Recent Commercial Real Estate Trends

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31 - CRE is Booming

 

The Commercial Real Estate market is BOOMING… but with knee pads, wrist guards, and helmets to protect timid investors. I am not saying that we have entered a bear market, but I am a believer in self-fulfilling prophecy – and investors and lenders have turned the corner and started talking about “protecting their downside”. Investors who just six months ago were begging for Class-A apartments and willing to pay a 5% CAP for CORE product have now changed their tune a bit and are asking for -B and -C “value-add” deals… and, as I’ll explore in more depth, that is driven 100% by their yield goals and underwriting of rent growth! In the apartment world, we have seen Class-A rents taper a bit as many renters have hit a threshold of putting 50% of their monthly income towards rent – a level that it is easy to argue is not sustainable… and at a minimum will self-limit rent growth as we move forward.

 

Today though I am going to talk in general terms from 50,000 feet and look at some recent trends affecting the buyer/investor pool in Commercial Real Estate:

 

1. Investors feel they are paying top dollar. Whether in industrial, retail, office, multi-family, or “other” (“other” being storage units, car washes, mobile home parks, etc. – you name it, I’ve done it…), investors are commenting to me about paying top dollar. Most recently, an investor told me that he was “okay with overpaying because while the asset may not appreciate, he would receive cash flow and eventually the property would be worth what he paid”. That is a very interesting comment to hear, and certainly representative of so many things, including 1) Capital is on the sidelines looking to be put to work, and 2) investors are seeing this as a frothy “top” to this cycle, and if not the top, then close to the top – but they want in anyway. Again, this is interesting and representative for so many reasons, but mainly as a hedge against inflation, and to take advantage of the incredibly low financing we are currently achieving.

 

2. Rents and pricing have and will continue to “taper”. Values, in some cases, are up 75% since 2009, and we have seen CAP rates compress year after year quickly. Pricing and CAP rates are moving at a slower rate now, indicating a stabilization of pricing, which would also indicate a “top” of the market. For example, we have seen the same stabilization or slight increase with Class-A rents over the last four quarters within our Class-A market studies in Downtown Salt Lake City and Sugar House. While demand is extremely high for Class-A apartments, pricing has started to become more of an issue with renters.

 

32 - Money

 

3. The Debt floodgates are wide open. Although financing is not quite as easily obtained as it was in 2007, we are seeing extremely favorable terms and pricing on the projects we are working on. Apartment financing is the darling of the industry as the demographics for multi-family are strong and it stands as such a conservative asset class. Recently I was quoted 10 years of Interest Only at 4.5% on a 30-year am deal. This type of financing is pushing more investors into apartments, and will keep pricing elevated and possibly increase it further – but note that this financing tool may be artificially raising pricing, similar to my prior reference to the investor’s acknowledgement that he is “overpaying”. Why not overpay when you are getting 10 years of I/O and amazing cash flow and debt service coverage! If the property gets zero appreciation, but you clipped away a 12% cash-on-cash for a decade, that is not a bad place to put your money!

 

4. Functional Obsolescence is keeping pricing flat on Class-C office, industrial, and apartments. Something that we have not historically discussed in detail has become a BIG issue for investors in today’s market. Functional obsolescence, in my words, is the lack of adaptability to modern needs of an older property. Take, for example, an apartment unit that doesn’t have washer and dryer hookups – this is functionally obsolete because a modern tenant is not going to want to go to a laundromat. Similarly, in industrial CRE, a modern tenant is going to want higher ceilings to stack product, and will choose a newer property with 24’+ ceilings vs. an older 12’ ceiling building. We are seeing opportunity in improving the functional obsolescence (i.e., add a washer and dryer unit), but buildings that don’t have the ability to improve have seen little-to-no appreciation, and will continue to see a lack of investor demand.

 

Functional obsolescence could and should be a blog post all on it’s own, but call me if you want to discuss opportunities in functional obsolescence across all product types – it is there! I wanted to bring up functional obsolescence mainly because we have seen such a massive increase in pricing for Class-A office, retail, industrial, and multi-family, but we have not seen that in -C because of functional obsolescence and Capital Improvement needs on older buildings. That will limit rent growth moving forward and decrease cash follow (capital needs = less cash flow!) and keep pricing low. If I owned an older -C building, I’d be selling right now and moving into a -B or an -A, even if it meant lowering my cash flow. On a 10- to 20-year hold, you will ultimately make more money.

 

Investor appetite is HUGE, driven largely by a lack of quality alternative investments and a need to get Capital to work, but it is also driven by the available financing. We will see values taper in Class-A, and investors move to -B and -C where they can “add value”, increase yield over time, and hit their Internal Rate of Return goals.

 

USA, Massachusetts, Boston, Financial District, skyscrapers, view from below.

 

To circle back to my opening paragraph and bring this blog post all together: my goal today was to let my readers know that from 50,000 feet, investors are not expecting values to increase on Class-A as they are not expecting rents to continue to increase in Class-A. This is a generic look at ALL product types, but I’m happy to discuss specific product types, markets, locations, etc. in more detail. IRR is driven by appreciation and cash flow divided by the years you have owned the asset. As appreciation is expected to continue to slow, buyers are chasing higher cash-flowing assets, or assets of which they can improve the look, feel, and/or functionality. We will see -B and -C properties increase in value more than -A’s as Capital chases value-add opportunities, again, to achieve their yield goals.

 

Now is a GREAT time to sell, if not THE time to sell. We can find places to put your money in 1031 exchanges if you have a low return on equity. Some of our owners are selling because they feel the market is truly frothy. Personally, I would not sell and pay the taxes if I owned something of quality, but I would take 10 minutes to understand and evaluate what the next five and 10 years look like while still owning my asset (be honest about Cap-X and rent growth) vs. what else Mark Jensen can put me into. Interest rates are expected to rise, which will put downward pressure on appreciation and values, so we need to be looking at cash flow and the ability to grow rents and occupancy over the next five to 10 years!

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There is so much in this blog post that I want to spin off into separate, more detailed blog posts! If you have specific questions about anything, now is the time to have these discussions! The joke around my office is that the best time to sell was actually eight months ago! The second-best time is………….. NOW.

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