytics.com/insights/cre-news/capital-market-quick-take-what-does-it-taketo-see-a-peak-to-trough-office-value-decline-of-40/
• (7) https://www.realtor.com/research/may-2023-rent/
• (8) https://arbor.com/blog/the-top-five-tightest-rental-markets-in-the-u-s/
• (9) https://www.globest.com/2023/06/29/vacant-sears-stores-find-new-life-as-housing-in-mixeduse-malls/
• (10) https://www.globest.com/2023/06/29/what-does-the-feds-breather-mean-for-net-leaseinvestors/