To say that COVID landed a global gut-punch, scoring a direct bullseye felt in every corner, is a huge understatement. While some commercial real industry sectors were beneficiaries of this phenomenon (think logistics and cold storage), some continue to reel from the pandemic’s wrath. And in that process, underwriting has undergone changes as well.
In examining those changes, a logical methodology is a timeframe of pre-pandemic, pandemic and present day in terms of how investors look at real estate investing.
It was clear prior to the pandemic investors felt strongly that real estate was a less correlated asset class in portfolios (to stocks and bonds). As a result, institutional investors ramped up real estate exposure in the past decade. Moreover, big pensions, endowments and foundations invested in upwards of 10 to 15 percent for that real estate allocation. That was reflected in asset prices as well as an appetite for commercial real estate. This extended well beyond traditional property types into interest in the niche sectors of self-storage, cold storage, seniors, student, medical office, etc. Historically, all asset classes, especially ones like real estate that utilized leverage, benefited tremendously from a 40-year declining interest rate environment. What a buyer is willing to pay is correlated to the tolerated risk above the risk-free rate; i.e., the U.S. Treasury. And that attractive return range is between 100 to a couple hundred basis-point spread. When the pandemic hit, it literally broke a bunch of models.
For one, interest rates dropping so significantly pulled cap rates down, which drastically accelerated exit opportunities. Where in original asset business plans, owners assumed it might take five to seven years to realize a return, but because property values had gone up so much in a short period, they were able to sell and realize a significant return.
The other piece that changed significantly was demand/supply fundamentals; albeit more on the demand side with regard to rent growth because of remote work. Rent growth exploded or evaporated in some coastal markets that weren’t anticipating massive migration changes.
That double-factor change impacted valuation, particularly in areas attractive for migration: the Mountain West, Sun Belt and then south-southeast areas. And the last piece was an undersupply in those markets. It was a combination of people moving in but also lack of supply that really impacted rents and rent growth.
Unlike the beginning of the pandemic, the opposite scenario is playing out today: there is no longer intense pressure on migration. Some of the big cities are now creating a magnetic pullback for workers in a tougher job environment, so the demand pressure is not as strong. The second piece is there’s significant supply due to demand moving toward low supply-constraint cities; i.e., there weren’t limitations in Texas or Florida markets to building. While this supply comes online, it has created headwinds for rent growth.
Another factor is insurance in general, which had underpriced risk in the last decade. Whether it’s global warming or major natural events, insurance pricing in coastal areas has gone up by 2 to 3X in the last two to three years. Therefore, expenses are going up way faster than revenues and it’s quickly eroding NOI and the ultimate investment returns.
The final and by far the most impactful issue is interest rates going from zero to closing in on 5 percent. Not only have interest rates increased but because of the strain in the overall system, we’re having a mass deleveraging across all financial assets. You’re seeing a lot of pressure on most financial institutions to not lend to certain property types. While the multifamily lending market is liquid and can still get financing from Fannie, Freddie or a number of other institutions, the regional bank community, which has historically been a major player in the space, is on the sidelines right now, and office and retail assets are untouchable.
To recap, the CRE industry has gone from a pre-pandemic histrionic reaction with lower interest rates, to the pandemic with interest rates dropping to the bottom, rent growth skyrocketing and more transaction volume. And today reflects the opposite: low or rent growth retreating, interest rates increasing, insurance rates rising and values plummeting.
From our conversations with clients, attitudes around their willingness to invest are varied from wanting to bury their heads in the sand until there is more certainty all the way to viewing this as the best investment opportunity in a lifetime. From an optimist’s viewpoint, we see a lot of opportunities in the data – it just takes more effort to uncover those needles. One certainty is underwriting activities across all clients have skyrocketed as it relates to the number of deals researched compared to closed deals.
Thomas Foley is CEO and co-founder of Archer, a real estate technology firm. Foley is a serial fintech entrepreneur with prior ventures focused on helping investors invest in startups (Xpert Financial), startups manage the fundraise process (CapRally) and investors invest in alternative assets (Venovate). Foley spent the prior four years working at JLL and HFF as a director on the investment sales teams. He earned an MBA from the Wharton Executive MBA program in San Francisco and a bachelor of arts degree in economics from UCLA.
