Archives for January 2023

The average multifamily going-in cap rate increased by 38 basis points (bps) to 4.49% in Q4 2022, exceeding the pre-pandemic Q4 2019 average of 4.16%. Heightened market volatility and higher borrowing costs have pushed the cap rate up by 113 bps over the past nine months.

Markets where multifamily cap rates increased rapidly in the second half of 2022 in response to rising interest rates are expected to see no additional increases early this year. However, markets with more measured cap rate expansion last year are expected to see notable increases in Q1 2023.

CBRE’s Q4 2022 Prime Multifamily Underwriting Survey found that investors are projecting 3.1% annual rent growth over the next three years, down from a 3.6% forecast in Q3 but equal to the level of the 2014 to 2019 period. Investors are slightly more optimistic about rent growth in gateway markets (3.25%) than non-gateways (2.97%).

Exit cap rates also increased to pre-pandemic levels, climbing 22 bps in Q4 to an average of 4.85%. Internal rate of return (IRR) targets rose 33 bps to 6.73%. Average asking rent was essentially flat during the quarter, rising just 1 cent to $4.46 per sq. ft.

The Federal Reserve’s ongoing rate hikes to combat inflation have caused debt to become more expensive and less available, precipitating a rise in cap rates across all asset classes. For prime multifamily, the initial 39-bp cap rate spike in Q2 was the largest dating back to 2014. Since Q1, the average multifamily cap rate has increased by 113 bps. Additional cap rate expansion is likely as the Fed continues to raise rates. Going-in cap rates have surpassed the pre-pandemic level of 4.16% and currently are the highest since the survey began in 2014.

Exit cap rates have increased by 73 bps since Q1 2022 and the spread versus going-in rates fell to just 36 bps in Q4—the lowest since 2014 and well below the pre-pandemic level of 58 bps.

Going-in cap rates increased last year in all 15 markets surveyed by CBRE, ranging from 188 bps in Phoenix to 50 bps in San Francisco. Although the Sun Belt markets had higher increases in average cap rates last year, they also had significant cap rate compression prior to last year and thus more room to move in response to rising interest rates. Many Sun Belt markets still have some of the lowest cap rates in the country. Meanwhile, uncertainty around the performance of Bay Area multifamily and other large coastal markets prevented their cap rates from declining as much over the past two years, leaving relatively less room for cap rates to expand as interest rates are now rising.

Multifamily investors are being more cautious in the current environment. While a bid/ask price gap exists for many assets, transactions continue to close. This reflects buyers’ long-term confidence and sellers’ willingness to lower pricing modestly considering many have significant embedded gains in assets purchased over the past several years.

Source: “Underwriting Assumptions Exceed Pre-Pandemic Levels for Prime Multifamily Assets“

The current political machinations in the US House of Representatives, and what Kevin McCarthy promised to win the speakership, is likely to turn into one of the fiscally riskier situations the country has faced in decades. At issue is the debt ceiling, and the risk is almost beyond description.

“The analogy that somebody used was it was like asking what happened if every nuclear warhead went off—whether you got [only] massive destruction or the end of everything,” Rohit Kumar, now Washington national tax services co-leader for PwC and one-time deputy chief of staff for Senator Mitch McConnell said during the 2011 debt crisis faceoff.

That can seem alarmist. As John Luke Tyner, portfolio manager and fixed income analyst at Aptus Capital Advisors tells GlobeSt.com, “They’ll probably get a deal done.” It’s always happened before — eventually. But that isn’t always soon enough.

In 2011, during the most recent major fight over the debt ceiling, the US didn’t default and still Standard and Poor’s reduced the country’s credit rating below AAA for the first time in history. That was after a deal came about. As S&P wrote at the time, “We lowered our long-term rating on the U.S. because we believe that the prolonged controversy over raising the statutory debt ceiling and the related fiscal policy debate indicate that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than we previously assumed and will remain a contentious and fitful process.”

Although many assume that debt ceiling limitation is about future spending, it isn’t. This is the authority to borrow money to pay for what has already been spent. The debt ceiling is a product of 1917 when Congress provided blanket ability for the executive branch to borrow money for the US, rather than having to authorize each act of borrowing.

The circle of spending and borrowing does drive up the national debt, but the economics of a country are not like those of a family. Take the pandemic as an example. If the government could not later borrow the money that it injected into the economy, the US could easily have fallen into a deep recession, if not a depression. And yet, with interest rates up, the debt becomes increasingly expensive to service.

But raising the debt ceiling keeps in place the full faith and credit of the US in place. Undermining that could easily affect the dollar’s place as a standard currency and recognized international store of value. That immediate raises the question of whether investors can trust in the value of their US investments, including real estate.

“The confluence of defaults in the primary and secondary debt markets will be catastrophic for CRE,” Richard Rubin, CEO of Repvlic, which converts commercial properties into housing, tells GlobeSt.com. “On the primary mortgage market many of these (mortgages) were procured at the height if the market and are now or soon to be under water. These have either been bundled and sold in the secondary market. The secondary market’s lack of liquidity should not be seen as a silver lining as the horse has already bolted.”

Source: “The Present Danger of a US Debt Default“

Watching experts trying to follow financial markets and explain what their movements mean sometimes seems like people slipping on an icy sidewalk in winter, waving their arms about as they try to maintain their balance.

That dynamic came into play last week with reports of a Treasury bond market rally that supposedly began to reduce the negative split between shorter-term and longer-term bonds. The negative split, which creates inverted yield curves (when short-term yields exceed those of longer-term bonds), supposedly began to recede, which should be a sign that perhaps a recession might not happen.

Unfortunately, a GlobeSt.com review of data from the Treasury Department suggested the opposite. The split between 3-month and 10-year Treasurys started on January 3 at 74 basis points, with the 3-month yield higher, and ended on Friday even wider at 112 basis points. That was exactly the opposite of some reports and should have suggested a higher possibility of a recession.

And then there was the difference between the 2-year and 10-year — another portent of a recession, although considered not as definitive as the 3-month/10-year. The 2-year was higher; the gap went from 61 basis points on the third to 69 basis points on Friday. Again, the opposite of some reports.

How did anyone point to a narrowing gap? Probably a result of intraday trading, according to John Luke Tyner, portfolio manager and fixed income analyst at Aptus Capital Advisors. “It depends on when they snap the data,” he tells GlobeSt.com. A drop can happen during a day when people are writing about the implications and then reverse direction before the end of trading.

“Humanity is so based on immediate gratification that we want to say that the Fed acted, and by them acting they fixed the problem, and we can go back to the easy money policy” of the past 15 years, Tyner added.

The longer answer is that understanding bond market dynamics is more complex. The relationship between recessions and yield inversions are really historical correlations, not necessary an issue of causation. Campbell Harvey, a Duke University finance professor who originally discovered the yield curve and recession relationship in the 1980s, has suggested the predictive power might have weakened because people recognize it and react by more prudent behavior. Although he also added that if the 3-month/10-year inversion lasted into 2023, he’d feel more confident that a recession was on the way.

“[W]hile we aren’t ignoring the signal completely we think the level of yield curve inversion is perhaps steeper/deeper than actual economic conditions may warrant,” Lawrence Gillum, fixed income strategist for LPL Financial said in an emailed note. “We think the odds are roughly a coin toss that the U.S. economy falls into a recession in 2023 but it is no sure thing. The consumer is still spending and with businesses still hiring at an elevated clip, there is a chance that we can skirt by with an economic slowdown and not an outright contraction—although if the economy does contract, we think it will be a shallow contraction due to the aforementioned reasons.”

By the way, this week the 3-month/10-year split grew to 117 basis points on Monday but then dropped to 112 on Tuesday and back up to 118 on Wednesday, while the 2-year/10-year went down to 66 on Monday and then 63 on Tuesday and 66 on Wednesday.

Whatever that will mean.

Source: “What’s Happening With the Yield Curve Is Anything But Straightforward“

Last year was one of the best years for retail real estate. Vacancy rates in Q3 were 4.3%, according to JLL, down from the 6.3% in Q2 reported by The Wall Street Journal as the lowest rate in 15 years, likely driven by high demand for retail space and little new development. Endless brands opened their first stores, and many other mature brands continued to expand their footprint. But, in 2023, the big question is how inflation and the looming recession may impact demand and retail overall.

Some may believe the effect will be negative, but strong evidence indicates that stores and physical retail may be the key to success this year.

Stores are the preferred, more affordable marketing channel that acquires quality, loyal customers.

Retail Media Networks and using various customer touchpoints as advertising platforms are becoming popular discussion topics. And along the same lines is the use of stores as a marketing platform. Many digital brands are seeing the customer acquisition cost of online increasing exponentially over the past few years. According to a study by SimplicityDX, today, merchants are losing $29 for every customer acquired, an increase of about 60% from five years ago. This increase is likely due to overcrowding in the online advertising space and more privacy regulations limiting the ability to target customers precisely.

Therefore, in many cases, turning to independently profitable stores is a logical alternative for acquiring new customers. For example, Bandit Running, a luxury performance and lifestyle brand, recently opened its first store in Brooklyn’s Greenpoint. Nick West, the Co-founder, and CEO, shared that “customer acquisition cost was significantly better [in-store], as compared to paid digital investment.” He also cited more repeat purchases and fewer returns from customers acquired in-store.

The now vast amounts of digital brands offer endless choices to consumers. For instance, a PwC survey shows that more than a quarter of respondents stopped using or buying from a business in the past year, primarily due to bad experiences. However, a third of respondents identified human connection as essential to their loyalty – something easily provided by stores.

As West states, “Those learnings are complemented by the fact that running is a community-driven sport, especially in New York. If you want to connect deeply with the running community, you can’t rely on Instagram ads to build a connection with the people driving the sport forward.”

Similarly, Cult Gaia, a women’s luxury fashion brand, is opening its first flagship store on Melrose in Los Angeles and will open its third store in SoHo this month. “We have seen a decade of e-commerce success, so it only felt natural to open stores and finally give our customers an immersive brand touchpoint. And most importantly, we can finally connect with them in real life. Social media interactions were a main growth driver from the jump, and now we get to develop deeper relationships face-to-face,” shared the Founder and Creative Director, Jasmin Larian Hekmat.

There’s a clear understanding from small digital brands, and even big ones like Glossier, that stores are essential for growth. Potentially even more so in a fragile economy. Therefore, the barrier is in the capital and financing, but the good news is that standalone stores are far from the only option.

If there isn’t enough real estate or capital, brands will find a way to exist in a physical space.

Vacancy rates are lower than ever for retail real estate, which means many brands are on waiting lists and contemplating going to neighborhood centers, destination street locations, or even class-B malls. Expanding into new real estate categories is a shared prediction with Placer.ai’s Retail Trends Forecast for 2023. Some less-funded digital brands may back out of deals in top centers due to low funding and capital. Still, ultimately, creativity will be critical to any retail brand that wants to build a presence in the physical world.

For example, Bandit chose Greenpoint due to its high “run traffic,” meaning many runners frequent the area. So, despite it not being a famous shopping district, it made sense as a destination location. The brand plans to take learnings from this first location and apply it to future expansion, but in the meantime, it will continue to host pop-ups and partner with wholesalers in the new year.

Another example is Lunya, which launched The Rest Shop late last year – a collection of third-party sleep wellness products. “This Shop offers people tested solutions they can implement to improve their sleep and allows Lunya to broaden our offerings. It’s an intentionally selected assortment. We’ve refined our go-to list of products to ensure our stamp of approval is meaningful,” shared Ashley Merrill, Lunya’s founder. In addition to helping these brands showcase their products in a physical space, Lunya is diversifying its offerings in-store, setting the brand up for success in a shifting economy.

Whether sourcing more destination or second-tier real estate, turning to wholesale, or opening shop-in-shops, there are many alternatives for brands seeking cost savings. And for all brands, but digitally native brands especially, the advantage of stores is clear, the opportunities in physical retail are endless, and a wavering economy isn’t going to stop them.

Source: “Why Retailers Will Continue To Open Stores This Year, Despite Economic Fragility“