Risk Assets Completely Fucked
Rate moves as of late, and the higher for longer narrative, has nowhere near been priced into commercial real estate. How does this play out and whats the extent of the damage?
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I'm not sure I agree that the higher for longer narrative has "nowhere near" been price in to CRE. While I don't think we're at the bottom quite yet, I think transactions will pick up in the next 12-18 months.
10y at 4.5, conservatively that would peg multi cap rates at 6-6.5, broadly. If you want to look at the forward curve long term 10y expectations are now at 4%. Putting multi at 6+/- meanwhile blackstone, Starwood, the core funds, etc all have their multi still marked at 4s. That’s a >30% drop in value that still needs to happen.
Now extrapolate this out to other asset classes, industrial at 6%, hotels and retail at 10 give or take, office should probably be in mid teens today.
We are not near the bottom and anyone saying differently is kidding themselves. Now let’s extend this out to corporate PE. There’s a lot of pain to come.
That’s just cap rate driven adjustments.
any further deterioration of NOI will also hit prices in a big way.
Office NOI in NCREIF NPI is still up 10% over pre-pandemic levels. What happens when it falls 20% as cap rates increase 200-300 bp?
We are looking at ~50% price loss.
There's been more repricing than you're giving credit for, especially in the past few weeks. There are some outliers, mostly markets still being driven by new sponsors, where in-place income / adjusted expense cap rates were high-4% in earlier 2023 but most primary and secondary markets were trading in the 5% to 5.5% cap rate range in 1H2023 and with this latest run up in treasuries the market has completely stalled and I expect we'll see 5.75% to 6.5% cap rates.
Probably an unpopular opinion but don't expect the same interest rate/cap rate spreads with higher rates from here. The higher interest rates go, the less correlated interest rates and cap rates will be. It wasn't really until the late-90s/2000 that there was a spread between long term interest rates and cap rates. If you look at the 1980s, when interest rates 12% to 15%, commercial real estate cap rates ranged between 6% and 8%.
While I agree that some of the deals getting done make no sense whatsoever, I wouldn't say it's "nowhere near priced into commercial real estate".
There has certainly been a pronounced downward slide in some markets. Phoenix Class A multifamily for instance has deals trading for 25%+ less than they would have in 2021 and Q1 2022. Shit, we just had a multifamily deal that sold for low $300k's per door after getting BOV's at $450-475k/door in February 2022. Sure, BOV's are generally aggressive, but comps supported $425k all day long. While it stings to let it go for that, it helps when we developed for ~$140k and deal is still a realized ~4x MOIC...
Vegas and Austin multifamily essentially at a standstill and therefore no pricing discovery...but the writing is on the wall given the lack of activity. Denver was holding up decently until the last two months, when a lot of buyers dropped out of the market and deals stagnated, with offers coming in well below guidance on several assets and others getting pulled from the market. DFW is the outlier and has been a fucking machine relative to other markets the last year in terms of operations and sales liquidity in the Class A multifamily market, but even it is starting to slow the last two weeks according to nearly every broker I've spoken to.
There's a bit more pain to come in the multifamily market IMO, but at some point, basis just starts to become too juicy to ignore in places where you believe in the long-term fundamentals & demand. Again taking Phoenix - there's a quality urban infill multifamily wrap deal that has guidance pricing just north of $300k/door...it would easily be $425k to replicate today (assuming you could even find a willing and reasonable land seller). Given the further runup in treasuries since marketing began, this could very well sell for below $300k, which is well below what even Class B/C 1970-80's product was trading at during the peak.
Anecdotally, one of the best multifamily brokers in Phoenix (IMO) said that if basis drops another 10-15%, the institutions and large discretionary fund shops will - and I quote - "just scoop up everything" as it'll represent anywhere between a 15-40% discount to replacement cost for very quality assets/locations. He's on the phone with these guys every single day, and said they've been licking their chops and getting smart on replacement cost. Maybe someone entrenched in the institutional world can add some color here.
The one spot where things will get really bad is the shitty syndicators of the world who bought at ridiculous basis and with high leverage debt. We all know this story will unfold eventually for some of these groups, despite the "extend and pretend" we've seen amongst select bridge lenders thus far.
WIth respect to other asset classes, office is a complete bloodbath and even major owners are simply handing back the keys rather than marketing for sale or refinancing. Don't think you can honestly say risk hasn't been priced in there.
I'm not super in-tune with the retail market, but my wife's firm (large retail owner/manager with very high quality portfolio) is still signing quality leases, maintaining good occupancy among credit tenants, and is getting acquisitions/dispositions/refinances done, albeit at values 10-15% lower than the peak (less peak-to-trough reversion in retail given values were already somewhat depressed coming out of COVID). Cap rates seem pretty damn attractive vs multifamily and T-bills, but again I'm not in the retail market every day and maybe someone has more to offer here.
I won't comment on other asset classes as I don't have much to add there. Overall, I agree there's generally more pain to come, but there's already been a big hit in high-growth multifamily markets, office, and to a lesser extent retail.
What were the cap rates on retail? Have heard on the industrial side net leased properties with term to quality tenants are trading in low to mid 6 caps generally (10-15 years, Amazon/amazon like credit).
I think the story that comps supported it doesn't mean much, there's been a huge run up in pricing which was unsustainable so maybe comps supported it (from how long ago did they trade and are they truly within your submarket?) but those comps were never realistic. Seems you have a much better view into multifamily than I do, but when you're telling me close to $500k a door in Phoenix that sounds insane and never realistic. Why would someone buy it at that price when I'm sure SFH are trading for similar on the low end at least in that same market. Not apples to apples, but something to consider in analysis and more holistic view.
I agree it got crazy, but it’s very submarket specific and demand/rent growth was pretty ridiculous for awhile in high growth Sunbelt markets. Market-wide, rents have generally pulled back mostly due to concessions on account of supply, but for best-in-class product in great locations, I wouldn’t call the drop precipitous by any means. To your home purchase point, some of these deals have median incomes north of $140k and are mostly renters-by-choice.
To give you some perspective, there was a multifamily deal in Phoenix that traded for more than $700k per door in Q2 2022 and a number of others north of $450k. Single family (non-condo/TH) homes in the area of the deal noted above are $600k at the absolute bottom end and there are $15M+ homes within a mile. While I personally wouldn’t have bought this massive deal, ultimately I think the crazy purchases were really the 1970’s deals north of $300k per door.
On the retail, 6.5-7 caps
While I agree with most of this, I struggle with the though that institutional allocators with access to discretionary capital are going to "scoop everything up" simply as a basis play when the current yield is not there.
Projects that broke ground from 2021 to 2022 in Southwest markets were underwriting to 5.0% development yields in markets with capitalization rates of 3.5% and long-term debt available at 2.5% - 3.0%. That puts you at a very healthy 40% development margin.
But as discussed, that cost of debt has risen to 6.0% - 6.5%. If you solve back to a long-term loan, you'll land at about 55% LTV on a 1.25x DSCR. That puts your cash on cash at 3.5%. That also assume the Seller exits at their own basis and doesn't want a small premium to replacement costs to move.
At a certain point in time, you're just making a macro bet that rates will come down. This would not be looked upon kindly by institutional investors if we really do hold higher for longer. There'd be some significant under performance to those that were aggressive and took on that level of negative debt to equity spread.
Just not sold on the idea they'd do that. I think at the end of the day they have plenty of holes to plug in their own portfolios as valuations re-rate and we need to systemically de-lever.
Generally agree with you and was adding some color around what brokers are communicating these days, but obviously it's always with a grain of salt as they're perpetually trying to create a market for themselves and want to create a sense of urgency today. I do think there's ultimately a basis floor in markets with tailwinds (assuming the broader economy doesn't completely shit a brick), but how much lower that is I don't know and yields certainly have to adjust.
I do know of one Class A deal in Phoenix where a very large institution was trying to pre-empt a deal before it hit the market recently, citing basis as the main driver. Went directly to the LP and submitted a low-ball offer (15-20% below replacement), but GP exercised the rights to fully market. Their offer price was around a 5 cap on our UW, though we're fairly conservative. I'd say most would peg this around a 5.25, but this was before the recent run in the 10 Year and I doubt they'd submit that today.
Also agree that it's 100% a macro bet that (a) rates will come down and capital markets will "settle" (whatever the fuck that means coming out of a super low interest rate environment for the last 10+ years), (b) growth/demand in these MSA's will persist, and (c) the infeasibility of development today will create a period in time 3-5 years down the line where all the current supply will be absorbed and operations will pop. Without making this bet, many deals today simply don't make sense.
Seeing some other unique situations where people are stretching for good basis. There's a deal out in Phoenix where the owner bought at the peak with an uncapped 80% LTV floater and is severely under water. Most offers came in ~10% below the par value of the debt, but a couple groups apparently approached the lender and said "we'll get you out whole, but you need to re-cast a new 5-year loan with us at a low 4 interest rate". Cap rate on that pricing is about the same, so at least they're neutral leverage and buying ~20% below replacement. Saw the exact same scenario unfold on a Denver deal earlier this summer. Debt yields for the lender are pitiful compared to market today though.
Market is in a really strange spot right now and IMO the next few years will be a defining moment in many 25-35 year olds' professional lives. Where's a crystal ball when you need one...
Your broker’s math doesn’t make sense.
He’s implying institutions with flexible capital will jump at Class A Phoenix multi family if it is trading at 40% below peak?
What was peak cap rate for that product? 3%?
For a 40% asset price drop, that would imply 5% cap rates for that product.
You’re telling me you believe flexible institutional capital would be happy with a 5% cap rate, when riskless 10 years are yielding almost 4.6%
No freaking way.
Doesn’t matter what replacement cost is - 50 bps over the 10 year is not gonna make any institution salivate.
Don’t lie to yourself.
Going to be really interesting to see where replacement cost trends over the next few years. The adage that construction prices never really decrease has historically been true, but we also have never really seen a runup like the one we saw in 2020-2022. I'm not expecting a 30% decrease in construction costs, but 15% would be meaningful. Said another way, buying something at $325K/unit because replacement cost is $400K does seem attractive, but if you have to accept a crappy yield and replacement cost trends down over the next few years as development falls off a cliff, was it really a smart buy?
As noted above, was reporting what some market participants are saying, backed up in my other comment by a deal that this literally just happened on (albeit to a lesser extent than we're talking about here). That group has been out of Phoenix since the 2022 peak but is sniffing around again.
Another institutional REIT has a midrise in Midtown Phoenix tied up at a 4.25 cap, and even though they think there will be operational efficiencies because they own in the area, call it maybe a 4.5-4.6 cap. We'll see if they actually close given what's happened with treasuries the last week, but when they tied it up, they were only looking at ~20 bps of spread to the 10-year. Broker reported that they loved the basis and believe in the market over the next 10 years.
Also real new-build Class A deals weren't trading at 3.0 caps (for the most part). Was more like 3.5 to a hair below 4.0, with most centering around 3.75. On your math, would put a 40% drop at high 5's at a minimum and more like 6.25 on average. I won't pretend to know where treasuries go, but my guess is there will be more than 30 bps of spread there. If 10-year truly pops to mid-to-upper 5's, our industry will be in for a reckoning.
It's the older syndicated stuff that was mostly 3.0 or lower caps on pre-reno numbers.
Lastly, as noted in my other comment, it's 100% a macro bet on markets that you believe in fundamentally over 5-10 years, as well as rates coming down slightly over that time.
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