A recent report from the Federal Deposit Insurance Corporation (FDIC) states that Commercial Real Estate (CRE) lenders are about to come under greater scrutiny. In the report, titled “Supervisory Insights Summer 2022”, the agency adds that there will be an increased focus on new lending activity, along with CRE sectors and geographic areas that are “under stress.”
This comes on the back of a record year, with “the volume of CRE loans held by banks recently peaking at more than USD2.7 trillion.” And while FDIC doesn’t oversee all these institutes, banks supervised by the FDIC account for around USD1.1 trillion of that amount.
The agency adds that there will be increased emphasis on transaction testing (i.e. sampling individual lending transactions), saying:
“Given the uncertain long-term impacts of changes in work and commerce in the wake of the pandemic, the effects of rising interest rates, inflationary pressures, and supply chain issues, examiners will be increasing their focus on CRE transaction testing in the upcoming examination cycle.”
Areas of concern
During 2021, FDIC examiners noted some specific CRE loan concerns, including poor risk analyses and improper assessments of whether loans could be successfully repaid. For example, some assessments failed to check whether a borrower’s business would be able to repay the loan when stimulus or other relief funds were no longer in the balance sheet.
Another area where some banks seemed to fall flat was in conducting a thorough and up-to-date analysis of prevailing market conditions. The agency added that examiners also saw cases where banks have “applied segmentation techniques ineffectively” or “have not drawn conclusions from the analyses performed.”
CRE lending outlook
Specific sectors identified as challenging for valuation in 2021 included some hospitality properties, offices, and malls, along with “some geographies, such as the Manhattan borough of New York City, [which] lagged.” In a Bloomberg article on the report, Brandywine Global portfolio manager, Tracy Chen added that “there are some challenges in pockets of CRE debt, such as offices and retails.”
In an environment where some banks have already announced cutbacks on CRE lending, the additional scrutiny may mean those lenders adopt an even more cautious disposition, especially for sectors they consider “high risk.”
Have there been any effects from changing lending policies on deal-making in your area?
Few innovations have had more of an impact on investment analysis than spreadsheet software. Dominated by Microsoft Excel for the last 25 years, this sector is currently used by an estimated 78% of U.S. businesses. While most know how to quickly copy, sum, drag and format, fewer may know about the real power of this software – a whole host of integrated functions and formulas.
I ran into a long-time reader a few weeks ago, who remarked on covering some ‘soft content’ during recent columns. As a result, this month we are going back to school to discuss some useful but perhaps little-known functions to help get your Excel game in gear.
Present value is a foundational concept and represents a value today for a series of cash flows to be received in the future at a specific discount rate. This concept has tremendous value to a real estate investor, as it allows us to determine what this series of cash flows is worth today. The formula is =PV(discount rate, time periods, periodic payments, future value).
Future value is also useful and is the exact opposite of present value. It rep- resents that value at some point in the future of a present lump sum value and/or a series of periodic payments, collectively compounded at a given compounding rate to a specific point in the future. The formula is =FV(compounding rate, time periods, periodic payment, present value).
We have discussed the concept of net present value several times over the years in these very pages. A kissing cousin to IRR, this concept adds a slight twist by discounting all future cash flows back at a target discount rate and nets the sum against the initial investment. The initial investment can be entered as zero, which makes this formula a very common way to determine the current value of an investment at a given discount rate. The formula is =NPV(target discount rate, series of periodic cash flows).
The addition of the ‘x’ allows for more specific control over the timing of cash flows. While NPV considers annual periodic cash flows, XNPV can distinguish between monthly, quarterly, semi-annual or annual periods, all within the same range of cash flows. The formula is =XNPV(target discount rate, series of periodic cash flows, range of associated dates).
Enter NPV’s kissing cousin. Most of us think of IRR as the rate of return that each dollar earns in an investment while it’s invested. But there is an alternative definition – IRR determines the exact rate at which all future cash flows dis- counted back to the present and netted against the initial investment equals zero. As a result, the IRR of an investment will be the same as NPV’s target discount rate when NPV equals zero. IRR is a very important metric to many investors but thankfully, the formula is simple: =IRR(series of periodic cash flows).
Similar to NPV, the addition of the ‘x’ allows for more control over timing. While IRR is an annual measure, XIRR can accurately calculate a mixture of time periods, including monthly, quarterly, semi-annually or annually. The formula is =XIRR(series of periodic cash flows, range of associated dates)
Back in the day, any real estate professional worth their salt would have a little red covered book called the “Ellwood Tables for Real Estate Appraising and Financing” right by their side. Filled with page after page of tables, it allowed the reader to quickly figure out the annual loan payment at a variety of nominal interest rates and amortization periods. This function in Excel makes the process a snap: =PMT(nominal interest rate, amortization period, initial loan amount). One word of caution – most loans are amortized and paid on a monthly basis so be sure that the nominal interest rate and amortization period both reflect this.
FV to find loan balance
Once you determine the loan payment, you can easily find the loan balance at any point during the life of that loan. The only time the future value (FV) will be zero is once the final payment is made and the loan is fully amortized. The formula is =FV(nominal interest rate, specific period for loan balance, periodic loan payment, original loan amount). Two input items of note. First, be sure that the interest rate, specific period and periodic loan payment all reflect months if using monthly compounding. And second, be sure to enter the periodic payment as a negative if the original loan amount is entered in as a positive.
Sticking with the loan theme, we know that the concept of classic loan amortization results in a portion of each periodic payment representing interest and a portion representing principal, which in turn reduces the outstanding loan balance. While both portions are important, we can use the IPMT function to determine exactly how much interest is associated with a particular periodic payment. The formula is =IPMT(nominal interest rate, specific payment period for interest component, total amortization period, original loan amount). Once again, be sure that all of the components represent months if using monthly compounding.
While IRR is a very useful tool, it has limitations related to its treatment of both negative and positive cash flows that the primary investment produce. Diving into the nuances associated with the treatment of negative cash flows can be the subject of an entire column (spoiler alert) so for now, just set that one aside. As for positive cash flows, IRR makes no assumption for cash flows that come out of an investment. The only thing that IRR cares about money coming out of a deal is that it is no longer in that deal. That’s an issue because, as an investor, I can re-invest that money into another investment. A concept known as Modified Internal Rate of Return (or MIRR) addresses this limitation by introducing consideration of a secondary investment, and associated reinvestment rate, for any positive cash flows that are generated by the primary investment. The formula is =MIRR(series of cash flows, safe rate applied to negative cash flows, reinvestment rate applied to positive cash flows).
While Excel has certainly changed the landscape of accounting and financial analysis, it wasn’t the pioneer. If you have a long enough memory, you may be thinking about Lotus 1-2-3, which was introduced in 1983. But four years prior to that was the OG – VisiCalc was the first spreadsheet software developed for personal computers in 1979. It is rumored that when co-founder Dan Bricklin, then a student at Harvard, showed his creation to a group of accountants, they sat in stunned belief at the ease by which simply changing a number would automatically update the sum total. And then, one of them started to cry. We certainly have come a long way, baby.
Financial Strategies by Alec J. Pacella, for October 2022 Properties Magazine.
According to a recent report by Moody’s Analytics, the rest of 2022 might be the start of an economic rough patch as increasing risk factors boost market volatility. Moody’s states that economic risks and tightening monetary policy could translate into higher cap rates all the way into 2023.
Cap rate forecasts
The report also points out, however, that all is not equal in commercial real estate (CRE) markets, with sectors like hospitality, office and retail already showing signs of an increase in cap rates in response to rising interest rates. Multifamily and industrial cap rates have meanwhile remained steady in the face of uncertainty.
Worth noting is that the existing low cap rates seen in multifamily mean that an overall rise in cap rates will likely cause an increase for the sector. Put another way: “…sectors that have been transacting at very low cap rates have little place to go but up.”
Is a bump up inevitable?
Earlier this year, the National Association of Realtors (NAR) predicted only a modest rise in cap rates in 2022, counterbalanced by upward pressure in CRE prices. NAR notes that sales price growth has been on the up, especially for the industrial and multifamily sectors.
Moody’s Head of CRE Economic Analysis, Kevin Fagan, adds:
“There are strong opinions in the market both ways, that cap rates will go up significantly with rising rates, and others saying that cap rates will go down, and demand and expectations of rent growth will compress risk premiums.”
In a May 2022 interview with Wealth Management, Fagan added that the biggest headwinds currently facing US CRE are a combination of inflation, lower consumer expenditure and the risk of a recession.
Moody’s adds that, given the current economic climate, the chances of 2022 being a recession year have risen to 33%, while 2023 faces an “uncomfortable 50% probability” of a recession setting in.
Taking the long view
Though these predictions certainly add some uncertainty in the coming year, worth bearing in mind is that the outcome of the current volatility is far from set in stone. The way these factors play out in the CRE market remains to be seen.
For now, Moody’s takeaway prediction is that we should “expect to see more volatility in transaction and capital markets before we record pronounced effects on rents and vacancies.”
SOCIAL: Have you seen any movement in cap rates in your area? And what sectors do you think will be most affected?
Growing up in a small town in western Pennsylvania meant that I wasn’t necessarily on the cutting edge of technology. Any new electronics took months if not years to trickle down and even then would usually mean a trip to bigger cities such as Youngstown or Pittsburgh to track down. A great example is the LED watch. It was initially developed in 1971 and became widely available by the mid-1970s. But it wasn’t until Darrell Knight showed up sporting one on his wrist right after Christmas break of 1978 that I actually saw one, live and in person.
The use of technology in real estate seems to follow a similar path, with innovations taking months, if not years, to be integrated into the industry. This month, we are going to discuss some ways, specifically in the area of smart buildings, that technology has finally begun to make a big impact.
While certain sectors, such as medical and clean manufacturing, have been driving advances in clean air filtration and monitoring, the advent of COVID- 19 has placed a spotlight on this topic. The result is a whole ecosystem of products and strategies known as IAQ, or indoor air quality. The most common IAQ technologies revolve around higher-efficiency filters. Humidification and dehumidification systems have also become much more advanced, helping to control dust and mold while maintaining comfort. More advanced systems assist with heat and energy recovery ventilators to offset the increasingly “air- tight” nature of modern construction, as well as UV purifiers to neutralize airborne bacteria and viruses.
Voice-and touch-activated tech
Again, this type of technology received a huge boost in the wake of COVID-19. If you have ever used systems such as Alexa, Siri or Google, you are already well aware of the power and convenience voice-activation can offer. And while touch-activated technologies have been around for decades, the overwhelming popularity of smartphones and apps are leading to more advanced applications. In the commercial real estate sector, it’s no surprise that the hotel sector has taken the lead implementing this type of technology, ranging from speaking to control lights, temperature and entertainment to accessing the room and ordering room service from your smartphone. And don’t look now but many larger commercial property owners are beginning to integrate these same technologies, offering them to their tenants as a standard building amenity.
This may seem like something reserved for only big cities such as New York, Chicago and Los Angeles.
In the commercial real estate sector, it’s no surprise that the hotel sector has taken the lead implementing [voice activation] technology, ranging from speaking to control lights, temperature and entertainment to accessing the room and ordering room service from your smartphone.
And these cities certainly began adopting technologies years ago, with the advent of apps such as SpotHero and ParkWhiz, which allow parking operators to maxi- mize their occupancy through digital notification, reservation and even sub- leasing processes. But if you’ve ever parked in the decks at Hopkins airport, you’ve probably seen another, even sim- pler example that uses a small green or red light above each space, allowing potential parkers to quickly differentiate vacant spots from occupied spots
Energy efficient systems
This can fall into two categories:
1) systems that optimize energy via continual monitoring and 2) clean or renewable energy features. The former is the real heavyweight when it comes to smart building design and is mainly based on the autonomic cycle of data analysis tasks (ACODAT) concept. Basically, the HVAC systems have a central processor that continually monitors usage, time of day, outside air temperature, building occupancy and a host of other factors to not only be reactive in running the HVAC system at peak efficiency but also be predictive by learning patterns over days, weeks and months. The latter includes a host of advances in technologies such as heat pumps and geothermal systems as well as solar- and wind-enabled sources.
The most common acknowledgement of building technology is a certification known as Leadership in Energy and Environmental Design (LEED), through the U.S. Green Building Council. A similar certification is known as the Building Research Establishment Environmental Assessment Methodology (BREEAM) rating. Both of these involve achieving points related to set standards that address carbon, energy, water, waste, transportation, materials, health and indoor environmental quality. There are many examples of LEED-certified buildings in Northeast Ohio, including the Maltz Performing Arts Center at Case Western Reserve University, UH Avon Health Center and the Children’s Museum of Cleveland, among hundreds of others.
And there have been many noteworthy projects worldwide, including the following high-achieving facilities.
Developed by Siemens, the build- ing contains a variety of dynamic and artificial intelligence to power its operation. A noteworthy feature is an advanced air volume system that can put the entire building into “green mode,” which is a setting that uses aggregated historical data to optimize humidity, air pressure and temperature. It also has a decontamination mode that raises the temperature to acceler- ate the decay of airborne virus particles.
This was the first building in Toronto to be rated as a LEED Core and Shell Platinum building. It links up Cisco’s business operations and helps to power Cisco’s Internet of Everything (IoE) while also streamlining all building data into a single network.
Arguably the most striking example of the IoE in smart buildings, the Mitie building uses automated alarms, remote systems management, machine learn- ing and data analytics to achieve a 95% accuracy rate for predictive main- tenance calls and a 3% improvement of energy usage by clients.
By the time we hit high school, Darrell Knight’s simple, push-button, red-hued LED watch had been eclipsed by a series of LCD watches that integrated features like alarms (with music, no less), stop watches and the ability to track multiple time zones. And while today’s smart buildings have shown great advances over the last two decades, the pace of technology promises to have an even greater impact on this sector.
A recent report – released in late May 2022 – shows the industrial commercial real estate (CRE) boom is far from over, even when the “headwinds” are accounted for.
The May 2022 Matrix Industrial Report, from Yardi Matrix, says that although the “economy hit a rough patch in the first quarter due to inflationary pressures and rising energy prices, […] demand for industrial space continues to be robust”.
The continued presence of market fundamentals like increased consumer spending and job growth are adding to the sense of resilience seen from the sector, which has made huge strides since the dawn of Covid-19 kicked online shopping and fulfilment into particularly high gear.
CRE in general and the industrial CRE sector in particular do face a range of economic pressures as we look to the second half of the year. Slower economic growth in the first quarter, supply chain issues, and “persistent inflationary pressures” are not insignificant depressive factors, but the drivers of demand are not going anywhere either.
The boost factors, on the other hand, include “healthy consumer spending”, and “the need to bring the nation’s stock up to snuff to support modern logistics”.
Additionally, occupancy across most US metros remains high and “rents are growing well above historical levels around the country,” according to the report. Rental averages across the US have increased by 440 basis points year-on-year.
Industrial building supply chain
The report calls the new supply chain for industrial building “extraordinarily robust”, but, as Commercial Property Executive reporting on the report highlights, “[a]lthough the under-construction pipeline is ballooning, experts see the industrial market as severely undersupplied”.
This assessment, from Prologis, draws from several different data sources including the Purchasing Managers Index, retail sales data, and job growth statistics, to posit that the US has “16 months of available industrial inventory”.
Reportedly, over 640 million square feet of industrial space was under construction nationwide at the end of April. Including planned projects takes the pipeline to 650 million square feet.
Far from being a US-only trend, demand for industrial is high among most developed economies – or almost anywhere with a strong consumer base demanding more and quicker online shopping and delivery.
As this Financial Times article shows, that’s the case even where Amazon space acquisition is slowing: “There has been record demand for UK warehouses in the past two years,” they write, “with take-up north of 50 [million] square feet compared with a pre-pandemic average of 32 [million square feet]”.
Social: Are you operating in a well-supplied industrial CRE market, or are people scrambling to find space? Tell us where in the world you are, and what the “pulse of industrial” is in your region?