Perspective for the Year Ahead: Commercial Real Estate

Telemus Weekly Market Review November 20th - November 24th, 2023

Commercial real estate has been bruised over the last two years by multiple factors. At the forefront are concerns around the office sector, which has been severely impacted by changing work habits. Second, and more broadly impactful, is the sharp rise in interest rates that has impacted financing costs on those refinancing or purchasing a property. In this piece, we consider the barriers and opportunities over a multi-year horizon for the public and private real estate asset class. 

Within real estate there are two dominant influences on property values. The first is net operating income, or the cash flow a property throws off. The second is the valuation multiple applied to the net operating income. In real estate lingo, a property’s capitalization rate is the most common valuation multiple used. A capitalization rate equates to net operating income as a percentage of a property’s value. For example, a capitalization rate of 5%, would imply a property with $100,000 of net operating income is worth $2 million dollars. The lower the capitalization rate, the higher the valuation multiple applied to the net operating income. 

Coming out of the pandemic net operating incomes were generally strong. A shortage of housing led to elevated rent growth, which for apartments, ran into the mid-teens on an annualized basis in late 2021. Industrial properties were even hotter, as the spike in online purchases resulted in retailers wanting more warehouse space closer to their customers. The one weak spot was and continues to be the office sector where even three years after the pandemic it remains unclear exactly how commercial office space will be used. A saving grace for office property owners has been the length of leases, which tend to run 5-10 years in length, and have gradually begun to expire. Over the course of the past year, rent growth has begun to moderate with apartment rent inflation back in line with long-time averages and warehouse rents having come off their peak. 

On the valuation front, interest rates have had a profound impact that in our view is just beginning to have a meaningful influence. As the Federal Reserve has thus far increased rates by 5.25%, borrowing costs for commercial properties have spiked. Today, its common to find financing costs in the 6.5% to 7% range for commercial real estate borrowers. If the borrower purchased the property for say a 6% capitalization rate, then they are only getting a cash flow yield of 6%, below their cost of debt. The fact that interest rates are above the cash flow yield on a property has resulted in many real estate acquisitions being done without any leverage. This means that the borrower has had to come up with more capital on their own. Most cash buyers are hoping that rates drop and plan to put leverage on when that occurs. In addition to higher borrowing costs, banks have pulled back and are more reluctant to provide financing on commercial real estate, especially office properties. The combination of expensive borrowing costs and less capital available from banks has had a significant impact on transaction volumes, which are down over 50% from year ago levels. 

More recently we have begun to see greater divergence in fundamentals and asset specific performance depending on the location and what’s transpiring at the property level. For example, within the office sector, some buildings have been lucky enough to hold on to anchor tenants, although at lower lease rates. Suburban office space is also holding up better than downtown urban locations. Within the multi-family space, rents have softened and are weakest in markets that were the hottest coming out of the pandemic. These locales, nicknamed the sunbelt, include Charlotte, Atlanta, Austin, and Miami. A glut of newly constructed units have hit the market and must be absorbed before rents stabilize. Elsewhere, cooler settings including Detroit and Chicago, have experienced firmer rents. In the retail sector, property types that have been coined ‘essential retail’, such as grocery anchored shopping centers seem to be attracting tenants and able to hold rents better than malls and smaller strip centers.

Outlook

We view the disconnect between valuations (capitalization rates) and interest rates to be significant. While valuations have come down on commercial real estate, they are still not at levels that account for where interest rates presently sit. If indeed the Fed holds interest rates higher for longer, we’d expect commercial real estate valuations to compress beyond what they already have. What we find interesting is that current share prices of public real estate investment trusts (REITs) already incorporate further valuation compression, while valuations prescribed to private real estate funds have some room to go. We think this provides an interesting set up, at some point, for public REITs given their valuations imply property values that are approximately 20% below that of carrying values on privately listed real estate assets. 

Looking beyond the next 12-18 months, we do expect that the Federal Reserve will indeed cut interest rates. While the circumstances at the time will dictate the ultimate timing and magnitude, our base case expectation is that the Fed may only cut rates by 2.5-3.5% over the next 2-5 years. Its unlikely we go back to the zero interest rate environment that persisted for much of the past decade. Lower rates will ultimately provide relief to the real estate sector and allow property owners the ability to put leverage on or refinance properties, lifting returns when this occurs. 

A derivate impact of higher rates is that they are beginning to preclude new projects from taking hold. Indicators such as land acquisitions and building permits indicate there are few new projects in development. This will ultimately lead to a period where there is greater demand than supply as it will take time to design, permit and develop new assets. For example, within the apartment sector there is a reasonable amount of supply hitting the market through 2024. However, at this point new project starts have stalled and its highly likely the amount of new supply hitting in 2025 will be well below average. Should the economy heat up at a time when supply is constrained that could lead to a resurgence of rent growth and ultimately higher net operating income growth. 

Collectively these perspectives leave us near-term cautious on commercial real estate, but longer term bullish. The growing divide between valuations of public and private real estate assets may present more nearer term opportunities for public REITs. Going back to an earlier comment, we do believe we are entering a period where sector, geography and the individual property fundamentals will matter. Among sectors, office is likely to remain soft for some time and we view the space as less attractive. Apartments are likely to face some near-term headwinds, but we project more favorable long-term fundamental support. Within geographies, areas such as the Midwest that were forgotten in recent years, may offer more attractive valuations and fundamentals at this point relative to the sunbelt region. At the property level the underlying structure of debt financing, location, amenities, rents, and tenant mix will all play a role in whether a specific asset is able to hold and grow the underlying net operating income. 

As we navigate the market ahead, we use this perspective in considering the best ways to allocate to the commercial real estate market not just over the next year, but with this multi-year perspective in mind. 

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