Higher Interest Rates, Cap Rates Still Keeping Markets Down
A dramatic rise in interest rates over a relatively short period of time will inevitably cause a downward pressure on the value of commercial real estate, and SIORs have certainly seen that in their markets. Moreover, while rates have seemingly leveled off, it’s not clear that activity will rebound any time soon.
“Interest rates were so low coming out of the pandemic in 2021-2022, they had a huge impact on the way real estate got bought and sold, and the way occupiers leased; one could argue they were too low,” says Jeremy A. Freid, SIOR, senior partner with 128 CRE in Newton, Mass. “When the pendulum swings that far it creates insatiable demand on all properties."
Interest rates in the high 6’s and low 7’s, he notes, take the majority of buyers out of the market. “Now, because rates are higher, there are fewer sellers in the market because there’s been downward pressure on pricing," Fried continues. “If you don’t have to sell, you don’t.”
“The average decrease in property values across asset classes is 20%,” adds Landon Williams, SIOR, senior vice president, Capital Markets, with Cushman & Wakefield in Memphis, Tenn. “However, office has experienced a much larger decrease in valuation while industrial hasn’t decreased as much.”
“Industrial Investment cap rates are rising due to higher interest rates, and banks are pulling back in overall CRE lending,” observes Todd Hamilton, SIOR, with Citywide Commercial in Phoenix, Ariz., who says the higher interest rates are causing buyers to look at lease options as an alternative to purchasing “as lease rates stabilize and the cost to borrow is increasing.”
And Marc Kirshenbaum, SIOR, executive vice president, sales representative with Colliers in Toronto, sees a wide range of impacts on the industrial market in the core of his city. In the leasing market, for example, he agrees with Hamilton that low interest rates brought “mass acquisition” from developers, with pro formas showing high rents. “With more product coming out, vacancies are increasing. And with interest rates being higher, we are seeing a softening of rental rates due to more product on the market,” he notes.
In terms of investment sales, Kirshenbaum continues, “cap rates are now rising to 6% and above to line up with interest rates; otherwise, groups will be in the red.” When it comes to sales of land or buildings, he adds, “we are seeing Loan-to-values (LTV) drop due to high interest rates. Due to how expensive it is to service debt, we don’t see companies giving some of the high leverage of 80%-90%, and in some cases, 100% LTV. We are seeing banks take risk off the table and lower LTV’s, which causes companies to put down a higher down payment. This is causing sale prices to decrease overall.”
STRATEGIES FOR THIS MARKET
Given these challenges, how are SIORs adapting their strategies? “I’m encouraging my owners to lock up long lease terms and to address lease renewals sooner than they have done in the past,” says Hamilton. “If I’m representing a tenant, I’m encouraging patience.”
“We represent a lot of owners of real estate,” says Fried. “For the majority of our clients, I tell them that until the pricing reaches a different level, to just hang in there awhile.” Hamilton, who’s been through a couple of downturns, notes the cyclical nature of CRE, and advises that you “ride the waves.”
Meanwhile, he continues, there are a few pockets where there are somewhat strong middle markets where clients can use cash and not introduce high interest rates. “Or there’s the owner-user market,” he notes. “Instead of buying for return, it looks at occupancy cost.” Rent renewals that show an increase of 30%-75% make such an option attractive, he points out.
“Investors are certainly still in the market looking to deploy dry powder for deals that make sense,” says Williams – adding, however, that “those deals are few and far between.” While for many investors it isn’t a good time to sell, he continues. “For investors that have some impetus to sell, – i.e. upcoming loan maturity, portfolio outlier, sale/leaseback, etc. – I am encouraging them to sell because they will have an unprecedented number of investors underwriting their deal. With that activity, we can make a market.”
It isn’t where the rates are that stunted the market, but it is how quickly the rates rose that effectively created market paralysis.
The hard data and anecdotal feedback that Williams provides investors comes from a wide variety of sources, including what his own team is experiencing in the market. “My advice to investors varies based on what they are trying to achieve,” he explains.
As for Kirshenbaum, he believes there needs to be some “settling” on both landlord and vendor pricing expectations. “On the buy side, there is a lot of capital in the market right now, but buyers are waiting for pricing to settle before making acquisitions,” he says. “As far as leasing goes, leases expire, and tenants must renew, expand, downsize, or close down. On both of these items, we need to keep our clients informed about what is happening in the market. We need to ensure we update them on the latest trends, comparable, availabilities, and market sentiment to keep them engaged.”
WHAT DO THE "CRYSTAL BALLS" SAY?
How are SIORs advising clients about 2024, and the impact less volatile interest rates would have?
“I see stabilized lease rates with more concessions,” says Hamilton. “Inventory levels will increase throughout the year, with many more lease and purchase options. Sales prices will stabilize as economic growth slows and inventory increases.”
Hamilton expects lease rates to soften in 2024 as the economy slows and supply increases. If Interest rates stop increasing, he surmises, “it may push buyers off the fence. Forecasting will be easier as capital costs stabilize and the economic uncertainty fades.”
Williams has a slightly different take. “It isn’t where the rates are that stunted the market, but it is how quickly the rates rose that effectively created market paralysis,” he asserts. “If rates were to stay exactly as they are indefinitely, then the market should adjust, resulting in a flurry of activity.”
Forecasting will be easier as capital costs stabilize and the economic uncertainty fades.
Kirshenbaum sees hope in 2024. “From the tenants’ outlook, we do see more product coming to market – thus, we see more opportunity,” he says. “Rents have skyrocketed for the past few years, but now, with more product coming out, tenants will have more choice, and at a lower rate than there previously was.” Tenants, especially in the big box market (150,000 square feet+), will have more opportunity due to more product being out in the market, he emphasizes.
On the ‘buy’ side, however, things look more challenging “due to wealth in our market,” Kirshenbaum notes. In other words, there aren’t a ton of groups or investors that have to sell. “Frankly, they have made so much in the past few years, that capital gains would be immense if they ended up selling their properties,” he notes. “Nonetheless, we do see a decrease in pricing, and it becomes [a case of] keeping your buyers at your fingertips, for the right opportunities that come forward.”
A levelling off of interest rates, he continues, will further increase the bullishness of tenants and buyers on opportunities as the market continues to see more product available, and willingness to transact. “We will continue to focus on the groups where landlords and vendors need opportunity to sell or lease product faster,” says Kirshenbaum. “Strategies will shift towards all landlords who have more vacancy in their portfolio who need it leased, and towards vendors who maybe had a lease expire who can sell to a user, or who need cashflow more than others.”
Fried is not that sanguine. “No one really knows how long this will run for,” he declares, adding that he can see another year or two of uncertainty. “I think there’s still a lot of dirty laundry that has to be ‘washed’ in the system; and until all of that works its way through the system, I think we’ve got to wait until we see a little more light at the end of the tunnel.”
But if interest rates have truly stopped — or nearly stopped — rising, would that make a difference in terms of his outlook? “It could help confidence overall,” Fried says, but adds that it really would not change his overall view of things. “Maybe if we’re on the path to recovery it could get a couple of folks on the fence to want to sell, but if you look at actual values, they will still be way down from what they were,” he notes. “In 2007-2008 there were these vulture funds, but now, there’s so much more sitting. A lot of people get paid for putting their money to work — and they’re not doing that. Something has to give to let all that equity absorb property; I do not know what that is — maybe a slight rate decrease.” In other words, he summarizes, “There are still a lot of major market fundamentals that are yet unsettled, so I do not have a lot of conviction that things will start to flip fast.”
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