The past year has been a volatile and challenging period for the commercial real estate sector, supported by the fact that transaction volume sank for virtually every property type. Investment sales activity decreased. Leasing activity paused. And financing activity plunged. The causes of this deal reduction are tied to a host of factors ranging from higher interest rates and rising inflation to fears of an economic recession and continued impacts from the pandemic.
The gap between what buyers were willing to offer for a property and what sellers were willing to accept widened. That disconnect created a bumpy price discovery journey that has buyers and sellers stuck in a standoff.
Kidder Mathews’ Brad Kraus, EVP, in the company’s Century City office, frames the current situation. “It’s all about interest rates and the ability to calculate what an appropriate risk-adjusted return represents in the current environment. Negative leverage or buying at a cap rate below the cost of your debt, hurts cash-on-cash returns. Coupled with a lack of clarity on which way the economy is tilting creates the buyer-seller gap. Transaction volume slows for a period until market forces adjust.
The current pricing standoff between buyers and sellers was set up by several factors that collided in 2023. Rick Putnam, EVP in Kidder Mathews’ Irvine office, says, “A dramatic rise in interest rates in late 2022 and into 2023 upset previous execution assumptions on cap rates, borrowing rates, and balance sheet (equity) values”. Geo-political and economic news trended negatively and hurt investor confidence. Transaction volume plummeted; traded values dropped 15-50%, with volume down 50-75%, depending on the sector, in this newly illiquid environment.
“Except for office, the reduction in sale volume is almost exclusively driven by the spike in interest rates,” says Kidder Mathews SVP David Hill in Portland, Oregon, adding the lack of tenant demand for office space and office investment transactions are almost non-existent in most markets. He says that simple interest rate/leverage calculations can easily account for 10% to 20% reductions in price. However, “with most non-office assets performing well from a cash-flow basis, few owners are willing to sell at significant discounts from recent years and are thus holding on to properties if they can.” “Sellers that were able to refinance at favorable rates for longer terms in comparison to today’s rates also create a lack of motivation to sell,” according to Eric Paulsen, Kidder Mathews Regional President of Brokerage for Southern California and Arizona.
The disconnect between what sellers want and buyers will pay from the lens of a retail investment broker is interesting, notes Maggie Wolk, VP in Bellevue, Washington. “High interest rates and overall economic uncertainty have led to low levels of quality inventory hitting the market, which in turn creates a supply and demand issue. This has allowed for cap rates, particularly in the retail space for deals under $10 million, to remain compressed, further perpetuating the gap between buyer and seller expectations.”
The problem, outlined by Kidder Mathews’ Erik Marsh, SVP in Phoenix, Arizona, is that “sellers are still stuck in pricing from 18 months ago and have not faced the reality of today’s market. Unless there is a compelling reason to sell, the spread between the bid and ask remains high, therefore reducing the transaction volume.” Marsh is convinced that interest rates are the primary factor contributing to the disconnect. “The rates are constantly changing and make it challenging to underwrite. There is a wait-and-see mentality with a lot of money on the sidelines.”
Kraus agrees that “sellers have yesterday’s price fresh in their minds and see no reason to sell at what they believe is a discount — having faith that the Fed is close to taming inflation, a soft landing will occur, and lending rates along with cap rates will simmer back down.” He adds that the buyer-seller gap is further being compounded by the fact that the long bonds are “bouncing around like a yo-yo.” The 10YT, commonly thought as the benchmark, hit a multi-year high yield of 5% in October and has since receded to 4.2% as of December 12, 2023. There is a bond rally going on with the belief the Fed will start tapering short-term rates in 2024.
The Road Ahead
According to Hill, we could see a pricing reset “when investors believe the 10-year treasury is relatively stable, and particularly if this occurs within the 3.5% to 4% range.”
In Putnam’s view, “the ‘reset’ to a 4.5 – 5.0% 10-year Treasury world has already occurred in the lending and equity markets, and if the Fed has truly stopped hiking, then sale volume will increase in early 2024 and those pricing levels will indicate that values have reset. Most 2023 sales were not ‘business as usual,’ and instead reflected unplanned reactions to cash liquidity, debt maturity, redemption, or opportunistic circumstances.” He expects that early 2024 will be different.
Any pricing reset is largely specific to asset type, notes Kraus. “Office is hanging by a thread and trading below replacement value. Net lease assets, and for the most part, multifamily, are interest rate sensitive, and retail is dependent on the health of consumer spending. In other words, we need clarity on which way the economy is heading before true pricing can be discovered.”
Property Types Impacted
Certain property types fared better than others this past year, though there is a general concurrence that office product has been most negatively impacted — with industrial and multifamily the least. Putnam believes this was because higher interest rates magnified the negative impacts of ongoing capital needs, which are greatest in office product.
Hill agrees that the office sector was clearly the most impacted. However, he says, “Apartments were impacted more than I had anticipated, reflecting the higher leverage nature of these assets. Retail seems to be faring better than most people might expect. This is likely more representative of the smaller size transactions than larger ones.”
Kidder Mathews’ Todd Davis, SIOR, CCIM, SVP in the firm’s Carlsbad, California office, says that industrial is the strongest property type, with office the weakest. “Pricing expectations will only happen over time, as forced sales will help determine how much investors will pay.”
“As long as interest rates are at 6% to 7% and government bonds are at 5.5%, there is little motivation to move into CRE,” Davis adds. “If interest rates are lowered, it will help, otherwise, values will come down slowly until they hit a point that returns are worth the risk.”
Strategies & Advice
Kidder Mathews experts offer a variety of strategies for sellers to determine what an asset is worth. Putnam points out that “unknown risks are getting a very heavy discount in today’s market. So, be open-eyed to any asset issues that have value-impacts, and either fix them completely or be prepared for that value impact.”
He advises to “wait for sale comp tailwinds before entering the market, if possible.” That is because appraisers’ and bankers’ underwriting are backward-looking and tend to be half-empty, not half-full perspectives. Putnam’s counsel, once in the market, is to “be patient for the right buyer and price; and understand that an offers-due deadline or lofty guidance applies only to the best asset in the best market, today.”
“Unless the property is small enough to secure a cash buyer, maybe under $4 to $5 million, sellers need to be realistic about pricing with leverage,” says Hill. “In most cases, buyers are simply not going to accept a sub-5% cash-on-cash return for a stabilized property when they can earn more than that at the local bank.”
Sellers who exhibit a clear understanding of the capital markets and financing are likely in a better position to cut a deal, points out Marsh. He advises carefully tracking the debt market and comprehending how this impacts the returns.
Timing & Approaches
As investors wonder whether to pause acquisitions until prices dip down, Hill offers this advice: “It may be a good time to acquire quality real estate that may not typically be available, at ‘reasonable’ pricing.”
Marsh agrees it is “nearly impossible to time the market. Now is the time to be a buyer and not a bidder. Real sellers are working with buyers to make a deal, which can always be refinanced later.”
Putnam points out that “successful investors we have all watched ‘average in’ to the market and are not afraid to buy when others are not. Paying a market-based price today for an asset that gets strong rent growth over the next few years, while overall interest (and cap) rates may drop, will likely look like a smart move in hindsight. Compared to prior years, good assets today might be purchased at under-replacement cost, which would be a nice benefit (for buyers) of this market correction.”
Solutions to Bridge Buyer-Seller Bid-Ask Gaps
Perhaps the best solution to navigate the price discovery conversation is to become an active market participant rather than waiting on the sidelines too long. Savvy brokers will help sellers uncover opportunities. “Some deals want to trade off-market, and when the market recovers, often that initial price action is quick and strong to the upside,” says Putnam. “So be ready with capital, watch the tenant demand side, and stay abreast of the debt markets, against which so much of the market is priced.”
Advice for buyers and sellers:
- Pay attention to the market.
- Watch for signs that transaction volume is beginning to thaw.
- Be realistic about where you think long-term interest rates might stabilize.
- Consider more history than the past decade.
- Buyers and sellers must meet each other in the middle.
- Bring an understanding that the market has changed.
- More flexibility on the part of sellers.
- Be prepared with very recent sold comps.
- Know the cost of capital and risk-adjusted returns.
- Find agreement on realistic market assumptions.
While navigating price discovery in the current market can be challenging, buyers and sellers can avoid a stand-off if they proactively seek out opportunities in the marketplace.
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