With increased interest rates, a war in Europe and a divided political landscape, everyone’s projections for commercial real estate in 2022 are out the window, and it’s time for some new assumptions. Large players are updating their macroeconomic projections, and here is what everyone is thinking about, and how it can impact you and your money.
1. Everyone is in real estate. The largest wealth in the world was either created or preserved by real estate. It is a staple of any economy. You are also invested in real estate, if not directly as an owner or investor in properties or REITs, then through your 401(k), your kid’s college fund, or even if you rent an apartment. The market impacts you, your disposable income and your retirement savings.
2. Interest rates impact real estate debt directly. Most commercial real estate deals are funded by a typical capital stack. That stack is composed of different tiers of capital; the further up you move on the stack, the higher the risk and the higher the potential return. The lowest part is referred to as senior debt, meaning it is the most senior secured position. That lender has the option to foreclose on the asset in case of default, ensuring they return their investment and returns before anyone else “up the capital stack” gets their part. These senior secured positions are usually tied to market rates driven by inflation and interest rates. Now that rates are in the higher single digits, this means the investment needs to turn a lot more profit to be able to pay off the senior secured loan, and still leave some profit to the other investors like the second lien, mezzanine, preferred and common equity.
3. So, if debt is more expensive, how do we make up the difference? The only two ways to increase the potential of real estate assets are by increasing revenues (usually rent) and reducing expenses (usually improvements and services, since we can’t control taxes, insurance, etc.). This equation means that the higher the interest rate, the higher landlords will attempt to raise the rents. This equation of “will rent increase as much as interest rates” is what you’ve been seeing on the news lately. Since rents are driven by market forces, it becomes a question of Supply and Demand in local markets.
4. So, are we all doomed? No, the market is always striving to find equilibrium and historical data shows us that rates adjust and correct over time. It’s been 40 years since we saw this kind of inflation, but we have reasons to believe the market will stabilize even quicker this time. The main alternative for commercial real estate developers is to pivot from buying to building. This process involves completely different sets of costs and risks, and tends to increase supply, which reduces cost, which leads to a lower cost of capital and hence has a stabilizing effect. Not everybody can do that, and unless you are a vertically integrated, experienced developer with the right know-how to build, then pivoting the business may not be an option.
5. What about other asset types? Most asset classes in real estate depend on residents, tenants or guests to pay the rent. The multifamily sector is more diverse, spreading the cost and risk across multiple units. The office building model tends to be driven by much longer leases and hence stable, but offices post-pandemic are still on the fence, as more companies are adopting a virtual, remote or hybrid model, reducing the need for large office space. Retail also took a huge hit during the pandemic, and non-anchored retail centers are still considered a risky investment. The hotel and extended stay sectors have rebounded very well and are experiencing some of their best times in recent history based on an average daily rate (ADR) and revenue per available room (RevPAR) data across the country. New community developments are also very popular, such as in Texas, which has seen an influx of companies and individuals, increasing the demand for housing along such key corridors as the Interstate between Austin and Dallas.
6. Why is everyone moving to Texas? They aren’t, but it sure seems like it. The pandemic has changed the conventional thinking for many companies and individuals, especially young professionals. You can now move to states that have more business-friendly local governments, less taxes, lower cost of living and offer more space for less money. Since travel has bounced back, companies are hiring everywhere and large companies including Tesla and Micron Technologies are moving to Texas. Even if you are not considering moving to such states yourself, the thesis for investment in real estate in those areas remains very strong.
7. Does the war in Europe affect me? It does. The ban on Russian oil (which represents about one-third of the global supply) is driving the cost higher. That means that anything that needs to be transported is going to be more expensive. That includes building materials, executive travel, marketing costs, etc. If you are investing in an area where most materials need to be transported in, you are doubly impacted.
Another impact of global conflicts is that they drive consumer uncertainty. With the threat of an armed war and U.S. involvement, most people tend to hold on to what they have and feel less excited about investing in future projects.
8. So, is this a good time to buy a home before it gets worse? Probably not. History teaches us that rates are cyclical. An average 30-year mortgage just a few years ago was 3%; now the cost is more like 6%. If you found the home of your dreams, consulted with a professional and feel that you have the financial means to support this cost, you will join many others who lock in a fixed-rate or roll the dice and borrow at a floating rate in this economy. If you have the means to rent and sit this cycle out, you may see lower rates in the next 24 months. Remember, that mortgage lender wants your business and will tell you all kinds of stories. Always consult with a professional who has your best interest in mind.
9. How do I learn more about real estate investing? Start by Googling it. There are tons of books, videos, courses, seminars, professional clubs and all kinds of gurus that want to teach you. The basics of “breaking into commercial real estate” are not complex, and most people become knowledgeable within a few months of reading, talking and listening to professionals. This doesn’t mean you will be ready to go out and become a real estate developer yourself, but it will give you the tools to evaluate some of the opportunities that are out there and make a more educated decision rather than a “gamble”.
10. Lastly, where do I invest my money if I want to make a good return? Everyone wants to know that, and we are not investment advisors. We can tell you to be careful whom you ask that question in the first place. It’s important to understand that any investment has risk associated with it, and many things can go wrong, just like in real life. The best thing is always to consult with a professional who can explain the risk profile and potential returns. That said, always consider whom you are investing with, especially in this economy. You likely want to go with someone who has a proven track record of experience, is diversified across multiple markets and asset classes and has the resources to pivot and fix issues as they come up. Because they always do.