Archives for October 2022

As the U.S. economy emerged from the pandemic-induced recession, office sales volume began to improve in the second quarter of 2021 and into the first quarter of 2022. Lately, however, in the wake of the Fed’s multiple interest rate hikes and the subsequent tightening in financing rates, those sales volumes have begun to drop off again.

The situation has been compounded by the weaker than expected return to office trends after Labor Day. Office investors remain uncertain about when and if a full comeback might occur, as working from somewhere other than the office has become the norm for over half of U.S. corporate employees.

“Prior to the rate hikes there was already a murky outlook on how, when and if there is a return to the office,” says Jonathan Bennett, president of AmTrustRE, a private real estate investor focused on value-add office, residential and mixed-use assets in primary markets, including New York City and Chicago. “I think over time there will be a comeback, but nobody knows when.”

All of this is taking a toll on the office sales market. In August, the most recent month for which data is available, office sales volume dropped by 56 percent year-over-year, to $5.3 billion, according to data firm MSCI Real Assets.

For the third quarter as a whole, office investment sales declined by 33 percent compared to the same period in 2021, to $26.9 billion. The decline was more pronounced in sales of office properties in Central Business Districts (down 54 percent) than in sales of suburban properties (down 23 percent).

The overall number of office properties sold also fell, by 23 percent. Year-to-date, sales are down 1 percent, totaling $88.5 billion.

In September, with inflation still rising, the Federal Reserve increased its target rate by another 0.75 percent to a range of 3.0 percent to 3.25 percent. The Fed also released median projections showing that it anticipates the target rate to be 4.4 percent by the end of 2022.

This less than optimistic forecast will continue to affect both the commercial real estate lending market and investment sales volume in the office sector, according to Russell Ingrum, vice chairman of capital markets with real estate services firm CBRE. While interest rate hikes are playing a significant role in the slowdown in transaction activity, so is the reduction in the amount of debt available in the marketplace, he says.

“It is natural to see that higher interest rates negatively impact asset valuations, in the short term,” Ingrum notes, adding that cap rates have expanded in response to the increase in the cost of debt. In general, cap rates will increase by about 60 percent of the change in whatever index you are pricing off, according to him.

In the third quarter, cap rates on office transactions averaged 6.0 percent, 20 percent down year-over-year, according to MSCI Real Assets. This decline, however, was driven largely by sales of suburban office assets, the researchers note. Moreover, the Commercial Property Price Index for office buildings in CBDs has declined at an annualized pace of 2 percent between the second and third quarters of 2022.

“The deals that are missing from the market point to challenges on pricing that simply have not yet been realized in sale activity,” MSCI researchers write. “The distribution of office sale prices as measured on a price per square foot basis is simply skewed towards the best of the best.”

“The pace of the interest rate increases over the summer and fall has been difficult for buyers and sellers to manage,” says Ingrum, noting that as soon as a seller believes they know where pricing is, interest rates move again. “We do not expect to see increased sales volume until interest rates stabilize, and there is more predictability for at least the next six months.

Sellers’ expectations continue to be at odds with potential buyers’ ability to underwrite worst case scenarios for leasing demand and income growth based on current market conditions, reports MSCI Real Assets. As a result, sales volume in August was down by 56 percent not only year-over-year, but from the average pace for August for the five years before the pandemic. With interest rates still on the rise and the possibility of a recession on the horizon, investors have been less likely to look at office acquisitions than during the firm half of the year, says Ingrum. “They are reluctant to make a bet when there is so much unknown.”

Leasing situation

The other side of the equation for office investors is gauging the level of leasing demand for offices in a market that’s undergoing changes. To an extent, office building occupancy levels depend on its main type of tenants, notes Bennett. For example, tenants in his company’s New York City buildings are largely government agencies, financial institutions and law firms, all of which are requiring employees to be in the office at least part of the week.

Not that long ago, many industry insiders believed that tech companies would be the most accepting of remote, or distributed work, but that’s not what’s currently happening, he adds. For example, while some viewed Facebook’s recent pullout from 200,000 sq. ft. office commitment at 225 Park Avenue as a sign of Big Tech’s loss of appetite for office space, the company still expanded its Manhattan office holdings, taking a total of 2.2 million sq. ft., including in the James A. Farley Building in Midtown and at Hudson Yards, in order to expand its staff in New York City by 8,500 people.

Nationwide, office leasing volume declined by 3.6 percent from the second to the third quarter, to 45.5 million sq. ft., according to the US. Office Outlook Q3 2022 report from commercial real estate services firm JLL. This was due to the cooling conditions in the tech sector, rightsizing trends and an uncertain economic climate that has created hesitation among tenants about committing to more space.

There’s little expectation of those trends improving in the short term, the report notes. A record volume of office lease expirations is occurring in 2022 and will continue in 2023, putting upward pressure on leasing activity, but renewal trends are still declining significantly and many tenants are downsizing while upgrading to higher quality offices.

Shifting targets

All this is causing some deals to fall through, according to Bennett. He cites an $800-million office acquisition where the investor opted to lose a $30-million deposit because the deal no longer made sense when the Fed raised rates and the cost of capital increased. The transaction involved an older building in a desirable location that has seen some capital improvements, but was going to require a lot more capital investment to generate an equitable rental rate, Bennett notes.

“Most investors are scared to death of office buildings” he says, but adds that some investors, including his own firm, are looking for opportunities in key markets, where older assets with high vacancy are now trading at a 25 percent discount or more. For example, he notes that some office buildings that were selling at $500 per sq. ft. prior to the pandemic are now selling for $50 per sq. ft. As long as a deal makes sense in terms of cost per sq. ft. and income exceeds expenses, investors will buy, Bennett says.

Plus, office deals might have a better chance of clearing today for two reasons, according to Ingrum. First, while rates are still going up, the increases are becoming smaller, so the impact on valuations is also becoming more manageable. And second, the sellers who want to move forward have a need to monetize the assets and a good understanding of where their value is today.

Source: “Office Sales Volume Declining In-Step with Interest Rate Hikes“

It’s been a long, strange trip since the earlier part of 2022, according to new survey research out from Lightbox. From a relatively rosy outlook on the markets months ago, things have taken a turn in keeping with changing clocks and in plunging into a land short on natural light.

Yes, the immediate future is looking rather dim, and many in CRE investment are worried. “Nearly 70 percent of respondents to this LightBox Investor Sentiment survey characterized themselves as either concerned or bearish about the commercial estate market for the balance of 2022,” the report said. The split was 56% concerned and 34% very concerned; 10% weren’t concerned at all.

Leading into the dual concern was a trifecta of factors that those in the industry saw as the biggest threats to CRE: rising interest rates, inflation, and supply chain. The combination shows particularly keen eyesight. While many, including some big names in economics, have wanted to blame everything on lax monetary policy, that seems overly simplistic. Long-standing dovish Fed strategy had been an attempt to gin up economic activity. But it was massive systemic supply chain problems experts had warned against for decades that, sparked by the pandemic and national responses to it, which turned into the logistical disasters that choked supply dry. And then came Russia’s invasion of Ukraine, pushing inflation in areas like energy and food even higher and faster.

“As complex economic issues continue to impact capital markets activity, investors are searching for investment bright spots in murky economic conditions,” the report quoted Tina Lichens, Lightbox senior vice president of broker operations as saying. “Market fundamentals still support a broad range of investment activity, but the more immediate question is how long any market downturn will last.”

With only a tenth unconcerned about the potential of a recession—and recognizing that companies expecting a recession might take the preemptive steps that could encourage one to happen—it’s not surprising that the main questions have become not if, but when and for how long.

What may have them most concerned is how quickly the Fed piled on the interest rate hikes once it started. But concern about not letting up too soon, as happened in 1980, forcing an ultimately prolonging of difficult times, could delay a needed lightening of corrective action.

“Arguably, the Fed has been oversteering. That implies the Fed will go through with their telegraphed 75 basis point increase in November unless there are substantive changes in the economic readings.” Marcus & Millichap’s John Chang wrote in a recent analysis.

“A tone of cautious optimism remains for the long-term, given strong capital allocations from global sources and the ability of commercial real estate to outpace alternative investment options,” Lightbox wrote. “The current level of uncertainty, however, is adversely impacting short-term deal flow and pricing, along with the availability of capital. This is a marked shift in sentiment and one that is leading many industry practitioners to recast projections for the next 12 to 18 months.”

Source: “CRE Investors Brace Themselves for More Inflation and Then Recession“

Multifamily leaders weigh in on local legislation and ballot measures that have nationwide implications.

Kingston, N.Y., a picturesque town on the Hudson River 90 miles north of New York City, could be a sign of challenges ahead for the multifamily industry.

In August, Kingston became the first city in upstate New York to adopt rent control. Declaring a housing emergency under the state Emergency Tenant Protection Act, the Kingston Common Council voted to adopt rent stabilization.

Approximately 1,200 rental units are affected. Landlords will only be able to increase their rent by a percentage determined by a nine-person board. Now the apartment industry is watching to see whether other municipalities in the region will follow in Kingston’s footsteps.

The national housing crisis has made rent control a hot topic all around the country. According to research by Redfin, rents in many U.S. cities have risen by more than 30 percent. Some organizations, including the National Low Income Housing Coalition, are in favor of federal rent control to eliminate what they see as price gouging.

“Our position is that these are failed policies that go by a number of different names nowadays, but ultimately they work against housing affordability because they reduce the quality and quantity of the housing stock,” said Nicole Upano, assistant vice president of housing, policy & regulatory affairs at the National Apartment Association.

Likewise, the National Multifamily Housing Council cites decades of research supporting the detrimental effects of rent control. “We recently surveyed NMHC members and 60 percent of multifamily firms were actively reducing or avoiding investments in rent-controlled markets. Another 15 percent were considering doing so,” said Jim Lapides, vice president of advocacy and strategic communications at NMHC.

This trend is counterproductive at a time when increasing supply is critical, he adds. “Unfortunately, rent control has the exact opposite effect. It exacerbates the very problem we’re trying to solve.”

Rent control spreads

“Policymakers are looking for that short-term fix to be able to satisfy their constituents and help them, especially during hard times. Since the pandemic, it’s become an even more heightened area of interest,” said Upano. “We’re seeing rent control pop up in areas around the country that you would never have (expected) to see them pop up.”

In Portland, Maine, for example, the rent control ordinance approved by voters in November 2020 went into effect on Jan. 1, 2021. It established the rate charged in June 2020 as the base rent for most units and capped annual increases. This ordinance applies to both long-term and short-term units. It also established a rent board to conduct hearings and consider landlord requests for rent increases.

In June, neighboring South Portland followed suit, issuing an emergency ordinance that will remain in effect through November. That measure established an eviction moratorium and capped rent increases at 10 percent annually.

Another hot spot is Albuquerque, N.M., where the city council is considering a resolution that would ask the state to remove its rent control preemptions. Though the resolution is non-binding, approval by the city council could hint at public sentiment in New Mexico’s largest city. “There was a large protest there from renters’ rights advocates, and with that kind of pressure we’re certainly concerned about what could potentially happen there,” said Upano.

Finding loopholes

Many Florida markets have also had serious discussions about enacting rent control. Florida has a statewide preemption on rent control unless a municipality declares a housing emergency. The city council or county commissioners can then put forth an initiative that is put to a public vote. Orange County commissioners approved a measure for the November ballot that would allow for rent control in a limited capacity that aligns with the state preemption.

“It’s a bit of a unique situation,” Upano observed. Thirty-one states prevent local governments from adopting rent regulation, but according to Upano, Florida allows for limited rent control when there’s a grave housing emergency. The Florida Apartment Association and the Florida Association of Realtors recently sued Orange County in an attempt to halt the ballot initiative.

“Barring a last-minute successful legal challenge, it is highly likely that voters in the Orlando area are going to have the opportunity to vote on rent control. And that’s a huge risk for the industry there,” said Lapides.

What happens in Orange County is being monitored by municipalities around the country and especially in Florida. “There’s so much continued pressure on rents in Florida and pain points for renters and pain points that are forcing legislators to consider possibly harmful short-term options,” said Upano. “Places like Miami- Dade (County) are closely watching what’s happening in Orange County to see whether their rent control policy will pass muster.”

Walking back restrictions

Last Fall, in St. Paul, Minn., voters approved what was considered at the time to be the most restrictive rent control ordinance in the country. It capped rent increases at 3 percent. There was no exemption for new construction or for when residents move out.

“Immediately, St. Paul had this huge blowback from that regulation,” Lapides noted. “Construction permits plummeted by 80 percent—investors and the industry pulled out because they couldn’t make this work. The effect was devastating.”

In September, the St. Paul City Council voted to allow landlords to raise rents by 8 percent plus inflation if a tenant moves out. They also added a 20-year exemption for new construction. According to Lapides, these fixes were telling because usually housing policy takes years, if not decades, to see the results.

“In St. Paul, they are walking back their very Draconian and inflexible rent control policies, because they’re seeing such a huge drop in permitting,” said Upano. “And that’s what we have been saying for so long regarding the very detrimental effects of rent control.”

This year several rent control ballot initiatives have been thwarted. In North Las Vegas, the local culinary union attempted to place an initiative on the November ballot. It was struck down due to a technicality regarding how signatures were collected. But the apartment industry predicts the that the union will try again and also push for statewide rent control.

In June, the Ohio legislature closed the key loophole in the state rent control law. Ohio cities are now blocked from imposing rent control measures on landlords.

The midterms may be telling, as well. To name one example, observers think it’s highly likely that Massachusetts will elect a Democratic governor who may be more open to rent control than others have been in the past.

“The midterms could play a huge role—will legislative chambers change, or will they become more or less progressive? Those are things we’re watching very closely in the midterms,” said Lapides. “And of course, in Orange County rent control is on the ballot this fall.”

Looking at the economics

For a variety of reasons, the most attractive locations for multifamily firms to do business are in those 31 states that have rent control preemptions. But there are no guarantees. Even in landlord-friendly Texas, inflation and severe housing shortages could push some cities toward rent control.

“We have to invest in projects and in markets where we can earn an appropriate risk-adjusted return,” said Laurie Baker, COO of Camden Property Trust. “There are always cost considerations and that’s what’s missing in these rent control conversations. Nobody is talking about the increase in costs. But you (need) revenues to offset the increase in taxes, increases in insurance, increases in salaries and the maintenance. It makes the numbers difficult to achieve if your rent growth is capped at some arbitrary number.”

Camden operates a geographically diverse portfolio of multifamily assets in 15 high-growth, business-friendly markets. The company is constantly seeking opportunities to expand its operating platform through new development or acquisitions. But Baker noted that the expansion of rent control in a market—especially for newly constructed properties—quickly changes the economics and negatively impacts the feasibility to develop.

Camden keeps an eye on regions that show signs of becoming less landlord-friendly. More California cities, for example, are showing an interest in rent control since the California Tenant Protection Act went into effect on Jan. 1, 2020. This state law limits rent increases and removes the right of landlords to evict tenants without just cause. It also restricts the allowable annual rent increase to 5 percent plus a local cost-of-living adjustment of no more than 5 percent for a maximum increase of 10 percent.

“Orange County, Fla., has been a topic of discussion, so we’re monitoring that market and what happens in the coming elections because we have 10 communities there,” said Baker. “We’re also keeping an eye on Colorado. In the last couple of years there have been some proposals in certain areas for rent control.”

The rent control discussion is happening all around the country. Lapides warns that the apartment industry must be mindful, vigilant and vocal. “No other group or industry is going to rescue us from these bad policies,” he said. NMHC has developed resources available at GrowingHomesTogether.org to help the industry talk about housing affordability and rent control.

Source: “Rent Control Heats Up Amid Challenges From Industry“