Jeff Davenport is today's feature on the Rockval Re:Cap; he is a commercial real estate consultant with extensive experience in market research, portfolio management, and leasing. From 2010-2018 Davenport was the Senior Vice President of Applied Market Research in the Real Estate Division at Regions Bank. This is where he was responsible for applying market strategy techniques to help inform and shape the corporate bank’s CRE credit portfolio. He is no stranger to real estate cycles and sheds some light with the Rockval Team on today's rocky commercial real estate environment.
There is always a great debate on whether cap and interest rates are correlated. Historically, cap and interest rates are moderately correlated; although it isn't 1:1, the degree of correlation varies in different economic conditions, markets, and asset classes. As a general rule of thumb, cap rates rise when interest rates go up and vice versa. The 10-Y treasury is commonly used as a baseline, with a historical spread averaging around 2.15%.
The above graph shows that cap rates have been on a downward trajectory since the mid-1990s. Besides one uptick in 2010 following the great financial crisis, a combination of the record-breaking low-interest rate environment and robust economy led to the lowest commercial real estate cap rates in history.
But over the past year, the narrative has completely changed. Rampant inflation and an aggressive monetary policy by the Federal Reserve have shaken things up in the market. As a result, on a national average, commercial cap rates are currently well below interest rates on debt. Even though transaction volume has slowed, many deals are still trading on negative leverage today. Davenport worries that more investors should be concerned that interest rates can continue climbing. According to StackSource's live commercial mortgage rates, CMBS interest rates are between 5.08% - 7.34%. Will we experience a reversion to the mean? Or will the Federal Reserve steer clear of inflation and captain us into a smooth landing?
Throughout 2020 and 2021, rents surged in most asset classes, especially multifamily. Davenport suspects NOI growth will struggle to outpace inflation and debt services in the near-to-medium term. Multifamily assets in key markets have witnessed 10% - 20% YOY rent increases, and rent growth simply cannot sustain this trajectory. In a severe downturn, multifamily is more susceptible to price depreciation because of their short-term lease structures, and if the cost of everyday expenses continues to rise, residents in Class A and B+ properties will begin to seek less expensive living arrangements. As a result, if you factor in inflation, your property trading at a five-cap has no real return.
However, Davenport sees office as the most exposed sector to an NOI recession. Vacancy rates are reaching all-time highs in many urban cores as work from home and work from anywhere have led companies to reimagine their physical office footprint. The end result tends to be a trade-off: quantity for quality. Less space, but in a nicer building. Class B and C office buildings in urban core submarkets have found themselves on a very slippery slope in terms of occupancy and, thus, pricing power. Davenport fears a reckoning has arrived for the office sector, but only time will tell how difficult of a slog is ahead for the sector.
Transaction volume is down 63% year-over-year (Q4 2022), as most investors have entered a "holding period," patiently waiting for a more dovish Fed policy. But the machine must keep turning. Pension funds, insurance companies, and banks must deploy their capital, but how they structure their commercial real estate deals has changed. How are firms dealing with the high cost of capital? Eliminate the debt. Davenport has consulted with companies considering removing debt from the equation to take advantage of the thinning marketplace competition. They’ll reach, in terms of cap rates, for quality assets, with the intention of applying debt once interest rates step back down. It is common to see 30% leveraged or even all cash deals taking place. Until cap rates rise or the cost of capital decreases, expect to see many creative deals taking place.
Unfortunately, no one can predict where rates or commercial asset prices are going. The best thing to do is be conservative in your underwriting and patient. Jumping into a negatively leveraged deal is risky as rates can continue to rise. Davenport reminds us that history doesn't repeat itself but does rhyme.
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