Buyers are beginning to ask for discounts and some deals fall through. But experts say the disturbance in the sector is based on “short-term uncertainty.”

In early June, two days before the Federal Open Market Committee increased the Federal Funds Rate by 75 basis points, Odyssey Properties Group struck a deal to buy a multifamily asset in Dallas at a 3.5 percent cap rate. The Los Angeles-based real estate investment firm was hoping to add the garden-style property to its existing portfolio, which consists of 44 properties comprising 7,217 multifamily units across 14 states with a total estimated value of more than $1.5 billion.

As Odyssey progressed toward a purchase and sale agreement (PSA), it struggled to obtain a float loan, so it put the purchase on hold, according to Derek Graham, president and principal at Odyssey. By late July, the firm had nailed down an agency loan and resumed discussions with the seller, who’d bought the property for $18 million in 2019.

For Odyssey to achieve the same returns it had projected just six weeks earlier, the firm needed the seller to reduce the price by $3 million, or roughly 10.5 percent off the original price of $28.5 million.

“Even with that decrease, the seller would have achieved an amazing return, given what he paid for it,” Graham notes.

The seller was willing to shave $1 million off the purchase price—a decrease of roughly 3.6 percent. To no one’s surprise, the deal ultimately fell apart.

“The seller’s question to us was: ‘Why should I sell for less?’,” Graham recalls. “I understand his position because I’m an owner too. The reality is that rents are increasing anywhere from 12 to 20 percent, and he’ll be able to increase his net operating income, probably by 15 percent or more. And if he decides to sell a year from now, he will have recouped the $3 million reduction that I needed to close the deal today.”

Shaking off the lost deal, Odyssey shifted its focus and locked down a multifamily property in Phoenix at a 4.4 percent cap rate. Unlike the Dallas owner, this one was “willing to meet the market,” according to Graham.

Odyssey’s experience certainly isn’t unique. In fact, it has become quite common in today’s uncertain investment sales climate. There has been a bit of a standoff between buyers trying to achieve a certain yield and sellers insisting on their original price, Graham notes. The sellers haven’t adjusted their expectations to an environment with higher interest rates.

“Just 90 days ago, their asset was worth a 3.5 cap rate, and they’re resistant to making needed adjustments. For us buyers, debt is now more expensive, so we need a 10 to 15 percent discount for a deal to generate the same kind of return potential.”

Diminished investor confidence

After the Fed’s initial rate hike in March, many multifamily sellers were willing to work with buyers and re-trade assets at 3 to 5 percent less than original agreements. The embedded gains that investors have achieved in recent years certainly helped by providing more flexibility to give some back to buyers so deals can get done, notes Brian McAuliffe, president of capital markets, who leads multifamily investment sales business at commercial real estate services firm CBRE.

However, with each successive rate hike, the buy-sell gap has widened. Experts estimate that valuations have decreased from 8.0 percent to 15.0 percent, with core assets in growing markets landing near the low end of the range and value-add opportunities hitting double-digits.

Because data detailing recently closed deals is not yet available, it’s difficult to pinpoint exactly how much valuations have reset. Furthermore, investment activity has slowed significantly over the second quarter, making it even more difficult for investors to confidently value properties.

“Right now, it seems like market participants—buyers, sellers, and lenders—are all looking for data for confidence,” says Martha Peyton, global head of real assets research at Aegon Asset Management.

No motivation or desperation to sell

Many owners are paralyzed by indecision, unsure whether they really want to sell off their multifamily assets, according to Kurt Houtkooper, CEO of Hamilton Zanze (HZ), a San Francisco-based real estate investment company that owns and operates 132 properties totaling 22,821 units across 17 states and 30 markets.

“Owners know valuations have changed, so they don’t feel very motivated to sell, and fundamentals are so strong, there aren’t a lot of desperate sellers either,” Houtkooper notes.

Since its founding in 2001, HZ has acquired more than $5.9 billion in multifamily assets. The firm’s strategy is to buy an asset that it thinks is broken, fix it and sell it once it’s stable. Then, the firm will do a 1031 exchange, investing the proceeds into another property.

“We’re a value-add shop, and we’re going to buy and sell through the cycles,” Houtkooper says, adding that earlier this year, the firm decided to dispose of several properties and has no desire to deviate from that plan. “We’re still selling the properties that we planned to sell, and we’re still making a profit, just not as much as we would have if we’d sold in January 2022.”

Beyond valuations, owners might be hesitant to sell because there are fewer properties on the market. Odyssey’s Graham likens the current environment to a game of musical chairs, where if an investor sells a property, it might be a challenge to find a replacement asset.

Shallow pool of quality buyers

Many buyers who have been active over the past few years are now on the sidelines, closely watching the action in the “field.” Houtkooper estimates that the buyer pool has decreased in terms of size and quality. He notes that four months ago, the firm was getting 30 offers and today it’s getting about 10, and those 10 offers may not be as high quality as they were previously.

He also adds that buyers have returned to the traditional due diligence period after three years of offering non-refundable money from day one.

That’s a bummer when you’re a seller, but a boon when you’re a buyer. “We like it when there’s less competition,” Houtkooper says. “Our thought is that we might sell at a discount, but we’ll also be buying at discount.”

HZ’s strategy to combat higher interest rates and increased cost of capital is to seek out properties with existing assumable debt. Currently, the firm is in the middle of acquisition process for two apartment communities in Tennessee totaling roughly $150 million. It will assume agency loans for both properties and expects to achieve a positive arbitrage on cap rates, according to Houtkooper.

“By assuming a loan, we know the loan constant, and we’re taking out market volatility,” he says.

Aegon’s Peyton says well-capitalized and respected buyers have increased leverage in this market. “As a function of changes and uncertainty in the capital markets, buyer credibility has certainly become of increased focus during seller due diligence,” she notes. “Operators with less reliable capital sources are being scrutinized much more heavily.”

Of course, all-cash buyers continue to hold the power position over buyers who use debt to acquire assets, even those like HZ, which boasts a balance sheet that is strong enough to assume loans.

How much will valuations continue to shift?

Industry players predict that investors will have a much better handle on the market by the fourth quarter, which should help stabilize valuations.

“If multifamily properties continue to perform well and rents continue to increase, I would be very surprised if there was another large shift in values,” says John Sebree, senior vice president and national director of Marcus & Millichap’s multi housing division. “They might slide up and down a little, but I think the big shift has already taken place.”

Sebree expects that once valuations stabilize, investment activity will pick up as well. He notes that here is little concern in the industry about multifamily investment levels and property fundamentals in the sector in the next five to seven years. The current market hesitancy is about short-term uncertainty, he notes.

Graham says his firm will continue to pursue multifamily acquisition opportunities even if interest rates continue to increase (as the Fed has indicated). “Our industry got intoxicated on cheap debt in 2020 and 2021, but interest rates are pretty much exactly where they were in 2019,” he notes. “With realistic buyers and sellers, cap rates will also return to 2019 levels, and I think we were all pretty happy with the returns we were getting back then.”

Source: “Increased Cost of Capital Forces a Reset of Multifamily Valuations“

“Critical site selection has driven decisions in unprecedented ways. Delayed supply chain concerns are an unknown factor for developers, who are adding several months to their schedules.”

It may not come as a surprise that Supply Chain Issues made The Counselors of Real Estate’s Top Ten list again. It’s a frustration we are all dealing with personally, from the grocery store to the home improvement centers to our automobiles. In the real estate sector, everything from routine repairs and maintenance to property improvements to new construction are greatly impacted. Delays in deliverables, rising costs, shortage of labor, and lack of materials are influencing nearly all companies and their related real estate.

Basic economics, as we’ve learned, is the creation of equilibrium between supply and demand to create economic harmony. Since humans first started trading, those with goods and services in demand adjusted their business to produce more to support growing demand. Thus, creating the earliest forms of trade and business.

Today, many factors impact the supply and demand tug-of-war, and the best supply chain systems run on flexibility. Most would assume this is all a COVID-19 side effect, which is only partially true. Many experts believe this started well before COVID-19 and may last longer than our vaccine and boosters. We all witnessed the back-up of cargo ships in the port of Los Angeles and the bottleneck caused by the cargo ship “Ever Given” in the Suez Canal. What has become profoundly clear is this is not a U.S. problem, but a global one. As the world’s economies have grown and prospered through greater efficiencies, we’ve become more reliant on others’ ability to maintain supply chain harmony.

In the past, warehouses held large inventories just in case. This antiquated system created excess and waste. As the world became more efficient and practiced just-in-time production, warehouses held less product to increase efficiencies. Once the need for those products stopped and production ceased due to a global pandemic, reserves were not prepared for the rush of demand as e-commerce erupted across the globe. We also realized how dependent we were on the efficiency of production from China. As China shut down, the world effectively shut down.

Other contributing factors include the weather and climate disasters.  Materials shortages such as wood, steel, computer chips, and electrical supplies all influence commercial real estate decisions today. Labor shortages are stressing nearly all areas of U.S. business, and commercial real estate is not exempt. According to recent research, 88% of contractors report moderate to high levels of difficulty finding workers and 35% have turned down work due to labor shortages.

As commercial real estate practitioners, we’ve been tasked with the challenge to adjust how location decisions are made. Critical site selection has driven decisions across the U.S. in unprecedented ways. Delayed supply chain concerns are an unknown factor for developers, who are adding several months to their schedules. They’re trusting vendors to get the labor and materials and meet construction deadlines, risking added costs and unmet contractual obligations.

If there is an upside, nearly everyone is affected by these challenges, and we are adjusting our expectations. Vacant retail stores are being repurposed as last-mile warehouses. Older buildings are seeing new life and leasing opportunities. However, the challenges continue as modern logistics experts are racing to keep up with demand, shifting how products enter ports and how transportation systems are utilized to get the products to end users.

Source: “Supply Chain Disruption”

Real estate may provide an attractive inflation hedge, as rents and property values are highly correlated with rising consumer prices. Today’s inflation is partly due to an economy running at full speed, increasing the demand for real estate and driving rents upward. We believe investors should play the long game to benefit from real estate’s inflation hedge characteristics.

Growth in rent has moved in line with inflation

Real estate has generally served as a hedge against inflation over the long term. A key to its effectiveness relies on landlord’s ability to raise rents in markets with low vacancy rates, thus outpacing rising inflation and potentially increasing income to investors.

Landlords benefit from pricing

power In the 50 largest cities across the U.S. and Europe, many sectors showed below-average vacancy rates, giving landlords the power to raise rents. However, above average vacancies in U.S. offices and European retail may mean rent hikes might not be possible at this time.

Strong demand meets limited supply

Developed market inflation has increased almost in unison to levels not seen for approximately 30 years. While we believe inflation will decline markedly as central banks take action to cool global economies, it is important to remember that, historically, higher inflation rates have not systematically affected real estate investment performance. Real estate remained relatively steady during the COVID pandemic, mainly due to the asset class’s stable income generation even during times of high economic volatility. Past data from the U.S. and European economies suggest that real estate may protect investors from inflation risks.

Inflation hedging works better in periods of demand driven inflation compared to cost-driven inflation. The current environment features both types. The strong economic rebound has led to aggregate demand driving up wages and prices of goods and services including real estate, which benefits from higher rents. However, higher energy costs and supply bottlenecks have left less money for firms and households to spend on real estate.

Inflation hedges in practice

Inflation can directly drive net operating income growth (real estate income) when long-term leases have built-in rent escalators tied to inflation, which protects the income generation of in-place leases. New leases allow investors to capitalize on rising market rents. Today’s sharp increase in commodities and building costs will constrain new supply to some degree, further supporting real estate values. In fact, construction cost inflation has outrun other measures of inflation in recent years. High construction costs imply increased replacement costs for buildings, making existing real estate investments more valuable.

The current run of inflation is partly attributed to an economy running at full speed, while also increasing the demand for real estate across the economy, driving rents upward. This can be witnessed across property types, in particular apartment rents and industrial/ logistics rental growth.

Target the healthiest cities and sectors

Inflation rates vary widely around the world, and property markets function differently. While this period of inflation should be largely benign for real estate, perhaps even offering a cushion from rising prices, investors are best advised to gain exposure to a variety of property markets and sectors with particular focus on markets and sectors with strong current fundamentals and demand tailwinds.

Source: “Real Estate as an Inflation Hedge“

Falling prices for gas, airline tickets and clothes gave Americans a little bit of relief last month, though overall inflation is still running at close to its highest level in four decades.

Consumer prices jumped 8.5% in July compared with a year earlier, the government said Wednesday, down from a 9.1% year-over-year increase in June. On a monthly basis, prices were unchanged from June to July, the first time that has happened after 25 months of increases.

The report offered welcome news for congressional Democrats and President Joe Biden heading into the midterm elections. Biden highlighted the flat monthly inflation figure.

“I just want to say a number: zero,” he told reporters. “Today we received news that our economy had zero percent inflation in the month of July.”

Republicans, who have made inflation a top campaign issue, stressed that prices are still painfully high. Texas GOP Rep. Kevin Brady highlighted grocery costs and said Americans “continue to struggle under President Biden’s cruel economy, with shrinking paychecks, a shrinking economy and a shrinking workforce.”

The reprieve offered no certainty that prices would stay on the decline. Inflation has slowed in the recent past only to re-accelerate in subsequent months. And even if price increases continue to weaken, they are a long way from the Fed’s 2% annual target.

“There’s good reason to think inflation will continue to slow,” said Michael Pugliese, an economist at Wells Fargo. “What I think gets lost in that discussion is, slow by how much?”

Even if it were to fall to 4% — less than half its current level — Pugliese suggested that the Federal Reserve would need to keep raising interest rates or at least keep them high.

Much of the relief last month was felt by travelers: Hotel room costs fell 2.7% from June to July, airfares nearly 8% and rental car prices a whopping 9.5%. Those price drops followed steep increases in the past year after COVID-19 cases eased and travel rebounded. Airfares are still nearly 30% higher than they were a year ago.

Gas prices dropped from $5 a gallon, on average, in mid-June to $4.20 by the end of last month, and were just $4.01 on Wednesday, according to AAA. Oil prices have also fallen, and cheaper gas will likely pull down inflation this month as well, economists said.

Last month’s declines in travel-related prices helped lower core inflation, a measure that excludes the volatile food and energy categories and provides a clearer picture of underlying price trends. Core prices rose just 0.3% from June, the smallest month-to-month increase since March. Compared with a year ago, core inflation amounted to 5.9% in July, the same year-over-year increase as in June.

All told, the July figures raised hope that inflation may have peaked after more than a year of relentless increases that have strained household finances, soured Americans on the economy, led the Federal Reserve to raise borrowing rates aggressively and diminished President Joe Biden’s public approval ratings.

Americans are still absorbing bigger price increases than they have in decades. Grocery prices jumped 1.1% in July and are 13% higher than a year ago, the largest year-over-year increase since 1979. Bread prices leaped 2.8% last month, the most in more than two years. Rental and medical care costs rose, though slightly less than in previous months.

A strong job market and healthy wage increases have encouraged more Americans to move out on their own, reducing the number of available apartments and pushing up rental costs. Wall Street purchases of homes and trailer parks have also lifted monthly payments.

Average paychecks are rising faster than they have in decades, but not fast enough to keep up with inflation. As a result, some retirees have felt the need in recent months to return to the workforce.

Among them is Charla Bulich, who lives in San Leandro, California. For the past six months Bulich, 73, has worked a few hours a week caring for an elderly woman because her Social Security and food stamps don’t cover her rising costs.

“I go over my budget all the time — that’s why I had to go get a job,” Bulich said. “I wouldn’t even think about buying hamburger meat or a steak or something like that.”

Now she worries that she will lose her food stamps in the coming months because of her extra income.

Michael Altfest, director of community engagement at the Alameda County Community Food Bank in Oakland, said his organization now provides about 4.5 million pounds of food a month, up from below 4 million in January. The group has also budgeted for a 66% increase in fuel costs. That’s mostly because of higher gas prices but also because it’s now using more trucks to keep up with the demand for food.

Altfest’s own rent recently jumped 14%, he said, forcing him to recalibrate his budget.

“All these costs are going up, all at once,” he said. “The people here were stretched already.”

Last month’s modest slowdown in inflation might enable the Fed to slow the pace of its increases in short-term rates when it meets in late September — a possibility that sent stock prices jumping. How quickly and how far the Fed raises borrowing costs has significant effects on the economy: Sharper hikes tend to reduce consumer and business borrowing and spending and make a recession more likely.

If the Fed doesn’t have to raise rates as high to restrain prices, it has a better chance of engineering an elusive “soft landing,” whereby growth slows enough to curb high inflation but not so much as to cause a recession.

Still, Fed Chair Jerome Powell has emphasized that the central bank needs to see a series of lower readings on core inflation before it will pause rate hikes. The Fed has boosted its short term rate by 2.25 percentage points in the past four meetings, the fastest series of increases since the early 1980s.

Biden has pointed to declining gas prices as a sign that his policies — including large releases from the nation’s strategic oil reserve — are helping lessen the higher costs that have hurt household finances, particularly for lower-income Americans and Black and Hispanic households.

There are other signs that inflation may fade in coming months. Americans’ expectations for future inflation have fallen, according to a survey by the Federal Reserve Bank of New York, likely reflecting the drop in gas prices that is highly visible to most consumers.

Inflation expectations can be self-fulfilling: If people believe inflation will stay high or worsen, they’re likely to take steps — such as demanding higher pay — that can send prices higher in a self-perpetuating cycle.

Companies then often raise prices to offset higher their higher labor costs. But the New York Fed survey found that Americans’ foresee lower inflation one, three and five years from now than they did a month ago.

Supply chain snarls are also loosening, with fewer ships moored off Southern California ports and shipping costs declining. Prices for commodities like corn, wheat and copper have fallen steeply.

Stubborn inflation isn’t just a U.S. phenomenon. Prices have jumped in the United Kingdom, Europe and in less developed nations such as Argentina.

In the U.K., inflation soared 9.4% in June from a year earlier, a four-decade high. In the 19 countries that use the euro currency, it reached 8.9% in June compared with a year earlier, the highest since record-keeping for the euro began.

Source: “Lower Prices Offer Americans Slight Reprieve From Inflation“