Archives for April 2022

But a new analysis from First American Financial Corporation suggests that there’s a bottom to cap rates the industry is reaching.

Think cap rates are crazy low? They could drop even more as investors battle to own CRE income streams, according to a new analysis from First American Financial Corporation. But the firm says cap rates may be reaching a cyclical bottom.

For most of the last 20 years, the average cap rate across office, industrial, retail, multifamily, hotel, and senior housing has been dropping and is now at a period low “due to today’s low interest rate environment and the limited supply of commercial real estate properties relative to strong post-pandemic demand,” Xander Snyder, senior commercial economist at First American, said in prepared remarks.

The firm has a model it calls the potential capitalization rate that “estimates capitalization rates based on the historical relationship between interest rates, rental income, prevailing occupancy rates, the amount of commercial mortgage debt in the economy, and recent property price trends.” It’s a theoretical bottom to cap rates. If the actual cap rate is higher, then, according to the model, there is room for rates to fall even more.

Since 2017, the potential rate has sat below the actual rate because of low interest rates that “reduced financing costs and increased buying power for CRE investors,” Snyder said.

In the last quarter of 2021, the actual cap rate hit 5.2%, a record low, but the potential cap was 4.4%. That means property price growth might still top income growth.

However, the zero-interest rate regime is officially over. With inflation rising faster than anyone is comfortable with, financing costs go up and buying power recedes. “The potential cap rate, as supported by market fundamentals, may be as low as it can go,” said Snyder. “However, since the actual cap rate remains above the potential cap rate, the actual cap rate could still go even lower as CRE investors compete with each other for the income streams that commercial real estate provides.”

As always, remember that models are approximations, not absolute representations of reality. The factors that First American has considered are clearly important, but there may be others, even ones specific to particular locations, that might be at play. Also, averages aren’t ultimately descriptive. The specifics of properties and locations can turn generalities on their heads, so bring questioning and local analysis to play.

Source: “Property Prices Could Rise With Cap Rates Poised to Fall Even Further“

As companies experiment with hybrid work, fit outs will increase, creating even more demand for materials and labor.

Increased delays, more uncertainty and higher costs appear to be the name of the game for office fit outs across the US this year, as supply chain challenges continue to plague deliveries.

That’s according to a new fit out guide from Cushman & Wakefield, which notes that “there does appear to be some light at the end of the tunnel” as the supplier delivery index, which measures manufacturer delays, has been declining since mid-2021.

The supply chain stress indices for both the US and China ended last year up 40% over pre-pandemic levels, according to the Federal Reserve Bank of New York. All the while, construction starts have been posting above-average numbers, led by industrial and residential. But office construction also remains elevated, with 118 msf in the pipeline—a figure that’s 43% above the 20-year historical average.

And as occupiers rethink their return-to-work strategies, office space usage will increase, according to Cushman & Wakefield experts.

“We expect organizations will expand their piloting and testing of different types of layouts related to hybrid work,” the fit out guide states. “This is likely to increase the amount of fit out and office space construction activity in the coming quarters, creating even more demand for materials and labor.”

Just 2% of contractors surveyed by Cushman believe that lead times had remained constant; the rest say lead times increased slightly (16%) or significantly (82%) over the previous six months. And a fourth of those surveyed said they hadn’t experienced lead time increases at all.

Contractors are also more optimistic about material lead times, with half of those surveyed saying they expect lead times to continue to increase “significantly” and 12% saying they expect no further growth.

“Experienced project development teams are required to ensure delays caused by material and labor challenges are planned for and mitigated,” the report notes.

Across all markets Cushman surveyed, electrical is the largest category for fit out costs, accounting for 21%, followed by mechanical at 18% of the total. In cities like Charlotte, Raleigh, Los Angeles and San Francisco, electrical accounts for more than 26% of the total. And mechanical costs account for more than 20% of all costs in fourteen markets across the US and Canada.

Drywall, acoustic and carpentry account for 12 to 15% of total costs, with highs of 20% in Toronto and 17% in Montreal.

Source: “Office Fit Outs Have Become More Expensive And Uncertain“

The Fed is poised to implement more hawkish policies, so “be ready for rate hikes.”

Parsing the minutes of last month’s Fed meeting had many commercial real estate experts reading between the lines of what might happen to the sector in the short term, particularly as many within the Fed are advocating a 50 basis point increase in the overnight rate.

Ultimately, the Fed stuck to a 25 basis point uptick, but “the minutes suggest that one or more 50 basis point increases could be appropriate if inflation pressures remain elevated or intensified,” said Marcus & Millichap’s John Chang in a recent video.

“That suggests the Fed could raise the overnight rate by more than 200 basis points this year.”

The Fed is also actively discussing a balance sheet reduction, or quantitative tightening.

“During the pandemic, the Fed used quantitative easing to keep long term interest rates down. They were buying $120 billion in Treasuries and mortgage-backed securities each month…and in two years, they doubled their balance sheet,” Chang said. “And now, they’re going to start reversing that.”

He explains that by using quantitative tightening, the Fed can push up long term interest rates, reducing the chance of a yield curve inversion. The two-year Treasury already pushed into the 10-year rate a few weeks ago, causing a brief inversion. But that flipped as soon as the Fed minutes were released last week indicating that they’ll likely use quantitative tightening.

Chang says that while the minutes didn’t provide specific timing or guidelines, it did suggest reducing the Fed balance sheet by up to a proposed limit of $95 billion per month, with most of that being through the natural maturation of Treasuries and mortgage-backed securities.

For investors, this means that the Fed is worried about inflation, and “they’re going to implement more hawkish policies,” Chang says. “Be ready for rate hikes.”

Those increases could be up to 2.5% this year, according to some estimates. And while quantitative easing will be used to “theoretically reduce” a recession risk, the 10-year Treasury could still get pushed to 4% by the end of the year.

Chang notes that the probability of a recession in the next two years is “elevated but it’s not a foregone conclusion,” pointing to strong wage and employment growth in the first quarter.

“Those are all positive forces supporting economic growth,” he says. “For now investors should really focus their strategies on inflation risk and be prepared for interest rates to rise substantially. But remember—investment real estate is one of the best places to be in economic cycles like the one we’re in.”

Source: “What the Fed Minutes Mean for CRE Investors“

New lease pricing should continue to increase throughout the summer after rising 20% over the last eight months.

Multifamily rents have increased significantly for new leases while concessions have tanked—and the sector is showing no signs of cooling off, according to a group of analysts from MRI Software.

“Two years after the onset of the COVID-19 pandemic, the multifamily market finds itself in a familiar position entering peak season: unemployment has returned to historical lows, housing demand continues to be strong, new supply continues to lag need and housing affordability is back in the headlines,” the report says. “These macroeconomic factors, which are normalizing as we move from pandemic to endemic, are setting up owners and operators for strong pricing power as seasonal demand peaks arrive.”

MRI predicts that new lease pricing should continue to increase throughout the summer after ticking up roughly 20% over the last eight months.  Data from Yardi Matrix reveals that multifamily asking rents ticked up yet another $10 in February to hit a national average of $1,628, with year-over-year growth also posting a 15.4% increase.

And the increases won’t be limited to new deals, either. “The widening gap between market rate and in-place lease rates will likely lead to aggressively higher renewal offers intended to close the gap, or to drive new availability that will be filled at current higher market rates,” MRI experts predict, adding that some renewal offers may feel “brutal” to existing residents.

That will be particularly true as concession volumes have returned to pre-COVID levels.  Concessions peaked last summer as operators used discounts to lure new residents into their communities but have decreased steadily since against a backdrop of rising prices and surging demand.

On-time payment performance has also bounced back in recent months and is near pre-pandemic levels, according to MRI.

“It’s already a landlord’s market,” says Brian Zrimsek, Industry Principal, MRI Software.  “And we’re about to enter the summer season, which traditionally is the most active and lucrative season for leasing. Given the other market forces we’re experiencing, such as low unemployment, low supply of new housing, and high inflation, we can expect a challenging summer for renters.”

Source: “Expect Another Big Summer for Multifamily“