October 24th, 2023
1. Interest Rates
All subsequent discussion in the world of Commercial Real Estate starts with interest rates. As of the morning of October 23rd, the 10 Year Treasury crept north of 5%. We’ve not seen interest rates this high since 2007. Why does this matter? Well, as it relates to commercial real estate, it matters for the same reasons it’s mattered since the Fed first bumped interest rates back in early 2022; interest rates go up, real estate values go down (or at least that’s how it should work in theory).
Since late 2022, cost of debt to acquire or recapitalize real assets is, in most cases, creating a gap too wide to justify transacting. As we stated above, in an ideal world, as interest rates rise property values should drop (i.e., sellers reduce price expectation). This is the sequence of events that makes sense and keeps the capital markets moving. . . . Tell that to the owner who paid a premium for their asset in 2021 and refuses to sell for a price lower than underwritten expectations. Or maybe to the owner who has no where else to place sale proceeds in order to avoid capital gains tax. Or even on the single family side, tell that to the homeowner who has a 3% interest rate locked in for another 5+ years.
The conversation starts with interest rates. And in today’s market, unfortunately usually ends there.
2. “Now is the time to buy!!”
Well that’s awfully contradicting relative to what we just discussed about interest rates. A recent GlobeSt article featured John Sebree of Marcus & Millichap who believes now is the time to buy multifamily assets. But why?? How??
Fundamentals are still strong across multifamily. Generally, occupancy remains high and rent growth continues. And, as you’ll read below in topic 3, while there’s been a significant amount of new construction the past few years, come 2025 the pipeline is thin. In other words, once the current projects under construction hit the market there’s not much more coming behind. Not to mention, we have a looming 3.5 million unit shortage over the next decade.
But the most important factor according to Sebree is the “enormous amount of capital on the sidelines right now.” As this capital starts entering the market once again, competition will ramp right back up to the heyday of 2021.
We’re not sure we’d hop on this train with Sebree entirely just yet. However, we will say the level of distress and “deals of a lifetime” many predicted across multifamily still hasn’t really come to pass. In fact, we believe Sebree’s view is much more realistic. He goes on to say buyers must first determine what their cap rate criteria is going to be; “Maybe it’s a five and a half, maybe it’s a six, but it’s probably not gonna be a seven in today’s market. You have to understand exactly where interest rates are, agency debt, or bank debt, and you’ve got to keep in mind that you may have to underwrite negative leverage for a short period of time.”
Right now this may be the unpopular opinion. In time, we would not be surprised if Sebree’s outlook aligns with reality.
3. Undersupply last year .. Oversupply this year?
Since covid, many in our industry have been screaming from the rooftops about the housing shortage that has plagued the country since the great financial crisis. Post GFC, we did indeed severely under-build which created this shortage. Post covid, we saw new construction starts shoot up as developers took advantage of low cost of debt. The question becomes; are those new deliveries enough to swing the pendulum to “oversupply”?
The discussion is quite nuanced and we must take several factors into consideration;
Geography – new development over the last several years was not evenly spread across the country. Markets like Phoenix and Dallas saw massive new inventory while Midwest markets like Chicago and Columbus only saw a small uptick. “The Midwest is holding up the best right now. Deliveries on Sunbelt are up 60% from 2019 before the pandemic. In the Midwest and Northeast, deliveries are up only 8%. Chicago, Indianapolis, Columbus and Cincinnati are above their pre-pandemic five-year averages. Even markets like Washington, DC, are not stellar but are not bad,” Jay Lybik of CoStar says.
Widening gap in demand – renters see a big difference between a new build Class A unit and a 1990’s vintage Class B unit. There was a time where the price difference between the two was not as prominent as it is today. Today, the price difference between top and middle product is about $600/month. Back then, the pain of oversupply was felt across the sector. Today, the pain is really only felt at the top within the Class A space. Class B/C are shielded to an extent but at the same time feel the pain of flight to quality from those renters who can afford it.
In the near term, certain sectors and locations will continue to feel pressure from new supply. Once those new units get digested, Paul Fiorilla of Yardi predicts “markets will be fine.” New starts have slowed significantly, dropping 50% from Q4’22 through Q3’23, due to the high cost to build and finance projects. Theoretically this means come 2025, once the post-covid projects have time to deliver and settle, demand will swing back due to the underlying 3.5 million units needed over the next decade.
4. Midwest Strength Continues
The cliche saying about the Midwest continues to hold true. As many markets across the country ride the rollercoaster of highs and lows, many Midwest markets remain “strong and steady”. CoStar recently released its top US markets for rent growth report and both Cincinnati and Columbus (75% of Ten27 properties reside in these two markets) sit in the top 20, among various other Midwest friends.
Even though Cincinnati has seen 3,500 new units delivered over the last 12 months, vacancy remains tighter than the national average which has contributed to the +3.4% rent growth this year. This is partially due to the fact that Cincinnati’s vacancy rate prior to these new deliveries was at a record low of 4% (in other words, the city was in serious need of new housing) and although we’ve seen vacancy jump it remains below the 10 year average.
As always, we hope this is insightful. If you’re interested in learning how to invest or discussing some of our current investment opportunities, don’t hesitate to reach out!
Mitch and Kevin