Archives for June 2022

Multifamily apparently is not immune to the forces of gravity after all.

Forty-five days ago, a multifamily asset on the market would receive bids from 30 groups, unintentionally driving up the price for the property. Today, the buyers are still there but there are fewer of them and many of the deals aren’t hitting their whisper price, according to Noam Franklin, Managing Director – Head of Eastern US, JV Equity & Structured Capital Group, at Berkadia. “Almost every deal I’ll ask if the whisper price has been hit and the answer is no,” he tells GlobeSt.com. “There still is a healthy return but there is some discount,” usually around 6 to 10%.

Multifamily, as healthy and robust as the asset class is, apparently is not immune to the forces of gravity after all. The same economic uncertainty the greater markets have been experiencing, led by spiraling inflation and rising interest rates, is nibbling around the edges of the apartment asset class with some clear effects. For many in the market, these cracks in the market may be worrisome but for Franklin they spell opportunity. Franklin represents institutional equity in the housing market and for the last year many of the multifamily deals he has sent over have been too rich for institutional capital seeking out value-add JV investments. Once they would unwind the rents and pencil in the money on upgrades, they would find that the return was not equal to the risk they would have to take. So these life companies, private equity providers and pension funds, for the most part, stayed on the sidelines instead of investing through JVs.

Instead, what they did was take a barbell approach, Franklin explains, blending some ground up deals, some core plus and so on to reach a value add return.

The multifamily market hardly noticed the difference given the abundance of private and GSE capital that has been targeting the space in recent years. “The feedback we received from sponsors was that, at the right time when we need an institutional partner we will call,” Franklin says. They rarely did.

The environment has changed dramatically in the last several weeks, Franklin says. “Now, for the first time we have value-add JV deals that our capital relationships can go to committee with and get approvals. Before that, prices were so high it was hard to make sense of it from the perspective of an institutional partner. Now, suddenly, the phone is ringing off the hook.”

Sponsors are finding they are not getting the leverage and pricing they thought they would get 30 days ago. They might go to their network and find they can only raise, say, $12 million instead of $30 million. Franklin is also seeing cap rate expansion in several markets. “For example, we have a client who is tying up a deal in Phoenix right now and the cap rate is in the mid 4s and we haven’t seen a multifamily deal in Phoenix trade above a 4 in a long time. I am confident that deal will tie up at a mid 4 cap rate.”

None of this is to say it has become a buyer’s market or that there will be serious distress in the market. “But it is much more a buyer’s market now than it was 30 days ago,” Franklin says. And institutional capital is ready to jump in.

Source: “Multifamily Dealmakers Aren’t Hitting Their Whisper Prices Anymore and Institutional Equity Is Moving In“

But it varied a lot in Q1 by type and the future is uncertain.

If you’ve been invested in commercial real estate, you’ve had a superb trailing four quarters—on average. But that depends on what properties your money sat. As for the future, that’s looking uncertain.

Aegon Asset Management, in its June 2022 US CRE market insights, gave the initial data credit to the National Council of Real Estate Fiduciaries (NCREIF) Property Index. For the four quarters that ended in March, try a 21.9% total return: income return of 4.2% and capital appreciation, 17.2%. That’s better than the previous 17.7% in 2021.

Aegon called it “a continuation of the extraordinary total returns produced during 2021.” Hard to argue with the wording. But, depending on the property type, things split out quite differently.

Industrial was on top with a total of 51.9%. Multifamily, which has been second mentioned by many in the field, saw 24.1%. But remove those standouts from the average and the returns of other property types didn’t have the pizazz. Retail only managed 7.1%, and office, 6.8%.

Time for a breath, because after “these stunning results … investors are eyeing the challenges above,” Aegon noted.

The big and immediate elephant in the room is the Federal Reserve’s response to inflation. The agency is trying to manage a double challenge in its mandate: cool inflation without sending the economy into a recession and setting unemployment numbers sailing.

But the ongoing strength of the jobs market, with roughly 2 empty jobs for every person looking, likely means, as Fed watchers are saying, a higher interest rate hike than the 50 basis points that had seemed to be in the cards. Back in January, Fed Chair Jerome Powell said at a Senate Banking Committee hearing, “If we see inflation persisting at high levels, longer than expected, if we have to raise interest rates more over time, then we will.”

With the increasing pace of inflation, there’s a strong chance that the Fed will raise its benchmark interest rate by 75 to even, yes, 100 basis points.

“Commercial mortgage lenders are absorbing some of the rate increase by squeezing spreads but borrowing costs are increasing albeit with ready availability,” Aegon wrote. “The increase will make it tougher for investors to hit performance targets if historically low borrowing costs had been assumed to continue indefinitely.”

A faster increase in interest rates could also set off a so-called hard landing, especially considering ongoing supply chain problems, the war in Ukraine, and ongoing Covid problems in some major manufacturing areas, like China.

Then there’s also uncertainty about whether companies will use office space the way they used to, what will happen in housing as prices continue to rise faster than household incomes, and how some big industrial space users are backing off from what had until recently been a warehouse acquisition mania. And, of course, if consumers are being hit in the wallet, retail will eventually share the pain.

Source: “CRE Investment Performance Has Been Sizzling“

This isn’t a guarantee of a recession, but one seems more likely to happen than not.

For those in commercial real estate worried about the immediate economic future, today brought a double dose of bad news.

First, in order of occurrence, the Atlanta Fed gross domestic product (GDP) tracker just indicated an update of estimated second quarter economic growth: 0%. Then came the moment many had been steeling themselves for. The Federal Open Market Committee of the Federal Reserve raised its benchmark interest rate by 75 basis points, the largest since 1994, according to multiple outlets, and a jump up from the 50 bp increase that the Fed had previously telegraphed.

As of 2:15 eastern, markets, while not joyous, are taking the changes in stride. The S&P 500, Dow, Nasdaq, and even the Russell 2000 are all up from yesterday. That may be because there were already expectations of the higher Fed hike and the GDP estimate news having come out earlier today. It might also be that investors are happy that the Fed is taking stronger action in an attempt to bring inflation under check. But there could be repercussions for CRE.

Both the events are significant. On June 9, the Atlanta Fed’s estimate had dropped from the previous 1.3% at the month’s opening to 0.9%. Hitting zero in the middle of June means plenty of time for an estimate to swing into the negative.

This isn’t a definitive sign of a recession. A couple of quarters of negative GDP growth are only a rough rule-of-thumb for a recession, not the final call made by the National Bureau of Economic Research. However, it’s not a good sign. As the Atlanta Fed wrote, “After recent releases from the US Bureau of Labor Statistics, the US Census Bureau, and the US Department of the Treasury’s Bureau of the Fiscal Service, the nowcasts of second quarter real personal consumption expenditures growth, second quarter real gross private domestic investment growth, and second-quarter real government spending growth decreased from 3.7 percent to 2.6 percent, -8.5 percent to -9.2 percent, and 1.3 percent to 0.9 percent, respectively.”

The Fed’s 75 basis point increase in interest is the largest jump since 1994, according to multiple outlets, and higher than the 50-basis point increase that had originally been expected.

Each of the events has a potential impact on CRE. The Fed’s rate increase will ultimately mean higher commercial loan interest rates. Interest rate caps have moved so high that they are killing many deals by making them unprofitable. Higher interest also means that refinancing deals that initially depended on cheap money could become a challenge.

“The increase in rates is likely to have a negative impact on asset prices, as potential buyers are expected to face higher borrowing costs, and lenders will likely be cutting down leverage so the property can cover high interest expenses,” Mitchell Rosen, managing director, head of real estate at Yieldstreet, tells GlobeSt.com. “However, as interest rates continue to increase, more and more people will look to put-off their home buying decisions which should result in higher occupancy and tighter rental markets within the multifamily sector of CRE.”

As for a recession, that’s bad news for companies and for consumer spending, which could mean more impact on retail and office properties, to say nothing of additional areas of impact from higher interest rates.

Source: “New Fed Numbers Show Zero GDP Growth at Best“

REIT balance sheets remain strong and management teams believe they are prepared to weather any economic setbacks.

REIT share prices have fallen as the broader stock market prices in interest rate hikes and the potential of a recession. But at the same time, REIT executives remain bullish about near-term real estate fundamentals in their portfolios and confident in how their balance sheets are positioned for any coming turbulence.

The current REIT repricing period began with Amazon’s earnings announcement in May, when the firm also announced its plans to return about 30 million sq. ft. of industrial space to the market. Since then, total returns for the FTSE Nareit All Equity REITs index are down a little more than 15.5 percent, including down more than 10 percent in June alone.

It was with that backdrop that more than 2,500 attendees and management teams from more than 170 REITs attended Nareit’s annual REITWeek event in New York City. There, the tone was decidedly more upbeat.

WMRE sat down with Nareit Executive Vice President and Economist John Worth to discuss highlights from REITweek and the current state of the market.

This interview has been edited for style, length and clarity.

WMRE: Can you put the current performance of publicly-traded REITs into context? What does the current selloff signify?

John Worth: We are in the middle or tail end of this repricing period for REITs and the broader stock market. With REITs, you can almost gate it to the Amazon earnings announcement in May. And over the last six weeks there’s been a repricing cycle where investors are pricing in rising rates and the prospect of slower growth. When we look at the all equity REIT index from the beginning of May through Monday, it is down a little more than 15.5 percent. In June, it is down 10.9 percent. May was not a great month. It was quite bumpy because of the concerns about pricing and rates and the slowing economy and that’s only been exacerbated in the early part of June.

What’s interesting related to that in the context of REITweek is that we talked with REIT management teams and they remain very upbeat about current operating performance. We heard from more than one team that in terms of operations, it’s all green. Occupancies are up, rents are up and current earnings trajectories look really good. They are upbeat about current performance and the near-term outlook is very positive. At the same time, they understand we could have a period of slower growth ahead and they are preparing for that period.

They feel confident about their ability to weather an economic slowdown. And we know they are well-positioned for higher rates with leverage at all-time lows and the debt they have is very well structured and termed out more than seven years. Very little REIT debt is coming due in the next two years.

Current operating performance remains quite good. First quarter FFO was at an all-time high. Balance sheets look great. But the outlook for the broader economy has really soured over the last six to eight weeks. And today, this week, we’ve got a lot of pricing activity ahead of the Fed [meeting]. It’s a very turbulent time. That said, when we look at REIT performance during periods of inflation, REITs outperform. And we are not seeing anything in the data to indicate that this period should be any different from previous inflationary periods.

WMRE: Aside from the high-level themes there, were there any other standout observations from conversations during REITweek?

John Worth: We heard consistently that transactions are where we are seeing the higher-rate environment really impact things. The pace of transactions has slowed down. And we heard color that the bid/ask spread has really widened. Sellers want yesterday’s prices. Buyers want tomorrow’s prices. And we haven’t seen consensus cap rates adjust to the new rate environment. It’s almost a certainty that will be addressed. We won’t see that many deals get done with negative leverage.

The other theme with higher rates: When you have a period with a part of the market that uses a lot more leverage, REITs with their conservative balance sheets and dry powder may be the beneficiary of deals that other investor groups can no longer participate in. As we see rates maybe scare away some buyers, that can be a great opportunity on a target basis to find some unique opportunities.

In other words, if your business model is based on 60 percent to 65 percent leverage and you find that’s not going to work in an environment with 3 percent Treasuries and 150 basis point spreads to Treasuries, all of a sudden that creates opportunities for lower levered strategies to come in.

WMRE: The other thing we heard was that there was a lot of buzz during the conference about the potential Prologis/Duke merger and then we saw that deal come to fruition on Monday.

John Worth: The deal is a continuation of one of the things we’ve talked about before. Over the past 18 months what have struck me as the most interesting M&A deals have been REIT-to-REIT, public market-to-public market transactions. And this is just the latest. REITs in the same sector are finding they have complementary assets and complementary management teams. They can grow in scale, having bigger operating platforms, lower their cost of capital and set themselves up for future growth. This deal fits that to a tee. And it’s also been a deal that has been extremely well-received among sell-side analysts. At $26 billion, the deal is only surpassed by Blackstone buying Equity Office for $39 billion in 2007 and Brookfield’s acquisition of GGP in 2018 for $27 billion.

WMRE: Can you talk a little about inflation? There was a time that the consensus was inflation was temporary, but it’s remained high and now drawn a policy response.

John Worth: Sitting here a year ago, we would have said, “As we get an increasingly vaccinated world and economies open up, it’s going to be bumpy, but the supply chain will sort it all out.” So we would have expected that to moderate. But now between the war in Ukraine and its effect on food and energy prices and continued disruptions to the supply chain, such as China’s “COVID zero” policy that led to whole cities shutting down, we’ve seen inflation continue in the U.S. and globally.

In the most recent figures we saw core inflation continue to moderate a bit. And what we watch carefully is “services exc. energy.” And what’s happening in the economy outside energy and goods sectors has been a concern. We’ve seen that number continue to rise. The risks of a wage/price spiral are higher than they were. But the current drivers of inflation continue to be geopolitical events as opposed to a wage-price spiral. And that’s where the Fed policy becomes so difficult. Raising the Fed Funds rate doesn’t do anything to reduce food and energy prices. So, you really are trying to push on an aggregate demand lever that is only tangentially getting at the most meaningful and most direct drivers of inflation. We have seen Fed policy have an effect on the housing market. It’s taken the life out of the refinancing market and its now having an impact on single-family home sales. That should take some heat out of the economy. But the question remains: Can you find that goldilocks policy and create a soft landing and reduce inflation and not put the economy in recession? When you look at consensus forecasts, the optimism for that scenario has diminished. There’s a consistent reduction in consensus forecasts for growth for 2022 and 2023.

That’s the slower-growth environment in which REIT management teams are saying, “We’re not seeing it in our operating performance, but we are ready for it when it comes.”

Source: “Publicly-traded REITs Weather a Repricing Period“