December 4, 2022

The music has stopped in the commercial-real-estate market.
The whirlwind of activity in high-flying real-estate sectors has gone quiet over the past few months as investors reel from soaring borrowing costs and bicker over how that’s affected the valuations of multimillion-dollar properties.
For the commercial-real-estate markets that enjoyed more than a decade of prosperity, the abrupt shift to high interest rates has shaken markets and pushed some notable investors to the sidelines. That’s even true in multifamily housing, one of the most favored sectors throughout the pandemic for its promise of rising rental income in the face of rising inflation, according to investors including Blackstone, PGIM Real Estate, and Ares, which assembled at Bisnow Media’s National Finance Summit last week.
The cost of debt — which is central to most commercial property deals — has nearly doubled since the start of the year as the Federal Reserve turns more aggressive with its rate hikes, deepening the bearish sentiment that took hold at the start of the summer, the real-estate leaders said. As a result, investors have turned defensive, en masse, Daniel Kwon, a partner at the $500 billion asset manager Apollo Global Management, said.
“Nobody wants to catch a falling knife,” Kwon added.
A day later, the commercial-mortgage strategists at BofA Global Research seemed to affirm that view, saying “several obvious negative consequences” were likely to emerge in coming months, with higher Fed rates dashing hopes of a “soft landing” for the economy. Year-over-year price growth has already slowed for commercial properties, signaling souring outlooks that could reduce values by 20 to 30%, the strategists wrote in a report.
To be sure, the market is not on the brink of collapse. Take, for example, delinquency rates. Last month, delinquencies on office, multifamily, retail, and industrial property loans backing commercial-mortgage-backed securities were below 3%, half of what they were last year, executives at the real-estate-data provider Trepp said on a September 1 podcast.
Executives at the Bisnow event pointed to high rents on multifamily properties, though growth is softening. While rents were higher year over year in August, they fell on a monthly basis for the first time in 20 months, according to Apartments.com.
Taken together, those snapshots still belie just how skittish markets have become. Valuations of buildings of all types have gotten so murky that PGIM, which manages over $200 billion in real estate, has floated a couple of multifamily properties for sale as “litmus tests,” in an attempt to close the chasm between buyers and sellers, Cathy Marcus, PGIM’s global chief operating officer and head of US equity, said at the Bisnow event.
By the second quarter, transaction volumes began to slow from a pace comparable to that of last year, when a record $212 billion in deals closed, Yardi, a company that provides apartment-management software, said. Property values have fallen 10 to 15% from their peaks after rising by 20% in 2021, according to Yardi’s analysis.
“If this doesn’t clear the market, then I don’t know what does,” Marcus said of her multifamily properties, which she described as large and relatively new. “I still feel like we are very much in a period of trying to figure this out.”
Reflecting on the $20 billion deployed by PGIM last year, Marcus said: “There’s no way that that’s happening this year.”
PGIM might not like what it finds with its litmus tests based on Yardi’s data and capitalization rates that, to Trepp executives, seem to be on the rise. Blackstone — the largest owner of commercial real estate globally — also sees rising cap rates, though it hasn’t had the opportunity to act on them, Michael Eglit, the firm’s originations chief, told the Bisnow audience.
In the multifamily market, properties that might have been valued at a 3% cap rate in January might now be at a 5% rate, but “that deal isn’t coming in the door,” Eglit said. “If it does, we’re going to be lower leverage because there’s less coverage, and we’re much more focused on debt-service coverage and cash flow than we were at the start of the year or a year ago,” he said.
Apollo hasn’t completely dropped out. It recently purchased a prime Florida property but with less leverage, or a lower loan-to-value ratio than deals of a year ago, Kwon said. What’s more, the cost of the debt has approached 6%, up from the 3 to 3.5%, he added.
In some instances, sellers have begun to lower prices. And buyers that couldn’t score a property a few months ago can do so now, even as they factor in their higher cost of borrowing, Deborah Smith, the CEO and founder of the boutique investment bank CenterCap Group, said.
Take one of Smith’s landlord clients in the Midwest, for example. When they bid on a property several months ago, the seller balked. Now her client — who kept circling the property after it was pulled from the market — is making a deal at a price “at or below” where it was because its competition has nearly disappeared, she said.
“Three months ago, you would have 30 bidders show up to a property,” Smith said. “It’s now down to a fraction of that.”
In another example, Hines, one of the biggest landlords in the US, closed on the largest single-building apartment deal in Miami history with a 7% discount after the original buyer’s financing fell through.
Meanwhile, properties in New York City, Memphis, Tennessee, and suburban Virginia were sold at cap rates about a percentage point higher than the average over the past couple of months prior, the Trepp executives said on two September episodes of its podcast, “TreppWire.”
“This may be a leading indicator that markets have started resetting,” Lonnie Hendry, Jr., Trepp’s head of advisory services, said on a podcast.
Andrew Holm, a cohead of US investments at Ares, the owner of more than $50 billion in commercial real estate, is hunkered down for the long haul, however. At the Bisnow event, he was so bearish on commercial real estate that he struggled to name a single sector that might be attractive over the next six months.
Holm laid the blame solely on rising interest rates. If he’s correct, the situation may have gotten worse after last week’s Fed meeting, where central bankers raised their benchmark rate and told Americans it would probably rise beyond their expectations from just a few months ago.
His advice: Start estimating how hard values will be hit, and set a plan of action for the bottom of this real-estate cycle.
“Sometimes it feels a little bit like the sky is falling, and we’re better off just practicing basketball with your kid or putting your head under the pillow and waiting for a brighter, sunny day to come out,” he said.
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