Leveraging Opportunity

Acquisitions and dispositions of commercial investment property make up a large part of our business. Prime lending rates have now risen above 8.00% for the first time in almost 15 years, which places the debt markets squarely top of mind for our team as well as the watching real estate world. Pin-pointing the exact ripple effect of this rate rise on commercial real estate is impossible, but the following includes a few observations. 

Fewer Properties for Sale

Anticipating brighter days ahead, most well-positioned sellers are simply putting off the decision to sell or market their assets. If a property is for sale, it is important to determine a “market” seller on the front end. If sellers are looking for the premium cap rates of 10-15 months ago, it is unlikely a deal will be made. “Off Market” is the new On Market – opportunities for buyers lie in those sellers who have some external reason driving a sale, i.e. lender pressure or another extenuating circumstances such as the end of a fund life, rent roll issues, etc…

Buyers’ Market: A Significantly Shrunken Purchaser Pool

Real estate is out of favor with some as yield seeking investors now have other options to produce income that have been unavailable in recent years. While the average REIT distribution sits around 4.00%, six-month Treasuries currently yield more than 4.8% (compared to a 2.88% historical average). In addition, stock and other equity instruments have had attractive buying opportunities in recent months attracting investment capital to those markets. Many buyers are also forced to the sidelines as their lenders become more selective; CMBS and life company lenders are largely on hold. Negative news this week on another bank, First Republic, continues to cause tightened lending from regional and community banks as well. Fewer buyers in the market leads to less competition for properties – advantage: buyers with capital and a solid/proven lending source.

Lingering Issues Merge with Today’s Challenges

Multi-tenant class B&C office and retail Covid woes are now exacerbated. Office and retail have improved but are not anywhere close to pre-Covid levels.  Now, the interest rate environment is causing some of these assets to plunge into an even more dire situation. While office properties face a difficult market, the major east and west coast markets troubles are magnified by their much slower Covid recovery. Many of those assets are being sold at deep discounts and auctions while some have even begun to go into foreclosure. The existential issues these large market properties face draw major media attention elevating concern across all property types.  Lenders are, at best, extremely critical and non-committal on multi-tenant office and large format retail. Slow fatalities such as Bed Bath & Beyond highlight the inability of these sectors to survive yet another setback in addition to lingering & ongoing Covid and e-commerce challenges.  

All Eyes on Loan Renewals

Five year loans originated in 2018 at 4.75% (then Prime rate) or lower mature in 2023. The most expected renewal approach will be “kick the can”. These renewal lenders, amid regulatory debt service coverage pressure, will likely extend amortizations while increasing rates as much as possible. Borrowers with conservative loan-to-value balances and reasonable cash flow coverage will have room to negotiate an extension that will carry them through the current environment, but those with higher leverage face more difficult prospects. Non-renewals and subsequent fire sales may take place putting additional pressure on the market until undercapitalized properties are cleared from the market.

The Opportunity

As with every market disruption, there is opportunity for those with capital. The difficult question is: Are rates going to be higher or lower and when? Are we at the beginning of a long, challenging stretch with higher rates causing a cascade of defaults and troubled sales by undercapitalized owners or toward the middle of the cycle which will stabilize and improve?  It is impossible to know, but it is my belief we are somewhere in between these realities. Inflation reports, elections and many other factors (all out of our control) could swing the future path. Watch the markets closely, be selective, don’t be greedy or over leverage. The opportunity awaits those that are positioned with strength to carry on in the current market and have the courage to seize opportunities when they arise.

We are already beginning to see early signs of it playing out, leading to some interesting opportunities for our investors. We expect the number and quality of opportunities to continue to elevate for at least the next few quarters as we tune out the noise and focus on what that the current environment brings.

Isaac Smith
Partner — Acquisitions