Realities of Real Estate

Telemus Weekly Market Review May 30th - June 3rd, 2022

The real estate sector is largely composed of commercial real estate assets that include apartments, office buildings, industrial properties, and retail centers. Coming into the year, the COVID-19 pandemic had created a dynamic where industrial (warehouses) and multi-family (apartments) properties were experiencing heightened levels of demand. Alternatively given the uncertain dynamics of employees continuing to work from home, as well as increased adoption of online buying by consumers, the office and retail sectors of the real estate market had fallen out of favor. As a result, valuation multiples among industrial and multi-family sectors, expressed as capitalization rates (or cap rates) had compressed leading to outsized price appreciation for these specific sectors.

The strength in industrial and multi-family has stretched to the point where strong demand and higher valuations have led to a market environment where cash flow yields are relatively low in comparison relative to historic trends. In fact, more recently we’ve heard of instances where some institutional investors have purchases assets where the current cash yield is not high enough to support interest costs and therefore the investor is electing to fund the purchase entirely with equity and not put a mortgage on the asset.

We’ve also seen some evolving trends as newer sectors and geographies have shown increasing interest. One example is life science real estate, which is office space specifically designed for the needs and specifications of pharmaceutical and biotechnology companies. Another is single family rental homes which have benefited from the lack of available housing stock. Institutional real estate investors have also been following the migration trends within the U.S. as the so called ‘sun belt’ regions in the south and west coast have become more popular places to allocate capital. In each of these cases we’ve seen notable compression in valuations, or cap rates.

Real estate assets can be attractive in an inflationary environment. For some properties, lease rates come with inflation escalators, while others that don’t are able to reset when leases expire. Multi-family apartments typically have one-year or shorter leases and thus able to reset rates quicker. We’ve seen statistics that indicate renewal rates on multi-family apartments are up mid-to-high single digits, with new leases being priced at least 15% higher. Office properties, on the other hand, tend to have longer leases and they may not reset as quickly. The ability to raise rents has led to strong net operating income growth for real estate assets in 2021 and that is likely to carry well into 2023 as higher rents from lease renewals continue to flow through.

An offsetting factor to rising rents is the likelihood that capitalization rates, or valuation multiples, are likely to go higher. Capitalization rates have historically had a fairly strong correlation to interest rates, although the sensitivity tends to come with a lag. As interest rates have risen, one would expect capitalization rates to eventually rise putting some offsetting pressure on valuations.

Real estate faces a mix of tailwinds from strong demand, growing rental rates and being a benefactor from inflation. Going forward headwinds of rising debt costs and the prospect for higher capitalization rates are likely to partially offset some of these benefits. We continue to view real estate as an attractive asset class over the long-term but believe investors should be cognizant that current trends may begin to evolve. In addition, given the disparity in pricing between publicly traded real estate stocks (REITs) and private real estate, investors should be cognizant of the prices they are paying for the underlying real estate.

All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however Telemus Capital cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. Investment decisions should always be made based on the client's specific financial needs, goals and objectives, time horizon and risk tolerance. Current and future portfolio holdings are subject to risk. Risks may include interest-rate risk, market risk, inflation risk, deflation risk, currency risk, reinvestment risk, business risk, liquidity risk, financial risk, and cybersecurity risk. These risks are more fully described in Telemus Capital's Firm Brochure (Part 2A of Form ADV), which is available upon request. Telemus Capital does not guarantee the results of any investments. Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, and may lose value.

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