What is the next big threat to CRE?

Just thought it would be good to brainstorm on this. CRE is at a high and regardless of fed hikes, it doesn't seem like cap rates are increasing. Investors are willing to take smaller spreads. At what point will the market turn? Is there a black swan coming?

 
TeddyTheBear:
Just thought it would be good to brainstorm on this. CRE is at a high and regardless of fed hikes, it doesn't seem like cap rates are increasing. Investors are willing to take smaller spreads. At what point will the market turn? Is there a black swan coming?

It seems when things are going good, it is hard to imagine them going bad. I have been looking closely at the Minneapolis multifamily market. Development has been ongoing in a big way for the last 3 years, the market continues to absorb it with 3% rent growth. When/if the economy takes a dip, the 4/5 star developments that are already at 10% vacancy will take a hit as unemployment increases and spending reductions/defensive consumerism become the norm. Most of the development has been 4/5 star development. It seems to be latent risk because luxury apartments have elastic demand. As vacancies increase, debt burdens become unbearable, forced sale, rising cap rates, and I can see that all happening fairly quickly once the ball gets rolling.

 

I personally think the Black Swan is already here: retail rents are significantly down; office net-effective rents are under pressure too; investment volumes are down in gateway cities.. ok, the logistics-indsutrial asset-class is holding up so far.. but real estate is like a steam-train, it take a while to adjust and cool. Sooner or later the investors will ask for higher returns based on interest rate hikes ( just taking a minute to settle in the food chain )

 

It will be interesting to see how parking components of properties are retrofitted, if at all, as spaces become obsolete. There is no question that last-mile distribution and other forms of industrial will take a hit.

Not sure the direct impact on core multifamily, office and retail. I live in a major city because I like the fact that I can walk to work and have all amenities that I need at my doorstep. Even if I were able to live in a suburban setting at a third of the cost, I am not sure that I would do so. This feeling might not be shared by others. I can see suburban development taking off and some major cities becoming more spread out like LA over the long-term. Who the hell knows. Interested to hear thoughts from others.

 

RE: near-term risks: cap rate expansion.

Most prudent investors have been underwriting cap rate expansion of 50-75 bps above spot cap rates for purposes of formulating an exit valuation. The current 10-year treasury - cap rate spread across property types is still fairly wide despite recent 10-year increases, so there is room for treasury rate hikes to be absorbed without causing an increase in cap rates. However, while cap rates do not have a perfect correlation with the 10-yr treasury (and have some room for spread compression), if the 10-year spikes to 4% - 5% in a short period (resulting from increased US borrowing to fund budget deficits, infrastructure, and there just being less global demand from global investors for US treasuries), then it is very possible that a jump in cap rates occur causing a reversal of property values. If this happens, then it could cause some serious distress in the market.

 

I think eventually higher interest rates have to result in higher cap rates. I’m working on a couple trophy NNN deals in core markets and I don’t even want to look at the model. We’re borrowing at 4.5% to put money to work at 4.3%. It doesn’t make any sense to me from a pure investment perspective but we have a few other considerations in mind that make it worth while.

 
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IMO, the threat to real estate is threefold.

  1. Drastically increasing construction labor and materials costs. This is further impacted by the Trump administration's immigration/trade policies.

  2. Irresponsible lending, particularly in the debt fund space. Deals are only making due to super cheap floating rate interest-only high leverage debt. Interest rates go up, cap-rates follow, supply shock of properties on the market to cover balloon payments, etc...

  3. Unrealistic rent growth assumptions due to low real wage growth and rising student debt in America. Millenials and Gen Z cannot pay ever increasing rent, education, medical, food, etc... costs if wages in America do not go up. Also, much of the anticipated rent growth stems from renovation work that is not pro forma'd at a realistic cost.

 

My sector (single tenant net leased properties and smaller class A strip centers) is affected by cap rate suppression due to cash buyers/1031 buyers , who will sell their multi family assets in core or gateway markets (LA, NYC, South Florida), and exchange into multiple absolute NNN retail properties in other markets, ( Atlanta, Charlotte, etc). A 250bps spread looks pretty good when you are selling at a 3.5-4 cap and buying at a 5.5-6 cap and not using debt. Can’t speak as much about the office or industrial mkt, but that’s what is keeping the cap rates artificially low in my field. Private money , non-institutional exchange buyers. Of all the deals we did in the last two years, I estimate about 70% involved a 1031. Doesn’t really answer your question OP, but maybe gives some insight into why caps rates haven’t moved much in certain sectors.

 

With office, I know that to a certain extent the whole 'creative' sphere has extended the underwriting/cycle assumptions for a lot of assets in coastal markets (i.e., buy a 4/5 cap in-place, assume you convert a good chunk of the space to creative tenants, jack the rents up, $$$$). With industrial, there's a perception that e-commerce, last-mile, distribution/SCM, etc still have a lot of room to run and therefore even though the yields are low they are relatively 'stable' in the mid-long term. Some of these assumptions are obviously bullish, but those are some of the talking points that I've heard repeated by many people.

"Who am I? I'm the guy that does his job. You must be the other guy."
 

There's also a lot of foreign money being invested into the US right now (still). It's way easier to swallow the pill of a sub 5% return when the investment landscape in your home country is substantially below that. Many of the large SWF's and foreign buyers leverage at very low LTV's as well, making the impact of rising interest rates in the US even less impactful. This obviously isn't every deal, but I've definitely seen quite a few fit this profile in last 18-24 months.

"Who am I? I'm the guy that does his job. You must be the other guy."
 

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