Pencils Down: The Fed and the Hungry Broker
“Properties aren’t worth what they were in 2021 or 2022.”
There it is. Those words, spoken by Chad Griffiths, SIOR, lie at the heart of the current disconnect between the Federal Reserve Bank’s ongoing struggle to rein in inflation and brokers’ need to get deals done.
But, says the Edmonton, Alberta-based partner at NAI Commercial Real Estate, we should have seen it coming. Prior to the past 18 months of interest rate hikes, “there was so much cheap money flooding into the markets that we should have anticipated a coming inflationary trend. Now it’s all unwinding.” In fact, he estimates the market overall has sustained a 10-20% drop in asset value.
For the record, CNN reports that the Fed is taking a temporary breather in its rate hikes, resting them at their current 22-year high ... for now, at least. Another increase is expected before the end of the year, which will push rates into the 5.63%-to-5.87% range. For those keeping score, this is the second pause the bank has taken since it began raising rates in March of last year. Eleven hikes have occurred since. Unfortunately, fewer decreases than anticipated are projected for 2024.
What does all this mean for transactional activity? “The goal was to slow inflation,” says Jonathan Hipp, principal of U.S. Capital Markets for Avison Young and head of its U.S. Net Lease Group. “But it’s slowed transaction volume and made financing extremely cost-prohibitive from a cap-rate perspective.”
“Over the past 14 to 15 months, we’ve seen a pretty significant rise in cap rates,” reports Colliers executive vice president, Jerry Doty, SIOR, in Las Vegas. “We were trending at about a 3.5% cap, and now we’re getting closer to six.” That, he says, is a 200-basis-point (bp) swing in just no time at all. As a result, “there’s a freeze on everything.”
All three of our speakers note that some sectors are weathering the storm better than others. That’s clear in a comparison between office and industrial.
(It is not insignificant that, as yet, another sign of the office market’s woes, W.P. Carey recently announced its exit from that long-time stalwart of its portfolio, “enhancing the overall quality of our portfolio, improving the quality and stability of our earnings, and incrementally benefiting our credit profile,” said W. P. Carey CEO Jason Fox.)
“Acquisitions and dispositions are slowing in industrial too,” says Hipp. Transactions are getting done, he says, but not at the rate of a few months ago, when an Amazon facility, for instance, could trade at a cap rate in the mid fours. “It just doesn’t happen today. Has the gap widened as much as in the office market? No. Is the volume off as much as in office? No.” But much like every other product sector, “it comes down to the disconnect between seller and buyer expectations.”
Indeed. “Sellers are still valuing their properties in the threes,” Doty agrees, “and buyer expectation is trending toward six or above. So, we’re stagnant.” In fact, he reports seeing a decline of more than 80% in investment sales year over year.
We all got drunk on the historically low rates, and their rapid escalation caused a market shock.
If industrial is showing more promise than other sectors, it’s due to the fact that rents and leasing activity are still rising—the overhang of the sector’s star status during the pandemic, “even though the Fed is trying to engineer downward pressure on the economy,” Griffiths says. “Vacancy rates are still well below the five- or 10-year average. And that helps offset rising debt.”
A MATTER OF PERSPECTIVE
As stated above, the interest-rate hikes came on fast and furious, and they are clearly not done. But stepping back for a broader perspective, Griffiths points out that “historically, they’re pretty much on par with where they’ve been for the past 40 years. But we all got drunk on the historically low rates, and their rapid escalation caused a market shock.”
The longer view doesn’t change the position of lenders, however. Deals are getting done, but they’re either getting done with all equity, which the institutional buyers can do and thus circumvent lenders, or they’re getting done through long-standing relationships. Even then, say our experts, borrowers need to come to the table with stellar projects in hand.
“If you do see trades,” says Doty, “they involve Class A, high-functioning buildings and good, strong credit.” Conversely, if someone has to sell a project that’s seriously underwater, “we’re seeing quite a few groups saying they have money for value-add.”
But even if the subject is Class A office, “people are still nervous about the sector,” says Hipp. In previous markets of uncertainty, such as the Great Recession of 2008 and 2009, refinancing with existing lenders was the popular lternative to a disposition. “That made sense. Not so much today.”
“When you can finance a project in the twos or threes,” he says, “it makes sense. That’s a different story from refinancing a project that was originally done with debt priced in the twos or threes.” With debt currently hovering in the high sixes and sevens, the numbers just don’t pencil out, and lenders certainly don’t want that on their books.
That need to be compliant with bank coverage ratios might be less of a hurdle for institutions, but it does impact greatly the investment plans of smaller mom-and-pop organizations. “It’s the smaller owner who’ll find pain in a sale into a down market,” says Griffiths.
The stress of the current uncertain environment, marked by what one speaker defined as a “pencils-down” attitude, ratchets up in the fourth quarter, when most investors typically push to get deals over the finish line. No one we spoke with sees a robust volume of closings in the final three months of 2023. Even 1031 like-kind exchanges, which have fueled the ramped up Q4 volume over the past few years, seem to have dried up.
Hipp confessed to being a “glass-half-full kind of guy,” not uncommon among brokers. “I’ve talked to a number of sellers, both private and institutional, and I think the fourth quarter will be active, even if not as active as in the past. But I’m optimistic it will be better than the first three quarters.” And the Fed’s current pause might provide a bit of an uptick in activity.
But the fact remains that fewer deals are closing, and the market as a whole is looking to the Fed to provide a more concrete reason for optimism. Doty says he’s telling his selling clients to hold their water until they get the “all-clear” from the Fed. “But it’s not happening this year.” The optimistic DNA of brokers aside, he predicts that a clearer picture will not emerge until the second or third quarter of next year, and given the recent news, that might be pushed out further still. When that signal does come, “That would unlock quite a few deals.”
And what of his buying clients? “We launched a handful of deals last year,” he explains, “and we had 15 to 20 potential buyers making offers.” By contrast, a deal he tried earlier this year produced half that number. “The sellers don’t want to put something out and have it not transact. They want as deep a buyer pool as possible. So, deals will be stagnant for a while, until we reach certainty.”
THE LONG-TERM GAIN OF CRE
The capital to make deals is out there. But, as Griffiths points out, sellers need to take a more realistic view of what pricing is like today. While we wait for that to happen, “prudent investors are asset-managing their portfolios to position them for long-term success.” That means potentially taking a longer-term hold than originally planned and waiting for the market to stabilize.
Buyers, of course, know what they want. They also know how much pain they can endure. “They want it or they wouldn’t buy it,” says Hipp. The deals that are getting done are doing so all cash, or because buyers are giving up more in terms of equity than they previously would, while sellers relent a bit on pricing.
But fairness in a transaction is ultimately judged on a sliding scale. “It comes down to a fair transaction in today’s market,” he says. “If you get to the closing table, then everyone is happy, some more than others. You wouldn’t get to closing if you weren’t.”
That happiness is at a premium today, however, and it will remain so until interest rates are stabilized. When that happens, says Doty, “sellers and buyers will come to the same page on where pricing should be.”
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