CBRE does this survey thing twice a year to see what’s up with prices in the commercial real estate world. Their latest one for the second half of 2022 covers a bunch of different markets across the US. I’ve been hearing a lot of random opinions lately, so it’s cool to have some actual data from a legit source to help form our own opinions.
Let’s jump in right away and chat about key points in the report, like current cap rates and possible trends, and what it all means for us in real estate.
No surprise here, but the average cap rates for all markets and assets increased by 60 basis points from the first half of 2022 to the second. However, this average does not show the whole picture. Some of the hottest asset classes and metropolitan areas in the US saw even bigger increases in cap rates. Look at this table, for example
Now low cap rates in the past benefited those who owned commercial property while rates were dropping, but they can also be a double-edged sword. If you don’t sell before rates go up again, property values can plummet quickly. Equity values could drop even faster if you used leverage on your deals.
Taking Phoenix as an example, the industrial Class A cap rates increased from 3.5-4% in the first half of 2022 to 4.75-5.5% in the second half. Assuming net operating income (NOI) remained the same, this would mean a value drop of around 26-27% in just six months. For multi-family Class A infill properties, cap rates increased from 3-3.5% to 5-5.25%, resulting in valuation drops of about 33-40% during the same period.
Now, these numbers assume that NOI stayed the same, but according to the Yardi Matrix Multi-Family National Report, multi-family rents in Phoenix actually dropped 1.2% year-over-year. So, value drops were likely even bigger, especially since inflation has made operating expenses skyrocket in many US markets.
These price changes are rough for investors, but it’s even worse when considering how much equity values dropped. Even if you thought you were playing it safe with a 65% loan-to-value ratio in 2020, 2021, or early 2022, you could’ve seen your equity values plummet by 75-78% for industrial investors and 95-114% for multi-family investors in Phoenix over the last six months. That’s basically wiping out all the investor equity in less than a year.
This is a big deal because a lot of these properties were financed with short-term loans that’ll need to be refinanced in the next 12 to 24 months. With higher interest rates and lower valuations, refinancing might not cover the outstanding loan value, meaning investors will have to cough up some cash just to keep their properties.
The weird thing is that these big cap rate increases hit hardest for asset classes with the lowest starting cap rates. When cap rates go up, assets with higher starting cap rates or valuations based on lower NOI multiples see smaller drops in value. This could actually be good news for investors in asset classes that haven’t been doing so hot lately, like office and retail properties, which have been trading at cap rates closer to 5, 6, and 7% compared to the 3-4% range for multi-family and industrial properties.
To give you an example, take a look at this table.
This table demonstrates how a property bought at a lower starting cap rate (3.0%) with a higher LTV (80%) would experience a much more significant equity loss (83%) compared to a property with a higher starting cap rate (6.0%) and a lower LTV (50%), which would only see an 18% equity loss when faced with the same 60 basis point cap rate increase. The table reinforces the point that assets with higher starting cap rates are less vulnerable to equity losses when cap rates rise.
So, what’s the takeaway?
Similar dynamics occurred during the Global Financial Crisis (GFC) in 2008. Prior to the crisis, low interest rates, easy credit, and increased demand for real estate investments caused rapid growth in property prices and a decline in cap rates. When the crisis hit, interest rates spiked, credit access tightened, and asset prices collapsed. Many investors and developers faced financial ruin, while property owners struggled with negative equity and foreclosures.
However, the crisis also created opportunities for investors with cash reserves and a long-term investment perspective who acquired real estate assets at attractive valuations. The real estate market recovered over several years, with stricter lending regulations implemented and investors becoming more cautious.
So now, even though we might see more trouble in asset classes like office and some retail properties due to weak fundamentals and COVID tailwinds, we could also see a lot of distress in some of the strongest-performing asset classes in recent years. This is mainly because of short-term financing from 2020, 2021, and early 2022 at low interest rates and high LTV ratios. With today’s less appealing lending conditions, investors might struggle to refinance their assets.
And to make things even more complicated, cap rates probably haven’t peaked yet in many US markets. The survey shows that a bunch of respondents expect industrial and multi-family cap rates to go up by over 25 basis points in the first half of 2023, depending on the asset quality and the deal’s business plan. Plus, 40-60% of respondents think office and retail cap rates will increase by the same amount or more during that time.
How this all plays out really depends on what the Federal Reserve does for the rest of 2023. If you’re trying to get a feel for where the commercial real estate market is heading, keep an eye on multi-family and industrial assets bought with short-term financing in the last three years, as well as outdated office and retail assets. These areas might have the most distress and could also be where you find the best opportunities to buy deals at sweet prices and turn things around with the right strategy and capital structure.
Hope this helps.
Cheers,
Vidit
P.S - Real estate is all location, location, location. Some markets are still thriving FYI. Check out the free market playbook on the site on how I find those markets.
