Finance
Seeking Shelter from Inflation? Here Are 5 Key Trends to Consider.
Published : 2 years ago, on
By Eli Randel, Chief Operating Officer, Crexi
As the Federal Reserve approved a fourth consecutive interest rate increase last week, raising to the highest level since January 2008, all eyes are on potential changes in monetary policy and what implications may be for investors. Right now, investors seeking stability from macro-volatility and shelter from inflation find commercial real estate attractive even as rising costs of capital have changed their underwriting and return profiles. Here are five key trends to consider, rooted in Q3 2022 data.
- The cost of capital increased, but cash-flush investors still sought to trade.
With the Fed’s most recent rate hike, it’s not been this expensive to borrow capital since 2008. Commercial real estate’s growth slowed in Q3 compared to the first half of 2022, as investors had to figure the additional interest into their ROIs, putting a damper on many in-process deals. Price had to be adjusted moderately to accommodate a flux of changing market conditions.
However, compared to other financial sectors, real estate is well positioned amid inflation and rising rates, attracting enough capital to the space where valuations only slowed their growth rather than slumped.
Buyers are still motivated to get deals done. Those with cash and a need to deploy funds or complete a 1031 exchange before the year’s end abound and plenty of opportunities exist nationwide. REITs and other institutional spenders seek value-add acquisitions to finish deploying 2022’s capital. Investors are also likely to want to finalize deals before future rate-hikes and the uncertainty of 2023, elevating overall buyer activity and producing, if fewer overall deals, higher-valued contracts.
- A result of some market softening is a flight to quality as investors become more discriminatory of how and where they deploy their capital.
Investors are waiting to find the best long-term ROI, not settling for yesterday’s prices. But with plenty of liquid capital still available, deals are getting done when buyers and sellers can agree on valuations.
Core deals continue to trade at aggressive prices while sub-core properties have bifurcated and, in some instances, softened in value.
Offers are increasing substantially, with nearly 30% annual gains in deals going under contract. Median sold price has increased every quarter for the last year. Commercial real estate’s cost of purchasing increased with rising rates, causing valuations to fluctuate to stay competitive. But buyers with liquidity are ready and able to deploy in top performing sectors and markets, so long as those markets provide good projected yields.
As such, deals are still getting done at a slightly slower clip. Class A properties are closing faster than Class B and C (141 days compared to a combined 153 days), following investors’ flight to quality likely to yield higher returns. In the U.S., major metros on both coasts are still commanding record sky-high prices with compressed cap rates. Opportunity is lurking in fast-growing Midwest markets. This is an area investors will want to keep a close eye on.
- Investing in land presents an interesting opportunity in a time of increased development costs and shifting zoning regulations.
Land remains one of the most-traded property types, clocking in at over 50% of completed transactions in Q3. Yet, acreage valuations have compressed amid a shortage of building materials and rising wages
as developers factor these shifts into their starting costs. Cash-flush land buyers are still seeking plots at an increasing rate, with buyer activity and median sales prices rising over the last year.
While it experienced decreasing valuations over the last quarter, the sector still benefited from improved demand. Reported sales indicated a median closing price jump of over 16% in the previous year, suggesting that activity around land acquisition is unlikely to slow down. Developers were simply pickier regarding land investments, perhaps given the rising costs to kick-start projects.
In regions with growing populations, particularly with more pronounced needs for housing, we saw impressive valuations on closed property. Markets that have established themselves as logistical hubs are seeing competitive demand for land assets, producing more attractive cap rates for the savvy investor.
- The retail sector’s strong occupancy levels paint a good picture of renters capturing and maintaining space to meet consumer demand.
A consistent 87% occupancy over the last two quarters – up 2.2% YoY – indicates that tenants are sticking to their leases and making enough to avoid delinquency. Leasing rates have barely budged, showing the tightrope that owners and tenants are walking together in a precarious economic time. Landlords need to attract and keep long-term tenants as a better hedge against higher rates and inflation, so maintaining competitive rents makes them more likely to land the contract.
Restaurants are an interesting exception to retail’s success. The sub-sector showed a surge in asking rates in Q3 2021 when COVID-era restrictions officially lifted and allowed pent-up consumer demand to flood to experiential retail. However, as inflation continues, customers are cutting back on dining out, focusing instead on purchasing groceries and other essentials (though the data says they’re still shopping). As such, restaurant asking rates dipped 5.25% in Q3 compared to the previous quarter, as we observed a 6% bump in restaurant inventory. We’ll keep an eye on the sector to see if cooling inflation – once it hits – makes consumers feel more comfortable dining out again. In the meantime, a Toast survey reports that restaurants are adjusting menus and negotiating with suppliers to keep costs under control and patrons returning.
- The multifamily sector remains among the most attractive investment sectors in commercial
real estate.
Per recent Realtor.com data, the median rental price fell for the first time since early 2021 in Q3 2022, though rents are still hovering around all-time highs. Consumers will always need a place to live;
more reasonable monthly rent and amenities are becoming increasingly attractive as mortgages get exceedingly more expensive. Bewildering housing costs and rising interest rates have priced out the final waves of many would-be homeowners in the wake of post-pandemic surging demand.
Renters are feeling inflation’s sting, spending more than 26% of income on rent, with about 15% of American households behind on their rents. Despite these hardships and staring down the end of
the COVID-era’s national eviction ban, renters aren’t going anywhere any time soon. This is driving strong demand for multifamily, in both existing supply and new or reuse developments, boosting rents on a
nationwide level.
Looking Ahead: Evaluating market changes and conducting due diligence against future market assumptions is critical.
Understandably, the commercial real estate market is reacting to overall market uncertainty, rate hikes, labor costs, supply chain issues, and fast-changing international and domestic affairs. Transactions may have slowed and valuations adjusted, but bottom-line fundamentals remain strong throughout the sector.
Growing or stable rents across asset classes, a strong job market, and nominal over-leverage, following
an overly cautious pandemic, position commercial real estate well headed into the end of 2022. There are opportunities to be found as others pause, particularly among newer buildings that benefit from completion amid rising construction costs. As supply constricted without new deliveries, existing buildings attracted more investor attention and drove up valuations in Q3. As such, we may see a rise in the creative reuse of older office or retail properties and conversion into multifamily housing or other higher-demand types. Time will tell if this trend will continue.
As the year ends and we approach 2023, we’ll likely see continued slow-and-steady activity as a sign of improved long-term ROI because, as CRE investors know well, to invest in property is to commit to the long game.
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