Archives for June 2022

There are three reasons why investors are continuing to buy CRE with negative leverage.

Negative leverage has reared its ugly head in CRE investing, as interest rates have risen, and cap rates have remained compressed. One of the most important axioms of a successful real estate investment and development program is to acquire or build real estate with positive leverage. Positive leverage occurs when the cap rate is greater than the cost of debt, which means the return on equity will be greater than the cap rate. Negative leverage is just the opposite and defined as when the cap rate on a property acquisition is less than the cost of debt or debt constant and therefore, the cash-on-cash return is less than the cap rate. The debt constant is the annual debt service (principal and interest) payment divided by the amount of the debt.

When negative leverage occurs, this means the cash-on-cash return or return on the investor’s equity is less than the cap rate and this is a big “No-No” in CRE. This is happening with more frequency in this robust CRE market because interest rates have shot up with the 10-Year Treasury currently at 3.0% and up from 1.48% only a year ago. Apparently, this has caught many real estate investors, even some of the largest and most astute private equity firms in the business, by surprise, as the property they signed a contract to purchase at a 3.5% or 4.0% cap rate only a few months ago, has to be financed with debt that now cost 4.5% to 5.0% or more.

Let’s say an apartment property is purchased for $50 million, with a net operating income of $2 million or a cap rate of 4.0%. If the property is financed with a permanent loan at 70% or $35 million, with an interest rate of 4.50% interest only, the annual mortgage payment would be $1.575 million. The annual debt constant is therefore 4.5% ($1.575M/$35M), the same as the interest rate since there is no loan amortization. Since the cap rate of 4.0% is less than the debt constant of 4.5%, the cash-on-cash return falls to only 2.8% (NOI of $2.0M less the debt payment of $1.575M, equals the cash flow to equity of $425K, divided by the equity of $15M, equals a return of only 2.8%) and this is negative leverage.

One of the most important financial incentives to invest in CRE is to provide the investors with a high cash-on-cash return or commonly referred to as, “levering the equity.” Leveraging the equity is the whole attraction of the CRE investment business. No other alternative investment program like private equity, venture capital and hedge funds provide this simple leveraging technique. The levered equity return structure is inherent in CRE investment and development. In the above example, if the interest rate on the debt was 4.0% and the cap rate was 5.0%, as they were a year or so ago, the investment would have positive leverage as the cap rate of 5.0% would be greater than the debt constant of 4.0% and the cash-on-cash return would be an attractive 7.3% and this is the yield the investors would receive in year one from positive leverage and substantially higher than the 2.8% in the negative leverage example.

Why are investors continuing to buy CRE with negative leverage? I think there are three reasons. One is they have the capital raised in a fund or private placement and are eager to spend it. Two, they believe that rent increases will be high enough in future years to create positive leverage down the road and three, many investors are seeking CRE investment for inflation protection, notwithstanding the negative leverage concerns. However, what if these rent increases don’t materialize and interest rates go even higher or cap rates continue to stay compressed? The halcyon days of CRE investment that we have all enjoyed since the end of the Great Recession in 2012, may be coming to an end with higher interest rates and higher cap rates. It all depends on the Federal Reserve. Is the Fed serious about jacking up the federal funds rate to over 3.0% from only .75% as many of the Fed Governors and Chairman have stated, or are they, “All hat and no cattle?” I believe the latter, but we will know who is correct in the next few months.

Source: “Welcome to Negative Leverage in CRE“

Interest rates help displace demand, so prices fall.

Look at six months of lumber futures and, if you depend on the material in your business, things look downright promising. At $555.9 per thousand board feet, it’s almost like a beneficent construction deity is blessing you with fairer weather and the ability to buy a 2×4 without needing a mortgage.

But look at the five-year view and, while better than recent pricing, the current futures are still $100 to $200 more than they were before all pandemic hell came loose. That may be the future: prices higher than it used to be in the good old days, but lower than just a few weeks ago.

“I believe we are seeing a cause and effect to higher inflation indicators—including rising mortgage rates,” Mickey chief operating officer Alex Meyers tells GlobeSt.com. He thinks that some rough times now and ahead may create conditions more favorable to virtually everyone in CRE.

“Single family home construction/remodeling project lead times are still lengthy due to the existing backlog of orders, skilled labor shortages and ongoing logistics disruptions, coupled with record fuel prices,” he adds. “These factors will price some participants out of the market, allowing for future price corrections and lumber producers to work through an existing backlog of orders while home buyers are less confident to pull the trigger on future projects as economic volatility looms on the horizon.”

In other words, “The big picture here is that interest rates have risen, and they will reduce the number of new home buyers,” MaterialsXchange CEO Mike Wisnefski tells GlobeSt.com. “At the start of the year the whole industry was very optimistic about the amount of business coming in 2022 and concerned about building materials pricing going higher so they built large on ground inventories of materials. As the overall industry builds an inventory, ‘apparent demand’ is strong, and prices do indeed go higher.”

But when the demand slows, as higher interest rates and costs of projects do, the built-up inventories get drawn down, that apparent demand falls, and prices move lower.

Will they keep dropping? “We believe that they will trade above long-term averages for the balance of the year,” Josh Goodman, vice president of inventory and purchasing at Sherwood Lumber, told GlobeSt.com earlier this month.  “However, in the short term, lumber is down more than 50% from the most recent peak.  The market is trying to determine where the new price equilibrium is compared to slowing demand and increased supply.”

Source: “The Lumber Roller Coaster Takes Another Price Dive“

Some industry experts estimate that industrial assets represent nearly half of all corporate sale-leaseback transactions in a market that’s been rife with deal activity.

The corporate sale-leaseback market is coming off a record-high first quarter for deal-making. Despite repricing occurring in the wake of rising debt costs, industry insiders remain optimistic of continued strong momentum ahead in the remainder of the year.

The $8.4 billion in sales logged in first quarter is on par with fourth quarter 2021 activity and nearly triple the $2.9 billion in transactions recorded in the first quarter of 2021, according to a market analysis by SLB Capital Advisors. “That is the biggest first quarter that we’ve seen. The dollar volume was driven largely by two casino deals, but the 186 is the highest count that we’ve seen over the last few years by a good 20 to 30,” says Scott Merkle, managing director of SLB Capital Advisors.

The casino transactions included VICI’s acquisition of the Venetian Resort, Expo and Convention Center for $4 billion and GLPI’s acquisition of two Cordish Companies’ Live! properties for $674 million. Merkle also attributes activity to the huge volume of M&A activity that occurred in 2021.

Traditionally, companies use sale-leasebacks as a financing tool to monetize or “unlock” 100 percent of the equity tied up in real estate. That capital is often used to reinvest back into the business, improve balance sheets or finance expansion. Another catalyst for sale-leasebacks is M&A activity, with the acquiring entity using a sale-leaseback on the real estate of the business they are buying to help finance the acquisition. According to BMO Capital Markets, the U.S. saw 478 M&A transactions last year that were valued at nearly $1.9 trillion.

“A lot of times what we see on the M&A side is groups that will utilize that sale-leaseback as part of the capital stack, and there was an incredible amount of M&A activity last year,” says Jeff Tracy, a director at the Stan Johnson Co. in Tulsa, Okla. A sale-leaseback of the real estate can bring in 20 to 30 percent of the overall capital stack needed, which helps to reduce the amount of equity and/or debt a buyer needs to bring to the table, he adds.

Some industry experts estimate that industrial assets represent nearly half of all corporate sale-leaseback transactions, and expansion of the industrial sector over the past few years has provided fresh inventory for eager buyers. “Our business has never been more brisk. We are seeing a lot of activity as corporate users continue to look to monetize their industrial real estate and corporate-owned facilities, because they realize it’s a better use of funds to be able to put that capital to work within their business,” says Erik Foster, a principal and head of industrial capital markets, Capital Markets at Avison Young in Chicago.

Market adjusts to higher rates

The broader market is adjusting to higher costs of debt financing for real estate, which has climbed 150 to 250+ basis points since January 1. Although sources agree that rising interest rates haven’t changed the volume of sale-leaseback deals that are getting done, it is resulting in price adjustments and fewer bidders. “As debt has gotten more expensive, buildings can’t sell as aggressively as they did a couple of months ago,” notes Foster.

On average, cap rates have increased between 25 and 75 basis points, depending on the building, location, tenant and term. “The better locations and better credits are going to be less impacted, because there is a significant amount of capital still out there that is chasing deals,” says Tracy. The smaller or more challenging credits and tertiary locations are seeing bigger moves in cap rates, he adds.

Although there is still significant capital targeting sale-leasebacks, the bidder pool has thinned with some investors that have pushed pause amid the repricing that is occurring. Instead of getting 10 offers, a sale-leaseback listing might get six or seven now, because buyers are being more cautious, notes Merkle. SLB Capital Advisors is currently working on a sale-leaseback of an industrial portfolio valued between $75 million and $100 million. First round offers came in during the first week of April with nine groups that advanced. Typically, buyers increase their offers when moving to the second round. However, due to the rise in interest rates, many moved in the opposite direction, lowering their price. The deal is under LOI and moving forward, but the pullback on bidding speaks to how buyers are moving more cautiously, notes Merkle.

Stan Johnson Co. is working on the sale-leaseback of a portfolio of properties for a recreational vehicle business. One of the bids received was structured with a floating cap rate. The bidder included a cap rate range that allowed the seller to choose the rent level they wanted to set, as well as a fixed basis point spread over treasury to account for rate fluctuations.  So, depending on how rates moved prior to the deal closing, the cap rate also could move. “That is something I haven’t seen before, and I think it points to the fact that groups still have a desire to get deals done and they need to deploy capital. But they’re trying to be creative as possible in not only making sure they are competitive, but also protecting themselves from a downside scenario of a big interest rate move,” says Tracy.

Avid buyer interest

Rising interest rates could cool what has been a white-hot seller’s market for sale-leasebacks over the past year. However, industry participants are still optimistic about the near-term outlook. “While cap rates have risen, real estate is still at incredibly attractive levels for owner-operators to monetize their real estate in a sale-leaseback,” says Merkle. When one looks at sale-leaseback from a multiple perspective, multiples on real estate that might have been 15x are now 14x. Those numbers are really compelling for a business to execute a sale-leaseback when their business is worth multiples of say 8-10x, he adds.

SLB Capital Advisors has seen an uptick in pitch activity, inquiries from companies considering a sale-leaseback on assets, in recent weeks. “So, in spite of the pricing environment shifting rapidly over the past 45 days, we’re still in an environment where there is a ton of activity, and I expect to see a lot of continued sale-leaseback activity through the balance of the year,” says Merkle.

Another reason for that optimism is that there is still a significant amount of investor capital aimed at sale-leasebacks. “The buyer pools are more diverse and deeper than I have ever seen in my career, and that continues to put pressure on pricing and provides owners with great liquidity options,” notes Foster.

W.P. Carey Inc. alone recently announced that it had entered into $400 million in new investment agreements since the end of first quarter. The net lease REIT specializes in corporate sale-leasebacks, build-to-suits and the acquisition of single-tenant net lease properties.

In addition, more investors have entered the sale-leaseback market looking to acquire assets. “There has been a huge wall of capital looking to be deployed into sale-leasebacks. We’ve seen even more buyers step up to the plate over the last 12 months or so,” says Merkle. Some buyers are moving more cautiously, but there is still a lot of capital available for sale-leasebacks, he adds.

Source: “Buyer Demand Remains High for Corporate Sale-Leaseback Deals“

It’s another 40-year high and no signs yet that price hikes will cool off.

The CPI calculation—consumer price index, or what’s commonly called inflation—was expected to run warm, but not like a Miami August afternoon on the beach without an umbrella for shade.

“A Labor Department inflation report proved many traders were wrong with identifying peak inflation,” wrote Edward Moya, senior market analyst for the Americas at OANDA, in a note.  “Everything came in hot [Friday] with today’s CPI data, the monthly core reading, the headline number, and a much stronger dollar will further fuel inflation here.”

Or, as Sean Bandazian, a senior investment analyst at Cornerstone Wealth, told Business Insider, CPI was “stunningly high.”

The news has a number of significant and potentially troubling implications for the CRE industry.

Start with interest rates. Those who hoped the Fed might see a cooling in inflation and hold off on some future rate hikes are likely to be disappointed.

“The surprise increase in headline inflation to 8.6% in May, from 8.3%, together with another strong rise in core prices raises the odds that the Fed will need to extend its series of 50bp rate hikes into the fall, and even opens the door to a larger 75-bps move at next week’s FOMC meeting,” Michael Pearce, senior U.S. economist at Capital Economics, told Reuters.

As if rising rates weren’t enough problems in CRE. Historically, a slight increase isn’t the worst the industry has seen. But the runup to inflation was riding on incredibly cheap money. Even now, interest rate caps alone are causing many transactions to evaporate. Those, and the ultimate rates themselves, are only going to get larger, making the dynamics of investments and projects trickier, in turn putting downward pressure on prices.

CRE sales are already beginning to slow. That will likely continue. But there may also be an increase in some sales, possibly at distressed pricing, because the five-year refinancing rule of thumb says that in any given year, 20% of deals will need to be refinanced. If the existing operating dynamics were built on low interest rates, higher ones could make them untenable.

Then there are direct and indirect effects of inflation. To date, the producer price index for construction, which doesn’t include labor or land, has been running about three times as high as the CPI. Will that differential continue? Perhaps not, but if there is an effect, the roughly 20% to 21% year-over-year increase will push building costs up even more.

As for the indirect issues, there are all those companies leasing space and consumers renting apartments and houses. Higher inflation means tougher times all around. Consumers, in particular, are glum. The University of Michigan consumer sentiment numbers crashed, approaching the figures for the depths at the end of 2008. As Jeffrey Roach, chief economist for LPL Financial, wrote in a note on Friday, “The crash in sentiment means that consumers are more and more worried about future economic conditions. Consumers are more pessimistic about future income with overall sentiment at the lowest on record going back to 1978.”

This is seriously glum. If consumers are right, they’re going to pull back on everything and may not have the money to keep up with rent increases. Landlords and operators may find themselves with challenging circumstances and no government help this time if there are widespread problems in people lacking the money to pay for their housing.

Source: “8.6% Inflation Means Serious Planning for CRE“