Monday Morning Scoop - Opportunity to Buy Assets at Lower Prices Might Not Last for Long

Opportunity to Buy Assets at Lower Prices Might Not Last for Long

Both interest rate hikes and cap rate expansion will peak later this year and should decrease in 2024. As a result, today’s opportunity to buy assets for lower prices may not last very long, according to CBRE’s H2 2022 Cap Rate Survey.

The survey was conducted in mid-November and December and reflects second-half 2022 deals. More than 250 CBRE real estate professionals participated.

Spencer G. Levy, global client strategist & senior economic advisor, CBRE, said in prepared remarks that the rapid rise in interest rates over the past year has had consequences.

“With short-term rates 400 to 500 bps higher than they were a year ago, the only way to maintain IRR is to acquire assets at lower valuations,” Levy said. “And this is before factoring in the risk premium associated with market uncertainty that keeps many buyers and sellers on the sidelines.

CBRE forecasts that the federal funds rate likely will exceed 5% in 2023, falling to about 2% by 2025.

A ‘Need’ to Find Equilibrium

Jeff Holzmann, Chief Operating Officer at RREAF Holdings, tells GlobeSt.com that every efficient market tends to find equilibrium, balancing supply and demand in a way that makes it efficient for both parties to transact.

“The recent increase in Fed interest rates is driving the cost of financing higher and unless CRE sponsors find a way to balance or offset those additional costs, transactions will ground to a halt,” Holzmann said.

“This ‘need’ to find equilibrium is what’s driving the lower valuation of properties, or in other words, higher cap rates. The question now becomes how long can this last, and will the trend continue?

He said that because the cap rates are seen more as a result of financing cost and less as a function of supply and demand, he believes that the majority of the impact is behind us, interest rates will raise at a slower paste, flatten or even retreat in the next 24 months.

“It is our observation that cap rates will lag slightly behind but will likely adjust accordingly by about one quarter after rates stabilize at a lower level,” Holzmann said. “Of course, macro-economic factors such as the war in Europe, another global pandemic, or political unrest can shake this equation up, resulting in a different outcome.”

The Preferred Narrative. But Wait.

Noel Liston, managing broker of Core Industrial Realty in Chicago, tells GlobeSt.com that CBRE’s recent cap rate survey and report seem to align with the preferred narrative for most real estate owners and investors.

“That being, the rapidly escalating cost of capital and the associated upward adjustment to capitalization rates will likely stabilize in the first half of 2023,” Liston said. “Once there is stabilization in capital costs, investors should breathe a sigh of relief, and capitalization rates should stabilize in kind.

“Moving forward into 2024 there would likely be a reversion to capital costs and capitalization rates perhaps not to rates that would mirror the averages of 2018-2022 but certainly more in line with those averages.”

Liston said the only challenge with this narrative is timing.

“The escalation of capital costs for real estate will subside and naturally there should be a tightening or reversion downward to capitalization rates,” he said.

“As inflation eases due to the mitigation or elimination of pandemic-related factors, the Federal Reserve should feel more comfortable about easing or eliminating rate hikes in the second half of this year.

“The biggest question remaining is will the Federal Reserve react in a time-effective manner. The recent increases to the cost of capital were very telegraphed and transparent as to the desired impact, reducing inflation to or closer to the Fed’s preferred inflation rate of around 2%.

“Gauging inflation for the cost of basic services and goods is relatively straightforward, gauging the impact of higher capital costs and what that does to values, deal flow and the health of real estate markets is not so straightforward.

“This is simply due to the factor that time plays in the real estate markets. There always remains the possibility of an extended timeline for the stabilization of capital costs and subsequent lowering. Notwithstanding, the uncomfortable scenario of higher rates for longer, it appears the economy is on solid footing and inflation is retreating and a new and more predictable normal is coming to the market later this year, of course, stay tuned.”

Peak Date Continues to ‘Move Out’

Martha Hargrove, executive vice president, DXD Capital, tells GlobeSt.com that her firm watches the yield curve and marks interest rate risk, accordingly, and the peak continues to move out.

“The historic run up in rates has impacted commercial real estate investment returns, however, we continue to see strong demand fundamentals in self storage that has protected the upside in our portfolio.

“We have yet to see serious cap-rate expansion, but there will be some sellers who will be forced to sell in 2023 in less-than-ideal circumstances and those transactions will likely show some cap rate expansion. We expect that assets in strong markets with good cash flow will command attractive exit cap rates.”

Investors Embracing Commercial Mortgages in 2023

Patrick Ward, president, MetroGroup Realty Finance, tells GlobeSt.com that after several meetings at the recent Mortgage Bankers Conference with chief investment officers of major life insurance companies, his observations interest rates should soon peak and come down slowly in the third and the fourth quarters.

“Credit spreads remain the same – approximately 150 to 225 basis points over corresponding treasuries – and all product types continue to be acceptable security with added scrutiny and caution given to office,” he said.

“All the major lenders that we represent feel investments in commercial mortgages continue to be an attractive asset class mixed with equities and fixed income evidenced by having larger allocations in 2023 than 2022.”

Seeing Transactions North of 5% for Good Assets

Peter Ciganik, partner and head of capital markets at GTIS Partners, tells GlobeSt.com, “We are seeing transactions north of 5% cap rates for good assets and don’t believe that the cap rate expansion phase is over yet. Real estate markets adjust fairly slowly and with a lag, but mostly they just stay very quiet when there is a lot of uncertainty.

“The Fed is not done yet with their tightening cycle, so it is very hard to know when cap rates might peak and where they might end up a year from now.”

Comparing to 2008’s Timetable

Chad Littell, national director of U.S. Capital Markets Analytics at CoStar Group, tells GlobeSt.com that historically, the Fed’s hiking campaigns have continued until achieving positive real yields.

“Therefore, the Fed may have more work to do, increasing rates through the first half of 2023, however, at a more moderate pace than witnessed in 2022.

“Looking back to the last market downturn, the Federal Reserve began cutting its policy rate approximately 18 months before cap rates peaked. The Fed Funds’ effective rate reached about 5.25% in 2007 before cutting to near zero, and it wasn’t until 2009 that cap rates hit their ceiling.”

Littell said that higher interest rates also introduce more risk into the system as higher borrowing costs affect tenants that support the property’s underlying cash flow.

“As investors continue to raise their total return targets due to more significant economic uncertainty, we could see cap rates continue to rise throughout the remainder of 2023,” he said.

Shifting to the New Paradigm

Karlin Conklin, co-president and COO of Investors Management Group, tells GlobeSt.com, “Falling property values and slower rent growth is a major departure from what we’ve seen in recent years. Investors and operators need to shift to a new paradigm.

“The double-digit rent growth narrative is out. The focus now is on the importance of driving net operating income through strong asset management. It’s a critical component in recapturing asset values.”

By: Richard Berger
Source: GlobeStreet