Historically, seasonality has been a predictable characteristic of commercial real estate (CRE) transaction volume, which typically peaks in the fourth quarter of each year before normalizing again to start the next. However, heading into the Q4 2022, the US economy is sending mixed signals about its health.
This year’s transaction cycle could face resistance from two interrelated headwinds: Quantitative Tightening (QT) by the Fed and a potential US recession.
Since MSCI Real Capital Analytics (RCA) began tracking Commercial Real Estate volume in 2001, transaction volume, on average, has performed better during the second half of the year compared to the first, both in terms of dollars and total properties. Historically, total sales are on average 19% higher during Q3 and Q4 compared to the first two quarters, while there is a 16% increase in total properties trading hands.
As CRE investment intensified to new highs in 2021, so too did it’s end-of-year uptick. Three of the four major food groups of CRE achieved record-high transaction volume in dollar terms during Q4 2021. Office, the only of the four that did not reach a new record, still experienced its best performing quarter since Q2 2007.
While history suggests that CRE should have the wind at its back entering Q4, weather predictions have been a dicey undertaking in recent years. Recession signals are escalating, with modest warning signs already flashing in the latest real estate data. During August, US commercial property transactions continued to climb, but at the slowest rate so far this year.
The average price increase across the major property types slowed to 14.0% year-over-year in August, 260 basis points lower than July as investors continue to digest the impact of higher rates.
Further, while transaction volume from a dollar volume standpoint has sat close to all-time highs for much of 2022, less properties are changing hands, indicating that price-growth is currently being driven more by supply shortages rather than a demand-spike.
As the Federal Reserve began its rate hikes in March in a bid to tame US inflation, many wondered whether a monetary soft landing was possible, where rates are raised just enough to calm prices but not throw the economy into recession. More than a half-year into QT, the US inflation rate remains north of 8% year-over-year, and policymakers have been forced to intensify their efforts — conducting three consecutive 75 basis point increases through September.
Reacting to moves by the Fed, as well as escalating global uncertainty stemming from the War in Ukraine and various fiscal conundrums — recession risks have begun to ratchet up in recent weeks. Utilizing a model based on Treasury yields, national financial conditions, and leading economic indicators, the Conference board recently raised its probability of recession to 96% heading into Q4. Markets are increasingly fearing the likelihood that a hard landing will be needed to calm overheating prices, and policymakers appear to agree.
In their latest Summary of Economic Projections released in September, the FOMC forecasts for growth, inflation, and unemployment were all revised in the wrong direction. The average forecast for the annual change in GDP through Q4 2022 fell to 0.2%, a drop from the 1.7% growth forecast at their June meeting. The Fed also projects that, because of higher rates and slowing growth, the unemployment rate will rise modestly by year’s end, while core inflation is expected to remain above the FOMC’s 2.0% target as we turn the page to 2023.
While Quantitative Tightening’s adverse effects are visible across rate-sensitive industries, concurrently, real estate market fundamentals continue to fortify CRE’s relative stability. For example, despite a modest slowdown, prices in the Industrial sector posted a far-from-pedestrian 24.7% year-over-year increase in August, supported by large inventories, and continued spending on goods. Apartment properties, which similarly experienced price deceleration in recent months, remain up 17.1% annually and will continue to largely reflect the effects of strong housing demand amid constrained supply.
The Retail and Office sectors are also being supported by a resilient US economy. Despite two consecutive declines in annual GDP to start the year (an unofficial marker of a recession), a combination of steady job growth, low unemployment, and robust consumer spending hasn’t resembled a typical recession. So far, this year’s decline in output reflects a pullback in private and residential investment and government spending, while inflation-adjusted consumer spending remains positive, averaging 1.9% year-over-year during the first half of 2022. Personal spending continued to rise in August (+0.4%), beating most market forecasts despite declines in energy spending amid falling gasoline prices. Meanwhile, retail sales climbed 0.2% between July and August, inventories ticked up, and the recent start to the school year helped push office occupancy levels to a new post-pandemic high.
Future rate hikes could begin to dampen demand if inflation continues to force the Fed’s hand, further pushing down on
price growth. On the other hand, supply and labor issues continue to make new construction projects challenging, which in turn, is providing a floor for property prices. According to July data from the Jobs, Opening, and Labor Turnover Survey (JOTLS), there are currently 375,000 construction job openings through July 2022, up 22k and 28k from the prior month and the same point last year, respectively. Unemployment claims also recently fell below 200,000 per week, which is supporting
prices through both limited labor supply and durable incomes.
The Q3 Real Estate Roundtable Sentiment Index showed continued optimism regarding the underlying fundamentals of real estate, despite some caution about inflation and rising rates in the short term. Other longer-term trends developing in real estate also remain at play. Remote work continues to play a significant role in driving local housing demand— accounting for more than half of all price increases between November 2019 and November 2021, according to recent research by the San Francisco Fed. The work-from-home renaissance appears to be here to stay and will remain an anchor of some of the best markets for Apartment investment. Additionally, the pandemic-era shift in goods consumption appears to have a degree of permanence, which combined with the upcoming holiday shopping season should provide some support to Industrial and Retail in Q4. Meanwhile, a takeoff in Life Sciences is driving new opportunities for the Office sector.
Recent volatility in the stock market has made commercial real estate even more alluring to investors seeking security in the midst of the mayhem.
According to John Chang of Marcus & Millichap, “I think it gives everyone a little heartburn to watch the S&P 500 tumble by more than 6% in just over a week.” But this trend has been present in the stock market for some time.
CRE values typically fluctuate more slowly than stock market values. They also tend to be less spectacular, “he argues,” pointing out that commercial real estate pricing has mainly remained stable over the last 20 years, despite “enormous” quarterly price changes.
The fact that CRE has delivered a compound annual growth rate of 7.8% since 2000, outpacing the S&P at 5.3%, further emphasizes this thesis.
Although it still experiences ups and downs, Chang notes that they are often far more moderate than those seen in the stock market.
One observer of the commercial real estate market claims that the most recent rate increase by the Fed has increased the “expectations gap” between purchasers and sellers of commercial real estate.
According to a recent research video by Marcus & Millichap’s John Chang, “Sellers tend to be reluctant to respond to a cooling market.” Many sellers still aim for the highest possible price when they sell, which frequently leads to price chasing. However, purchasers are drastically altering their underwriting assumptions, which has led to a wider buyer-seller disconnect and a slowdown in commercial real estate activity.
Chang advises motivated sellers to adjust pricing to the market, and buyers to take advantage of the opportunity to focus on strategic acquisitions to position themselves for the next growth cycle.
According to a USA Today story, Fannie Mae has a new strategy to assist landlords in paying for rent reporting to credit agencies in order to assist tenants in raising their credit scores.
GlobeSt.com requested a comment from Fannie Mae but did not hear back.
Fannie Mae will collaborate with Esusu Financial Inc., Jetty Credit, and Rent Dynamics, three New York-based third-party services that Fannie Mae will work with to offer information for landlords and property management firms.
Rental payment data, which can impact credit scores, is accepted by the major credit reporting companies. When made on time, timely payments can raise them, whereas late rents can have the opposite impact. Many operators and landlords have already reported late payments, according to Credit.com. While timely payments are “growing more common to be reported,” smaller property owners are still less likely to do so. Reports can be generated by third-party providers, but they do so at a cost.
According to Michele Evans, executive vice president and director of multifamily at Fannie Mae, “We’re attempting to be a catalyst to speed this adoption given the reach that we have across the country.” “We’re rewarding borrowers [landlords] so it benefits historically underserved communities that just have disproportionately low credit ratings,” the statement reads.
Tenants who pay their rent on time may see their credit score rise, which may be helpful in the future when applying for items like a mortgage.
According to a report from the Consumer Finance Protection Bureau in 2015, “26 million Americans are “credit invisible,” which means they have no history with any of the three main credit reporting companies. 19 million more people are classified as “unscored,” meaning they don’t have enough recent credit history to receive a score from a rating agency.
Esusu states that utilizing their system, “the average resident’s credit score grew by +51 points in 18 months” and that “[reporting] rent payments to major credit agencies helps renters boost their credit ratings, all while helping owners and property managers maximize returns.”
In their marketing materials, Esusu, Jetty, and Rent Dynamics all state that they assist landlords in developing ESG efforts by collaborating with tenants (the “S” stands for social).
According to Marcus & Millichap statistics, sales activity for net-leased retail increased between 24% and 27% over the 12-month period ending in June as record rents approached historic highs and vacancy stayed below pre-pandemic levels.
In recent research, business analysts make the following observation: Going forward, investors wanting long-term cash flow may leverage on high pricing in other sectors and shift equity via 1031 exchanges into less management-heavy single-tenant properties. Buyers that are yield-focused will likely continue to target Midwest regions where 30 to 80 basis points higher than the national average.
Marcus & Millichap analysts claim that midsize markets have room for growth, with vacancy rates at record lows and transaction flow gains of over 25% year over year in 11 locations, mostly in the Mountain region and Florida. Tampa had the most closings among Florida cities, and Phoenix had one of the largest single-tenant transaction totals across all U.S. retail areas.
Secondary markets in cities such as St. Louis, Cleveland, Charlotte, Nashville, and San Diego have seen the biggest increases in prices year over year.
With shop openings more than tripling the number of closures in the first seven months of this year, retailers are also expanding their reach as core spending rises. Research further states that historically low number of single-tenant spaces constructed during this span obligated many of these merchants to occupy existing assets which continues to aid single-tenant vacancies and marketing rent advances.
Jimmy Goodman of The Boulder Group stated earlier this spring that when interest rates rise, cap rates for institutional quality net lease assets are anticipated to spread.
While Goodman believes this to be fact, the author writes, “On the other hand, a significant amount of cash from funds and 1031 exchange investors that buy single-tenant assets will counteract that upward trend.” He adds, “It’s just a matter of buyers and sellers determining agreeable pricing.”
Our Orange County commercial real estate brokers will help you every step of the way in finding the right commercial investment property, contact us for details.
(AIMI) for Q2 dropped nationally on both a quarterly and an annual basis, driven mostly by record mortgage rate growth, which resulted in historic results.
The country and 11 markets saw the biggest annual fall in the index’s history. The AIMI index declined 17.9% from the second quarter of 2021 to the second quarter of 2018, or 11.7% overall.
The AIMI index considers employment, multifamily permits, net operating income, and property price to help investors assess the relative worth of investing in multifamily buildings in a few key metro areas.
The greatest annual increase in mortgage rates in AIMI’s history, which began in 2000, was 131 basis points. The 30-year fixed rate reached 6% last week.
Property values climbed significantly over the past year, rising by 21.8%, while net operational income (NOI) jumped by 17.7% and mortgage rates increased by 1.31 percentage points, the highest increase in AIMI history.
Every metro saw growth, and the national NOI increased by 3%. Phoenix had the weakest growth rate with a 4.5% increase, while Miami had the best performance with a 4.7% increase.
This won’t seem normal or enjoyable.
From the start of Q1 2022 until the middle of September 2022, US Treasury rates increased, high-yield loan funding has all but disappeared, and agency spreads have varied between 160bps and 200bps, according to David Fletcher, Managing Director, Head of Acquisitions at Excelsa Properties.
According to Fletcher, the remarkable rent rise experienced in the majority of the United States has kept cap rates from rising as much as they otherwise might have, according to Fletcher.
The option value of purchasing a 4% cap rate in an economy with a 3.4% 10-Year Treasury Rate (2.97% SOFR) will be drastically reduced if the unprecedented rent increase is removed, he claimed.
Fletcher continued, “The enormous rent growth won’t last for much longer.” “Multifamily investors will be compelled to return to a world where producing current yield and working hard to grow and improve properties are the only ways to make money.” While it is typical for anyone who has been in the industry for more than three years, the move away from ultra-low cap rates and loans with 80% LTV at 4% interest rates won’t feel “typical or enjoyable.”
The best deals are made when markets are disconnected.
According to GlobeSt.com’s interview with Neil Schimmel, CEO of Investors Management Group (IMG), “Investors can take advantage of good value by disciplined buying in down or stalling markets.”
IMG is currently engaged in three purchases, a refinance, and three disposals, according to Schimmel, making it the busiest it has ever been. “Market disconnects are when the best transactions happen, therefore I anticipate there will be more alluring entry points in the future.”
In cities like Atlanta or Greenville, South Carolina, where tenant demand is driving up property values, Schimmel said he buys.
He claimed that “our Class B apartment assets are prudently positioned to perform through cycles.”
Prior to 2008, subprime markets grew at an alarming rate, but today’s stronger credit standards have restored stability to the housing market and longer-term fixed-rate mortgages.
Fewer People Can Get Home Loans.
The Freddie Mac Multifamily Apartment Investment Market Index Fewer purchasers are now able to qualify for mortgages as a result of the quick increase in interest rates and subsequent rapid rise in mortgage rates, according to Doug McKnight, President and Chief Investment Officer at RREAF Holdings.
According to McKnight, “this has encouraged more families to stay in, or resort to, rental properties, both single-family and multifamily.”
The consequent increase in NOI and the ongoing decline in vacancy rates have increased rental market values as market rents continue to rise.
According to McKnight, as leverage eventually falls into the negative zone, cap rates will rise, which would probably cause markets to respond by driving down the value of rental assets.
According to him, RREAF “continues to be net buyers of multifamily buildings with a careful focus primarily on locations where migration and economic growth continue to show signs of strength, allowing us to retain returns to investors.”
Shrinking current buyer base
P.B.’s chief financial officer, Jeff Thompson Bell, tells GlobeSt.com that because home ownership is becoming less feasible in the current market due to rising mortgage rates, the number of renters has remained high.
According to Thompson, as interest rates rise, the number of investors in multifamily acquisitions has decreased. “People are still buying and selling even if the available buyer pool is getting smaller and the number of bids in the market is declining. Among other real estate investment options, multifamily is still a desirable option.
Ground-up development hasn’t been greatly hampered on the development side. Strong population and job growth in the Phoenix metro area continue to be favorable for the multifamily market.
Freddie Thinks Investment Choices Are “Moderating”
In prepared remarks, Steve Guggenmos, vice president of research and modeling at Freddie Mac Multifamily, stated, “NOI growth is strong even though higher rates and property prices have caused the index to decline.”
The decline in AIMI this quarter is a result of weakening investment conditions brought on by shifting economic trends. Vacancy rates are still low and rents are high because of the overall housing crisis.
We are ready to assist investors with Santa Ana multifamily properties. For questions about Commercial Property Management, contact your Orange County commercial real estate advisors at SVN Vanguard.
Many economists experienced a bad shock last week when the official consumer price index (CPI) was released. In reality, there was only one, and it suggested that the Fed would probably increase its benchmark interest rate by at least 75 basis points, if not more.
According to Charlie Ripley, senior investment strategist for Allianz Investment Management, “it’s becoming more evident to market players that the amount of tightening from the Fed thus far has not been enough to cool the economy and bring down inflation.”
These are the immediate repercussions. However, the company also took note of some additional repercussions through the potential implications that certain parts of inflation could have on the firms that have rent obligations. Groceries and dining are “one area where consumers’ wallets have taken a big hit,” they noted, because despite the fact that food price inflation “slowed by nearly a third last month,” it is still up 11.4% annually.
Value-oriented meal alternatives are popular in both grocery stores and restaurants. Nevertheless, people are once again spending more on dining out than on groceries. According to Marcus & Millichap, “although food prices are rising, eating out offers a convenience and social experience that may offset the higher checks in consumers’ perceptions.”
It’s safe to claim we can respond to the question, “Does history repeat itself? after experiencing a number of recessions and identifying important trends. The answer is a loud “yes,” but we can use what we have learned from the past to lessen the risk by planning ahead more effectively.
The news stories of today make it clear that a recession is either coming or has already begun. In any case, the commercial real estate industry has historically been affected by market downturns, and this situation is no exception.
Although past recessions have had both beneficial and negative effects on companies, from credit restrictions to changes in sales volume, the legal issues that arise are probably the most expensive and long-lasting. Understanding the risks that arose during previous recessions and how they were handled may help lenders and developers stay safe during these trying times.Additionally, being aware of the past might help both parties take the appropriate safety measures to prevent a repeat of the same events.
According to statistics, there are statistically more construction-related litigation cases than any other loan litigation claims in any given year, and these numbers are even higher during a recession. Recessions have caused and are expected to continue to cause a variety of legal problems with building financing. Without market changes, these loans are already risky, but during a recession, cash-strapped contractors or those who underbid a project may end up doing shoddy repairs. As a result, there may be more faults as a result of hurried work, supply chain delays, labor shortages, cost-cutting measures, and/or manufacturing issues.
Construction-related issues can become more common and more expensive to handle during a recession, in addition to a rise in construction-related issues. Government shutdowns can affect the timing of permits and even necessitate the suspension of project work amid a recession and pandemic, in addition to the more usual weather delays, workmanship concerns, and supply chain delays. Events of default under the terms of the loan, fines, or extension costs may be triggered by delays. They may also have an effect on long-term funding sources and result in higher carrying costs. Delays may also result in guarantor responsibility for some loans, making it harder for the project to sustain in the long run.
Of course, variable interest rates are sometimes a sign of a volatile market. Early interest rate locking, however, can have benefits and drawbacks. Variations in interest rates can have a significant impact on the expenses of completion for those uncommon construction-to-permanent loans. Numerous lenders had to make difficult decisions regarding the feasibility of loan commitments during previous recessions in the face of claims from borrowers, which led to many borrowers with forward commitments having loan approvals revoked as a result of shifting interest rates.
Broken promises may lead to protracted legal proceedings and, in rare cases, punitive damages. Additionally, the impact and delays that follow might virtually ruin a project’s feasibility. There may also be personal liability if there are guarantors on the loan and the borrower defaults. Numerous lawsuits involving loan commitment termination were filed during previous recessions, and many courts carefully considered whether the reasons for the termination were valid.
Finally, a less reliable renter pool can result from recessions. Borrowers are more likely to default on their mortgage payments when tenants are unable to uphold their rental responsibilities. It should come as no surprise that during a recession, there are more foreclosures, deeds in lieu of foreclosure, and collection attempts. Due to the financial uncertainty, there are more bankruptcies.
Contrary to what many commercial lenders and developers may believe, a recession can really present opportunities. With appropriate planning, some risks may even be reduced. I genuinely believe it comes down to these ten suggestions after decades of risk management and litigation in the aftermath and with the benefit of hindsight:
To completely comprehend all of your contract provisions, have a new set of eyes look over your loan documentation, building contracts, and land purchase agreements. Make sure to carefully review your notice requirements and force majeure clauses and to adhere to them. Throughout the course of the project, review your documentation frequently, especially if construction loans are involved.
Ensure that your deadlines are consistent across all of your documents. Give yourself plenty of time to account for conceivable delays that might be unavoidable.
Make sure you start off by keeping precise, thorough records and notes. Follow up on the performance of the contract, noting any deviations or delays.
Inspect the area on a regular basis. Lenders should personally verify that deadlines are being followed while owners and developers should be monitoring their contractors and the project’s progress.
The key is communication. Although it sounds cliche, effective communication can save a relationship and raise the likelihood that a loan or contract can be modified when necessary.
Examine and keep your insurance.
Limit your promises. Although managing expectations may seem easy, it can sometimes make a difference in a project’s success.
Maintain your lane. In a recent ruling, a judge stated that “[i]f a lender exercises excessive control over a borrower, Although there is no fiduciary responsibility, “if a lender takes a particularly active role in the business decisions of the borrower,” it “may become liable for tortious interference,” even in the absence of one., a lender can take on the role of fiduciary rather than creditor.
Make use of specialists who have the expertise and knowledge to handle any issue that may arise, such as construction managers, inspectors, supervising architects, lawyers, and/or accountants.
Request document revisions as needed, secure the relevant approvals, and record any alterations to agreements.
Following these ten procedures will reduce legal risk, if not completely eliminate it, even during a recession.
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.
The good news is that REITs as a group have recently performed well. They were up 4.2% as of last Friday, per BTIG Research. Comparatively, the S&P 500 and Russell 2000 stock indexes saw returns of 3.6% and 4.0%, respectively.
But then there was this line: “Rates are expected to be in focus again for REIT with strong inflation measures on tap for this week’s economic calendar (CPI prints on Tuesday, PPI prints on Wednesday).”
Additionally, Tuesday’s CPI prints, sometimes known as inflation data, fell far short of forecasts. Almost everything else was up, even if oil was down. Core inflation, which excludes food and energy, reached 6.3%, exceeding experts’ expectations by a factor of 2. Consumers suffered from the basics. Monthly growth in food was 0.8%. Shelter increased by 0.7% from month to month. August to July had a 0.5% increase in transportation.
When the Fed meets next week, the benchmark interest rate will likely rise by 75 basis points, with a potential increase of 1 percentage point.
According to a Nareit piece from early 2022, inflation is often advantageous for REITs. The company stated that “REITs have traditionally offered protection against inflation and outperformed the broader stock market during periods of moderate and high inflation,” where it defined moderate inflation as occurring between 2.5% and 7.0% and high inflation as occurring beyond 7.0%.
But there are also interest rates, which the Fed has aggressively raised in an effort to restrict economic growth and bring inflation back to about 2%.
According to BTIG’s analysis, “REITs as a sector have significantly cleaned up their balance sheets since the GFC.” However, in 2022, both the weighted average rate on REIT debt and the ratio of interest expense to NOI will be at historic lows. If rates continue to rise, which they will, this creates a danger to projections and results.
As a result of rates being so low for so long and seeing so many false starts, the company added, “We think there is a danger that interest expense has been rooted in consensus projections.” To put things in perspective, the current SOFR forward curve indicates an average rate of 3.84% in 2023, before taking into consideration any credit spreads. As a result, the weighted average rate for total REIT debt throughout the industry in 2023 will be higher than the average 1-month rate at present. Unhedged variable-rate balances will be impacted by this, and there may be volatility for external growth if buyers are compelled to reevaluate their financing assumptions.
