It's not pretty, but it's not doom and gloom either
High interest rates have done a number on the commercial real estate landscape, resulting in a “big destruction of value.” So how do lenders even begin to underwrite in such a volatile environment?
Alex Horn (pictured), managing principal of lender BridgeInvest, spoke to Mortgage Professional America about the future stability of the CRE space in light of the mercurial market.
“When you look at today versus a year ago, trades have really diminished in a very meaningful way,” he told MPA during a telephone interview. “So you don’t have great comps [real estate comparables] to be able to compare to, and that makes underwriting a little bit more of a challenge.”
He cited a recent CBRE study attempting to provide somewhat of a barometer: “CBRE came out with a good study recently that had a good rule of thumb – and again, this is a rule of thumb not necessarily to be taken in as gospel – that for every 100 basis points of increase in interest rates it roughly equates to about 60 basis points of increase in cap rates.”
He expounded: “Consider we’ve seen about a 250 basis point runoff in interest rates, we’re talking about anywhere from 150 to 170 basis-points in cap rates,” he said. “It’s a big runup in cap rates, which in turn means it’s a major destruction of value. There’s no denying it, there has been a big destruction of value in commercial real estate.”
According to the CBRE study, econometric evidence further suggests that a predicted rise in the 10-year rates to 4.75% from 2.2% would cause a 150 basis-point increase in average cap rates. “Under this scenario,” CBRE economists wrote, “a prime asset trading at a 4.5% cap rate would now trade at a 6% rate, equivalent to an approximate 25% fall in capital values. While not a disaster for commercial real estate, it would cause pain for some investors and some losses in the banking sector.”
Let’s talk multifamily
Properties more reliant on debt financing are further impacted, Horn said. “The asset types with fates that are intertwined with the cost of debt are seeing the biggest changes,” he said. “Take, for instance, multifamily which historically operated with higher leverage and lower cost of leverage. So a multifamily deal is more affected by this cost of interest rates. Multifamily is hugely reliant on debt, so the value of multifamily has dropped a bit.”
How about hospitality? “Because coming out of the pandemic, it was increasingly difficult for hospitality to find debt financing, hospitality has also been operating with a lower amount of leverage and higher cost. The percentage change of cost of debt for hospitality is lower comparatively than multi. Multi has seen a much bigger change delta in their values as compared to hospitality.”
And yet, it’s not doom and gloom. While South Florida may be something of an outlier given how hot the market is, Horn cited it as an example of positive development.
“What we’re seeing in terms of valuations is that trades for multifamily in good infill markets like South Florida - there are still multifamily trades for Class A properties going off in the low 5% cap rate, which is crazy if you think about it. Ten-year Treasuries are in the 5s and people are buying multifamily properties for the same cap rates. You scratch your head and wonder why. Why does that make sense? Because people believe in the growth. What it comes down to – especially in big markets – is that rents will grow over time, and we share that opinion very strongly.”
The precarious housing situation only helps to further the notion, he noted. “The latest stat I saw was that 28 million people are getting priced out of being able to buy homes because of the cost of interest rates, how they’ve gone up,” he said. “So what that means is that more people are going to rent. When you couple that with the fact that we already have a housing issue and the cost of building is more expensive, you see there’s a path of improved valuations in the future for multifamily.”
It’s like Texas weather – if you don’t like it, just wait 15 minutes and it will change, at least figuratively speaking. “We see a period of time where we see a value destruction of higher cost of debt and that has basically happened and may continue to happen but that’s the short-term, and over the medium- and long-term you see asset classes in core infill locations that we actually feel pretty bullish about.”
It’s a “yes” on industrial and retail but a hard “no” on office
Another bright spot – all being relative given the shape of the market – can be seen in industrial, he said. “We are active in industrial,” Horn said. “On the industrial side, we think it’s very appealing. Because of the geopolitical tensions between the US and China, it’s caused so many companies to onshore their products. They’re bringing their manufacturing and distribution to the US. And as such, the US is quickly building up their infrastructure and manufacturing facilities.”
Retail is another promising area: “We also like retail,” he said. “Not so much from a shopping center – a big mall – but neighborhood retail.” As for the office market, he was succinct. “We categorically don’t lend on office today.”
That’s the state of things now. But if history has taught us anything, it’s that things change with time.
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