by recentricrealty | Apr 25, 2023 | Articles, Perspective
Interest rates are up, real estate valuations are down, and inflation is cooling. The latest CPI numbers are out, and inflation is at a 5% annual rate as of March 2023, still well above the Fed’s 2% target rate. The banking system is being stressed to levels that are making the Federal Reserve consider a pause in their rate hikes. As a real estate investor, this can be particularly good news. Here are exactly what the opportunity indicators are showing:
Commercial Loan Maturities
A leading indicator of broader distress finally playing out in the marketplace is in maturing commercial loans that were underwritten at a certain debt service coverage ratio and at much lower interest rates. Now that these loans are expiring and returning to the market at much higher interest rates, there is a wave of defaults expected to hit the broader markets.
According to Trepp, there is $52 billion worth of loans comprised of just over 3,000 properties contained in the Trepp database maturing over the next 24 months where the current debt service coverage ratio (DSCR) at the property level is 1.25x or less. Almost half of the properties are multifamily with roughly 1,450 properties meeting the above criteria. Additionally, $17 billion of the $52 billion has occupancy below 80%.
Personal Bankruptcy on the Rise
Families have increased non-housing debt by 75% over the last 10 years, and are now cutting back on expenses, vacations, house upgrades, and more to help offset the costs of a more expensive inflationary world. Unfortunately, the projection for personal bankruptcies is trending higher, which will lead to defaults not only on residential properties but also on commercial properties which are personally guaranteed by individuals.
Fallout From the Banking Sector Stresses
Recently, the US central bank economists have predicted a US recession will begin later in 2023, citing fallout from the recent bank failures of Silicon Valley Bank and Signature Bank. This will cause the unemployment rate to rise through early 2024. Additionally, many officials have indicated “there would be some tightening of credit conditions.”
This in turn will make it harder for commercial loans to refinance, especially if they are underperforming.
The Federal Reserve is playing chicken with the economy and a freight train called inflation. Yes, the freight train may be slowing, but it is still going too fast for the likes of your average household in the United States. All these signs point to a slower economy and even signs of distress.
It is during distress that the best opportunities present themselves, and the Recentric team is actively seeking out opportunities in this dynamic market. In the words of the great Warren Buffet, “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
by recentricrealty | Jan 20, 2023 | Articles, Perspective
As President Franklin Roosevelt observed over 80 years ago: “Real estate cannot be lost or stolen, nor can it be carried away. Purchased with common sense, paid for in full, and managed with reasonable care, it is about the safest investment in the world.” Recentric shares the same sentiment as our former US president. As we all put our thinking caps on to navigate the economic uncertainties that lay ahead in 2023, we would like to provide you with insights to help you to strategize on the real estate component of your overall portfolio.
Where to Focus Within Commercial Real Estate
For many, stability is the main goal given all the uncertainties both domestically and globally. This makes core and core plus real estate (properties with strong tenants and locations) especially attractive to investors. If you are more concerned about higher return potential, focusing on value-add with a strong operator, and ground up development with a large percentage of pre-leased are the better options.
A Hedge Against Continued Global Inflation
Returns on real estate, farmland and infrastructure typically perform better in an inflationary environment, according to Nuveen’s Global Investment Committee. While offering portfolio diversification and relatively low volatility, returns on these assets have historically exhibited a positive correlation to inflation. On a local level, Recentric has been experiencing double digit returns on its Denver-based health care stabilized assets which has been a strong hedge against inflation.
Fed to maintain aggressive hawkish interest rate approach
Over the course of 2022, the Fed approved seven interest rate hikes, which included four consecutive increases of 0.75%. Despite this very unnerving reaction, inflation continues to remain stubbornly high. The Fed’s only option to slow down inflation and reverse its damaging course is to continue to raise rates throughout 2023, while trying to avoid a recession or worse. Residential and commercial real estate valuations will continue to decline over the course of the year, making for some great buying opportunities.
Aside from location and strategy, real estate investors need to prepare for the unexpected and align themselves with seasoned real estate investment property managers who can handle the occasional hiccup brought by today’s high-inflation, supply-constrained environment. When times are good, investors have a wealth of options. But in today’s market, real estate investment should follow a more focused approach that capitalizes on larger social trends, such as health care which will persist regardless of economic conditions.
by recentricrealty | Oct 25, 2022 | Capital Markets
Remember the 1970s? Bellbottoms, feathered hair, the peace sign, and the VW Bus. And who could forget out of control inflation! Now that much higher inflation is back, many economists would argue that this time around is different, and we won’t see a 1970’s return to 14% inflation at its height. In 1979, Paul Volker, former chair of the Federal Reserve took a very aggressive stance to put the dagger through the heart of this persistent and destructive invisible force the only way he knew how. Raise interest rates to 20%, and effectively destroy the economy in the short term.
Here are several ways this type of inflation fighting response can affect the commercial real estate markets and your investments:
Increasing rates reset values
Interest rates have increased by at least 3% or 300 bps since early 2022. For example, this equates to an extra annual interest expense of ~$200,000 for a $10 million dollar loan on a $20 million dollar asset. If you were to remove that profit from your return-on-investment calculation, that represents a 14% reduction in total property value (based on a 7% cap rate) showing just how directly and severely higher debt costs affect asset values.
Sellers living in the past
Recentric has made several purchase offers in the last three months, and the trend we are finding is that sellers are still stuck on the higher valuations from six months ago. This gap on the bid/ask price for assets is still very much an obstacle. If buyers leave the market, sellers will be forced to hold on to their assets until the market returns or acknowledge that this commercial real estate market has fundamentally shifted negatively in a short period of time and sell at a lower price.
More competition for commercial real estate
With interest rates on the rise, investors will begin looking at other alternatives. For example, one consequence of rising inflation is that the yields on U.S. Treasury bonds are on the rise. Just recently, the 10-year treasury surged above 4%. Properties that were trading at a low 4-5% capitalization rate become less compelling if the rate on 10-Year Treasury bonds is 4 percent. Risk averse investors will direct their investment funds toward bonds and T-bills rather than real estate providing the same return. Alternatively, the 4 percent “risk free rate” of a 10-Year Treasury bond does not offer any upside or future appreciation, while solid long term real estate deals operated by experienced managers can still offer much higher upside.
As of October 13th, the CPI Index (which does not include energy, food or housing costs) reported that inflation as measured by this index, was 8.2% annually through September. The real inflation rate is likely more in the 12-15% range and having a real impact on people’s ability to make ends meet. The similarities of the 1970’s Nixon administration to pump up the economy by keeping interest rates low in a major inflationary environment to improve re-election chances makes the case that history is repeating as the 2022 midterm elections are upon us. Either way, the US economy has to pay for its rampant spending and draconian government shutdowns on the economy, as the inflation tax seems to be back, in ugly 1970’s fashion.
by recentricrealty | Jul 27, 2022 | Capital Markets
You undoubtedly have heard the phrase “Keep your powder dry.” The origins of this phrase stem back to the Battle of Edgehill in 1642 in the First English Civil War. Oliver Cromwell told his Roundhead troops in the opening fight, “Put your trust in God, my boys, but mind to keep your powder dry.” This phrase carried on from use in war to more commonly as a financial phrase, to keep your cash at the ready! Here are three signs that the US economy may already be in a recession and why you should keep your powder dry:
Personal savings rates plummet to 2008 levels.
Michael Burry, the author of the Big Short and the predictor of the 2008 recession tweeted out on Friday, “US Personal Savings fell to 2013 levels, the savings rate to 2008 levels – while revolving credit card debt grew at a record-setting pace back to the pre-Covid peak despite all those trillions of cash dropped in their laps. Looming: a consumer recession and more earnings trouble.”
Small business hiring reverses.
The Alignable small business network’s July report showed that 45% of small businesses are halting new hiring. According to the report, “This represents a significant hiring shift, and is largely a reaction to mounting labor costs, skyrocketing inflation, fears of a recession, and rising interest rates.”
Yield curve inversion
A yield curve inversion occurs when the two-year bonds have a higher return than the ten-year bonds. An inversion of the yield curve has preceded every US recession for the past 50 years and has only been wrong once before. This indicator typically calls recessions up to 18 months before they occur. In early March 2022, the yield curve inverted for the first time since 2019. As of July 20,2022, the two-year rates stood at 3.23% much higher than the 3.03% ten-year yield.
More than 80% of Americans now believe the U.S. will fall into a recession in 2022, an April CNBC survey found. And consumer sentiment, as measured by the University of Michigan’s Consumer Sentiment Index, sank roughly 30% year over year last month, closing in on levels not seen since the Great Recession. According to the Federal Research, US households lost 25% of their aggregate wealth from 2007 to 2009.
Even though the White House is changing the definition of a recession, it does appear that we are in one or directly heading for one. Dry powder in the form of cash will provide you with opportunities to be on the winning end of a recession.
by recentricrealty | Jun 23, 2022 | Capital Markets
The Federal Reserve has decided it’s time to start fighting the worst inflation since the 1970’s, by announcing on June 15, 2022, a 75-basis point increase in the Federal Funds Rate. This is the largest increase since 1994 and one that should not be overlooked. To give you additional historical perspective, the 10-year treasury is the standard to which most lenders in the commercial real estate industry peg their loan rates, and today this number stands at 3.25%, and has increased by 117% in 9 months. Here are a few indicators to provide insight as to where the industry is heading.
Negative leverage in commercial real estate
The single most important aspect of investing in commercial real estate is net positive cash flow. Negative leverage is when the capitalization rate is less than the interest rate assigned to the debt. This becomes an untenable situation for investors. If a buyer currently has a property under contract, and has yet to lock in an interest rate, they may have to trade down on the price, or walk away from the acquisition.
Possible Outcome 1: More properties coming back on the market at lower prices.
Commercial loan term cycles
As interest rates rise, and debt becomes more expensive, overzealous buyers who paid a premium at the top of the market, and leveraged with debt to excessively high levels, are now being forced back into an increasingly hostile debt market with tighter lending criteria and more expensive debt service. According to Trepp, an estimated $450 billion in CRE loans will mature in 2022, a new annual record.
Possible Outcome 2: More properties falling into default by lenders.
Small Business Defaults
Higher interest rates not only affect real estate markets. They affect small businesses that rely on debt to finance their business, from receivables, to equipment and leasehold improvements. According to Markus Lahrkamp, a managing director at advisory firm Alvarez & Marsal, “The first wave of real distress is probably going to hit us kind of mid-year. For the first ones, they might have too much leverage, they were not prepared, the companies were not operationally sound. And then from there, it will probably trigger into more and more.” When businesses don’t pay rent, commercial real estate suffers. Watch the Business Bankruptcy Meter to help determine the health of the overall CRE market.
Possible Outcome 3: Small business bankruptcies may cause more commercial real estate to default on loans.
The inflation tax is inescapable, and extremely hard on the poor and middle class, especially seniors who live off fixed income. We could argue who caused this inflationary environment, but I would rather talk about how to profit from predictable factors that may cause distress in the commercial real estate market.
Disruptions in the marketplace are when opportunities arise, and this may be one of the best times to start thinking about where and who to invest with in commercial real estate.