After a whopping 11 Fed rate hikes, commercial real estate investors are still grappling with the same issue they have been battling for months—pricing uncertainty. And it remains to be seen just how long the divide between buyers and sellers will last.
“We’re definitely in a very different environment than we were a year ago,” said Jim Costello, chief economist–Real Assets at MSCI. Interest rates had started to increase but were still relatively low and investors were hungry for yield. In fact, second quarter 2022 was a record quarter for transaction volume. Ever since then, it has been a story of falling volume and challenges related to pricing, he added. According to MSCI, the $175.9 billion in sales during the first half of this year was down 58% compared to the prior year.
The below average deal volume is one obvious indicator that the bid-ask gap is still very much in play. However, there is some evidence of progress in the pricing reset. The latest MSCI CPPI from July shows a 10.2% year-over-year decline in pricing across all property types, while the latest Green Street CPPI shows a 12% average drop. MSCI is tracking transaction data, while Green Street is gauging market values in the public REIT universe. “Prices are down, but not as far down as buyers of assets want them to be,” says Costello.
The bid-ask gap has been fueled largely by Fed rate increases to the federal funds rate and an increase in SOFR from near zero to 5.3% over the past 16 months. Liquidity from lenders also has tightened. “In the latter half of 2022 we started to experience a deep freeze in credit markets, but deals were still moving because property income was rising quickly and expenses were moderating,” said Anthony M. Graziano, CEO of Integra Realty Resources. By the first quarter, income fundamentals in all classes of real estate had started to erode, while expenses spiked, particularly on insurance and labor costs. “I think the bid-ask is widening at the moment where buyers are still projecting stronger rent increases than buyers believe,” he said.
The transaction market isn’t likely to thaw until seller pricing resets to account for increased risk. In addition to market risk, buyers are wary of liquidity risk and challenges of being able to sell on demand. “Only the long-term money is going to play—and it’s going to want a deep discount or higher return premium in exchange for poor capital liquidity,” said Graziano.
Uncertainty hampers repricing
The market is still in the relatively early stages of repricing assets, and the reality is that it is tough to come to terms on pricing when there is so much uncertainty on the outlook for capital costs, demand and rent growth. Even as annual inflation has narrowed closer to the Fed’s 2% target, many owners are seeing their operating expenses creep higher.
Valuations are difficult across all sectors emphasized Graziano. The challenges in office and retail are based on the lack of clarity in fundamental demand both currently and for the foreseeable future. Apartment and industrial assets are difficult because the future income-expense fundamentals are no longer valid with a deceleration in rent growth and increase in operating expenses. “The most difficult asset to value at the moment is land. Everything else is just a matter of perspective and property-specific market research relative to peers in the market,” he added.
Contributing to the cloudy picture on commercial real estate values are divergent opinions on where interest rates are headed. There is some hope that the Fed is nearing the end of its rate hiking cycle. However, while some believe that the rate environment ahead will be “higher for longer,” others are holding onto optimism that interest rates could begin decreasing as soon as later this year. “I think most investors want to believe interest rate cuts are around the corner, but mixed views abound,” Graziano said. As to when rate cuts would start, that usually only follows a recession, which could in turn weigh on NOI and values in the near term, he added.
“Direct real estate investors are scrutinizing deals more heavily, and really weighing rent growth and demand in the market much more heavily,” Graziano said. Two other tried and true strategies for understanding deal fundamentals when pricing is uncertain are comparing sale prices to replacement cost and better understanding the future supply pipeline, he says. “At the moment, this is not as much a pricing problem—we are having a liquidity problem,” he added.
Investors adapt to new paradigm
When the cost of debt was zero and investors were hungry for yield, it was feasible to buy an asset at a 3% or 4% cap rate. Now the market is in a new paradigm where buyers are still trying to figure out the right basis. When you think about running an exit cap rate for a five-year hold, are you getting the levered return for your investors over that hold period?
Some investors are choosing to ignore some of the “noise” in the market surrounding price fluctuations and are focusing on the property-specific, sub-market and micro-market dynamics. “While there are markets where we would avoid purchasing at any price, we acknowledge that each deal is unique, and a one-size-fits-all approach isn't appropriate,” said Mark Green, chief investment officer at the Cottonwood Group, a private equity real estate firm based in Los Angeles.
Cottonwood's approach involves a comprehensive evaluation of micro and macro market fundamentals, identifying factors that could influence asset demand, and assessing the leveraged return potential based on the associated risks. “Our investment decisions are based on a meticulous understanding of the specific property and market conditions rather than being solely driven by general market trends,” Green added.
Jones Street Investment Partners sees both sides of the bid-ask gap both as an investor that is buying apartment assets and as an apartment developer that is selling stabilized assets. “If you're measuring valuations on a day-to-day or week-to-week basis, there has certainly been a reset in pricing compared to where we were six or 12 months ago,” said Matt Frazier, CEO of Jones Street Investment Partners, an apartment investor and developer. “We tend to think about things with a longer-term time horizon though, and we have a lot of confidence that whatever short-term noise we're feeling from interest rates and their influence on cap rates, that will be offset by rent growth.”
Jones Street is focused on the Northeast and Mid-Atlantic markets where occupancies are still high and rent growth is positive. “We've been preparing for a recession for 12 months, and so far, we haven't seen any evidence of it,” Frazier said. “So, while it may be true that cap rates today, or at some point in the short-term future, are higher than where they were a year or two ago, whatever influence that has on valuations will be offset by growth in net operating income.”
Waiting for a bottom
For those looking for a ballpark number, the headline view is that there has been a 10% to 15% discount on prices. The reality is that the reset in prices is highly situational depending on the property type, geographic market and underlying fundamentals.
Office has been the most negatively impacted, and it also is the sector where there is more fear that pricing could drop significantly lower. The Green Street CPPI shows a decline in office values of 27% compared to an 8% decline in the broader MSCI CPPI. There is significant uncertainty around where tenant demand will come from, and how much money a buyer might have to put back into a property to attract tenants. Liquidity for office also is tighter. So, for investors that might be still looking to acquire office assets, they’re likely going to need a lot of additional equity for improvements on top of the equity they need to close a transaction.
For investors evaluating opportunities in the office sector, their primary focus is to accurately gauge the true demand for the property, noted Green. Additionally, investors also pay close attention to location in a market, amenities and where the asset falls on the spectrum of a class-A property or a property of older vintage, as those factors can significantly impact the investment potential and overall strategy. “Potential buyers are exercising caution and hesitating to enter the office sector too early, as they fear that pricing may undergo further adjustments and potentially decrease,” he said. However, Green also believes that interest rates will eventually stabilize, and investors will regain confidence in the office sector.
Digging into the pricing and transaction volume also shows some bifurcation in the market in certain sectors, notably, office, retail and hotels. For example, the limited-service segments of the hotel market are performing well, while many full-service hotels have had a tougher recovery. The MSCI CPPI data showed the biggest decline in hotels with a drop of 11.7%. “I suspect that the pricing trends that we’re seeing for hotels is really tied to the limited service sales,” Costello said.
Across property sectors buyers are wary of getting in too early when pricing could adjust lower. “It’s hard to see this as a bottom right now as long as we still have this gap with mortgage rates and cap rates,” Costello added. “Cap rates have been rising, but not nearly as much as interest rates have risen. So, it makes it difficult to purchase a property with leverage unless you are underwriting tremendous income growth moving forward.”
One sign that the gap may be narrowing is that there do seem to be more deals hitting the market and closing, adds Frazier. “There’s also a lot of activity just under the surface where deals are being shown around, not with a full marketing memorandum, but they’re available for sale. So, we are seeing more people getting back into the market,” he said. “Stabilization in the debt capital markets is going to give people the certainty that they need to start to have some conviction on valuations. I also think that will help to bring more activity to the market.”
