The Impact of Rising Rates on the CRE Market
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Joe: So for the last 12 to 18 months, the dominant theme in investing has been interest rates rising, inflation, impact on, uh, asset values. Uh, and here we sit, uh, in the middle of July in 2023. And the question is, well, what does that mean for the next year? And more importantly, uh, as two guys in a firm that are boots on the ground dealing with asset values, buying assets, where are interest rates headed?
What impact do you expect it to have, and what decisions are we actually making based on what we see for the next year and the next five years? Yeah. Ryan, maybe you can frame what's happened so far.
Ryan: Yeah, uh, for most, I'm sure most people know, but we've been in the, um, one of the most historic, uh, rapid rises in Fed interest rates.
Uh, we started at effectively zero and moved effectively to five percent. over a very rapid period of time. And the first kind of immediate impact that that had on real estate is uh, you know, real estate is predominantly financed. Majority of real estate has some form of debt on it. And so as soon as that Fed rate moved up, debt costs moved up.
That has an immediate inverse impact on values. And we saw it in real time, which was When the first-rate increases occurred, we were out to market on particular properties, looking to obtain financing, debt costs went up. And so we ran our underwriting model, the same underwriting model that we had run when we first put the property in contract, and it yielded a different value.
It said, we can only pay this for that property now because our debt costs have gone up. Yeah. And I remember going back to multiple sellers and saying, sorry, but the world has changed and the price that we could have paid for the property, we can't pay that. This is what we can pay and many of them said, no, thank you.
A few of them understood at that early stage and they, they, uh, they accepted our changes. But I would say that real estate values in particular were impacted most directly and instantaneously by that Fed rate because of that change in debt costs.
Joe: Real estate's really interesting because it's not an efficient market.
Like, stocks and bonds rise and fall based on, instantly and daily. But real estate is a, is a human endeavor. Uh, most of the assets we buy are from families that have owned them for years and years and years. And their motivations to sell and, uh, desire to sell is, is hinged on a lot of different things.
Uh, human psychology in many ways. Their, their legacy or their, their, what they thought the property was worth in their head. Um, so the, it, it's not like cap rates went up and the whole market shifted. The truth is, transaction volume dropped about 75%. Uh, we, I get a weekly update from Yardy Matrix on, uh, multifamily, basically apartment sales in the western U.S.
And in the markets we cover, a year ago, there would have been 25 transactions in a given week. This week, there was one. One. Last week, maybe two. Some weeks, zero. So it's not quite fair to say... Interest rates have gone up and asset, uh, values have gone down. In many cases, they've set new records. In some cases.
And the reason being is that capital sporadically needs a home. Like there was a 1031 exchange extension. There, there was things that happened. There was a mansion tax in LA that freed up, uh, capital that was looking for homes. There are, it's been selective that, um, for certain types of assets. There just isn't a place for the money to go, and that's driven new prices, even record prices.
But for the types of things we buy, which are less commoditized, more human, messier, more of a story, we have seen prices drop 10 or 15 percent. When you look at the data that Green Street and The Coast are, and the specific data, the secondary markets we serve on industrial and multifamily assets, have seen cap rates, uh, cap rates are projected to rise about a point to a point and a half.
When you look at their charts and their curves, we're about halfway through that rise. The idea is, it's just like inflation doesn't moderate overnight, cap rates and prices don't move overnight. Yeah. The expectation, I think, is that, uh, prices will, cap rates will continue to go up, putting downward pressure on prices, but it's still a hit or miss market.
Ryan: Yeah, and we spoke to this a little bit earlier, uh, when you and I were talking, that we're still in an environment where generally participants are transacting because there's a felt need on one side or the other. Yeah, we're not in a market where it's kind of everybody recognizes the prices and, you know, it's kind of a free open and we're seeing that in transaction volume.
And so we've seen that both on the buy and the sell because, uh, the properties that are transacting at a bar setting high or unusually low cap rate are the ones that are being driven by a buyer that has a felt need. They have a 1031 exchange. They have some sort of, uh, need to transact. And then on the flip side, uh, when we're acting as the buyer, uh, the, the properties that we are buying are the sellers that have a felt need.
They, even though the market is uncertain and, and not a lot of people are transacting, the ones that we're finding where they actually are transacting at a price that we would pay, that we're being, you know, appropriately paid for, for the opportunity ahead of us. Um, those sellers have some sort of a internal motivation that, that requires them to sell in this market.
And so with that, you can get kind of a bifurcation of, of, well, you know, wait a minute, we're getting some market highs here and we're also seeing assets that are 10 to 15 percent discount compared to what
Joe: they were a year ago. What's interesting about our strategy is that we, virtually everything we buy is off market.
In fact, the more off market, the better. And there are degrees of off market ness. But in many cases, uh, most cases even, we are, uh, the only bidder. So we're in escrow on 55 million worth of deals right now where we're the only bidder on these. It's such a rare market. These are, these are times where we might be the only buyer for the types of assets we're buying.
And because of that, we're able to command, uh, get better prices and be in a non-competitive or less competitive, in this case, non-competitive environment. Yeah. The seller had an expectation that, uh, was perfect for us. Yeah. I know that if they went to the market, they would probably do better, but we were the right buyer and we were able, we are able to execute where others can't.
Ryan:Yeah, and on the flip side, there's such limited properties being listed right now. You've just got a highly competitive, bidded environment, even today, on the kind of openly listed properties because there are so
Joe: few of them. I think we're in a sweet spot. I think we're in a delicate sweet spot right at this moment.
If you looked at three months ago, there was no inventory and no capital. Today, uh, there's, there's There's like a great, a, a, a, a, a reasonable amount of off market inventory and we're seeing, uh, capital flows looking for the things that we're doing right at this moment. I think if you come six months from now, there will be more properties and [00:08:00] more capital.
So it'll be a, a bigger, uh, market. But right at this moment is a, is a really precious spot, so.
Ryan: So let's talk a little bit about the effect of rising interest rates on specific property types and how it varies by
Joe: property type. Yeah, what's really interesting is, uh, with apartments and small bay industrial, the two, uh, property types that we invest in most heavily.
You have shorter leases, you are closer to the consumer, and with inflation, with interest rate rises, that impacts their spending ability more dramatically.
Ryan: Yeah, and that's kind of the, I guess you could say the long tail of value change related to interest rates, because the ultimate effect that the Fed is trying to accomplish is a softening of the economy, a cooling down of the economy to bring inflation down.
And, of course, that means that their ultimate desire is that the end consumer be a little less frothy, be a little less exuberant, and, uh, in many cases, actually see their pocketbook damaged to a point where they don't want to spend. So, on Small Bay Industrial and Multifamily, where you've got kind of constant lease rollover, those property types do tend to be impacted more quickly than kind of long duration office leases or retail.
Joe: The mitigating part of that, though, is that the secondary and tertiary markets we work in have had an influx of population, sort of post COVID. These are people that can spend more than current populations, and there's a shortage of housing, and there's a shortage of warehouse space. And the types of assets we buy, we usually pay about 50 percent of replacement cost.
Which means they cannot build more, uh, easily to satisfy that demand. And so that has continued, even though purchasing power for [00:10:00] consumers has gone down almost 10%, rents have still risen. So it's a really interesting dynamic.
Ryan: Yeah, and I think that also speaks to kind of the long term outlook, which is in areas where there is positive population growth.
They are less impacted than geographies that have seen negative population growth. One of the other impacts that rising interest rates has on real estate is development. And for value-add operators such as us, this is kind of a good thing. In the development arena, it's not. Um, development is financed.
Almost all development is financed. Those rates have gone up significantly. Making the economics of new development harder. Yeah. So you've got essentially kind of a headwind to be able to bring new, uh, inventory to market. We've seen that on, on the small bay industrial side, interestingly, the big box industrial.
So the large distribution space, the Amazon warehouses, I think everyone has seen significant new development in that arena. Everywhere you go, you see new concrete tilt ups going up all these big bomber warehouses. In the small bay industrial space, there's been very limited new development, and that primarily came because rental rates, we were in an inflationary environment, and rental rates still haven't kind of gotten to a point where it justified new development.
Yeah. So we've got a huge supply constraint. And then you add rising interest rates and all of a sudden new development is even harder than it was. And on apartments, we have seen new development, but that new development is now being muted because of the rising interest rate environment.
Joe: On many of the small bay industrial complexes that we own, uh, rents were 50 cents gross five years ago.
Today they're a dollar a net. Yeah. There's been that strong of a demand, and I think part of that is, uh, retail has moved towards warehouse, and, uh, there hasn't been enough warehouse built, and online commerce, and... Those sorts of things have, uh, increased demand. Also more people are working from home, there's more entrepreneurs, there's more smaller businesses.
Ryan: So what does all this mean as we go forward? Really values the change in debt cost, which was an immediate effect on valuation, that's been effectively baked into values today. Everybody underwriting today is underwriting at new debt costs and so therefore the value we're willing to pay is lower as a result of that.
The long tail that we will see continue to play out really has to do on the side of recession, consumer demand, that sort of thing. Depending on how deep that is, it will have a greater or a lesser impact on commercial real estate.
Joe: As I thought about this, you can read the data either way. This is really a tale of conviction and perspective. It's not that the market just goes up or down. There's so many dynamic and moving parts to investing. The type of thing you're buying, the value-add strategy that you can employ, the markets that you're in. You have to, if you're looking for a sad, difficult story, you can find it.
If you're looking for an optimistic, once in a lifetime story, you can find it. I guess by nature, it's our job to be optimists. But, uh, I think we're really enjoying this current moment where there is, uh, much less capital and much less, uh, competition in the market. And larger assets that are, that fit what we do well can more easily be bought at 50 percent of replacement cost.
Especially in markets where demand is very high, vacancy is very low, people want the product. And when you can buy things at half of what it costs to build them new. in great locations. Uh, I think, I think the answer is selectively buy, buy, buy. I think our hold times, which were normally 2 or 3 years, are now 5 to 7 years.
Ryan: Well, and this kind of goes back to, as a professional investor, when everybody is frothy and exuberant and, oh, real estate, it's amazing, everybody should be investing, which is what we had a year or two ago.
That's the time that you kind of have your radar up and you're and you're, you're looking at, okay, what's going to go wrong? And we fast forward to a time today where real estate is pretty much in the headline almost every day, you know, bottom and empty skyscrapers and values going down. These are the times that professional investors like us start to get excited about.
Joe: Well, a year ago or six months ago, you didn't even have the raw materials to do this job. You didn't have the properties to buy and you didn't have the capital to do it with. Today you have those things, but the market still hasn't blessed this asset class. It's still a, uh, it's still, you know, on the dark side, which is probably the perfect time to be a buyer.
Summary
Joe & Ryan discuss how they see rising rates impacting the Commercial Real Estate market, how it affects the firm’s strategy going forward, and what changes they see on the horizon.