CRE 2022: Positive metrics for the first six months

A new report out from JP Morgan Chase provides an interesting mid-year review for commercial real estate (CRE), showing positivity in the first half of 2022, despite the various headwinds the industry faces.

“Despite rising interest rates—with the potential for more hikes in the coming months—commercial real estate has seen success in 2022,” writes Al Brooks, Head of Commercial Real Estate, Commercial Banking at JPMorgan Chase.

Giving retail a boost
Even the beleaguered retail space has some standouts, according to JPMorgan. The report highlights a handful of factors that have bolstered strip malls in highly populated residential areas, underpinned by the likes of “grocery stores, fast-casual restaurants, and other retailers offering in-person services”, reads MPAMag’s coverage of the findings.

“JPMorgan observed that walk-in MRIs, testing clinics, and other non-traditional tenants may fill more shopping centers as retail evolves and adapts,” they add.

Class B and C malls, however, “continue to struggle” and the report authors call them “prime candidates for adaptive reuse” – into affordable housing and even industrial use, like fulfillment centers.

Industrial still booming
Given the huge demand for industrial space – a trend that continues unabated – the report posits that we may start to see this category of property maturing in interesting ways. This could include adding the kinds of facilities and amenities which we associate with offices, such as gyms, complimentary snacks, nursing rooms, and so on.

This would fit with the evolution towards “multiple business purposes” within industrial sites, “such as a shipment center with offices or a showroom”, according to the report authors.

Casting forward
As for the next six months, the report has a tone of tentative positivity, writing: “Multifamily and industrial properties have thrived in 2022. With healthy balance sheets, consumer demand could bolster retail, multifamily and industrial asset classes.”

But, they say, they’re keeping an eye on how “the country navigates hybrid work” and “on interest rate hikes, supply chain issues and geopolitical events, as well as ongoing relationships between public and private entities in affordable housing”. 

For more information, and a link to the webinar replay, click here.

Social: What was the state of CRE in the first six months of 2022 in your region?

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With interest rates and risk rising, cap rates may be next in line

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?

Flowers & Roots

Alec J. Pacella

I’m always pleased to see comments from loyal readers. Most of the time, these are complimentary. But as a wise Yoda once told me, “Compliments grow flowers, but criticisms grow roots.” And while one of the comments I received in response to last month’s column wasn’t a criticism, it was insightful.

The gist was a historically limited viewpoint from the lender’s perspective. The comment wasn’t wrong; prior to the concept of 365/360 loan amortization covered last month, it had been a few years since anything related to the lender’s perspective was considered. And make no mistake – lenders are a dominant part of the commercial real estate landscape. Last year, nearly $4 trillion of capital invested in commercial real estate came from lenders, as compared to $2.7 trillion of equity. Given the significant role that lenders play, this month will be a bit of a ‘two-fer’ and follow up on some basic metrics that a lender uses to determine the appropriate level of participation in an investment.

One of the most common (and easy to understand) metrics used by a lender is the loan-to-value (or LTV) ratio. This approach considers the underlying value of the real estate as compared to a ratio established by the lender. For example, the lender determines a property to have a value of $1 million and has established a 75% LTV ratio.

In this instance, the lender would be willing to provide a maximum loan of $750,000 ($1,000,000 x .75). Another metric related to LTV but less common is the leveraged ratio. It measures the amount of equity as compared to the total investment. In the example above, the leveraged ratio would be 4:1, which means that every dollar of equity equates to four dollars of total value ($1,000,000 divided by $250,000). LTV and leveraged ratio are both focused on the underlying value of the real estate, but a lender will also look at the income characteristics of the asset. A primary measure with this focus is known as the debt service coverage ratio (or DSCR), which helps to ensure the property has sufficient cash flow to make the loan payments. LTV and leveraged ratio are simple and only require one step. DSCR is a bit more involved and requires two steps. The first step is to determine the maximum annual debt service given the property’s income, as represented by net operating income (NOI) and the DCSR established by the lender.

This ensures there is not just enough but more than enough income to service the debt. Assume a property has a NOI of $80,000 and the lender establishes a DCSR of 1.25. In this instance, the maximum annual debt service would be $64,000 ($80,000 divided by 1.25). This ensures a measure of safety for the lender, as the NOI could fall by up to

Another metric that has risen in popularity over the last decade is known as debt yield, which represents the percent of NOI as compared to the original loan amount. This is a helpful measure of risk for a lender as it illustrates the yield that a lender would realize if they were to come into a direct ownership position due to a default by the borrower. It is also a valuable metric as it helps to ensure the loan amount is not inflated by low cap rates, low interest rates or a long amortization period. Calculating this is straight-for- ward: dividing NOI by the loan amount. Again, using our example and assuming a $750,000 loan, the debt yield would be $80,000 divided by $750,000 = 9.375%.

The last metric I would like to discuss is also one that has been around the longest  the venerable loan constant. It measures the annual debt service, including principal and interest, as compared to the original loan amount. Using our example and again assuming a $750,000 loan, the loan constant would be $61,910 divided by $750,000 = 8.255%. At the risk of sounding like the kid that had to walk to school and back uphill and in two feet of snow, a loan constant was used to calculate loan payments in the days before financial calculators. The cutting-edge real estate tool back then was a little book with a red cover entitled “The Ellwood Tables.” It was filled with pages upon pages of tables with eight-digit numbers.

At the risk of sounding like the kid that had to walk to school and backup hill and in two feet of snow, a loan constant was used to calculate loan payments in the days before financial calculators. The cutting- edge real estate tool back then was a little book with a red cover entitled “The Ellwood Tables.”

To use it, you would match up the columns for the lender’s nominal interest rate and loan amortization period. Once the corresponding eight-digit number was found, you multiplied it by the initial loan amount and, shazam, the annual debt service would be known. In the example above, matching up the column for a 20-year loan amortization with the row for 5.5% interest would result in a factor of .08254667.

Upon reviewing a sampling of past articles, the topics associated with mortgages and the debt market are indeed far and few between. And if it wasn’t for some- one taking the time to point this out, this month’s article would likely have been centered around internal rate of return, net present value or cap rates.

Keep those comments coming, gang! AP

Published in Properties Magazine July 2022

Report says CRE leaders expect post covid resurgence

In May, law firm DLA Piper released the 2022 edition of their Annual State of the Market Survey report, highlighting that “optimism about the future of commercial real estate (CRE)” remains strong despite the headwinds the industry faces.

The survey on which the report is built was conducted in February and March of 2022, by collating and analyzing input from CRE leaders and professionals in the US – specifically their take on matters including “pandemic recovery, economic outlook, attractiveness of investment markets and overall expectations over the next 12 months”. This input is further contextualized with additional research, presented the report.

Highlights

Overall, the report [PDF] shows “increased bullishness”, with “more respondents in 2022 [having] a higher level of confidence for the real estate industry’s next 12 months”.

Findings from the report also include that 73 percent of respondents are “expecting a bullish market”. This is consistent with 2021 expectations. “However,” they added, “this year, respondents reported feeling a higher level of confidence in a bull market over the next 12 months; 33 percent described their bullishness as an 8 or higher in 2022, compared to just 16 percent in 2021.”

Top contributing reasons include the apparent availability of capital in the market, with over half of the respondents citing this as the main source of their confidence.

Viewed per sector, Commercial Property Executive says in their analysis of the report, “Industrial (66 percent) and multifamily (57 percent) remain the property types that investors believe offer the best risk-adjusted returns over the next 12 months.”

Shaping CRE

Inflation and interest rate changes were ranked most likely to have an impact specifically in the CRE market in the coming year, but ecommerce, migration of workers out of city centers, and the “redesign/reimagining use of office and other commercial spaces” were also common responses.

Concerns remain

Top concerns included interest rate increases (cited by 26 percent of respondents), inflation (18 percent), as well as the Russian invasion of Ukraine.

US gains and advice

Finally, respondents to the survey said they felt the US would be seen as a safe and stable option, attracting non-US investment. “During times of uncertainty – like the pandemic or the conflict in Ukraine — investors often flock to safe havens,” the report reads, adding “a well-defined legal system, transparency and proven economic resiliency” are among the US’s assets.  

In the face of global uncertainty though, the report authors caution that CRE professionals and firms must “remain agile and prioritize adaption, with an eye towards staying ahead of the curve”.

SOCIAL: Do you see the US CRE market as a safe haven in times of global uncertainty? How do you expect inflation to make itself known in your CRE specialty?

REITs sag under general market pressure in April, May 2022

The Q2 2022 has been a scary ride for markets and investors around the world. Increased geopolitical tensions, widespread inflation, and rising interest rates in many territories have been a cause for concern, and the capital markets bore the brunt of that low sentiment.

A recent look at the numbers shows that real estate investment trusts (REITs) didn’t escape the sell-off.

Crunching the numbers

The FTSE Nareit All Equity REITs index shows a decline of 3.66 percent in April. This is, as Wealth Management succinctly argues, “a major reversal from 2021, when REITs posted a 40 percent rise in total returns”.

Benchmarking against peers

Despite this, REIT total returns are trending stronger than many other indices in 2022, including some “darlings of the market” like S&P 500 (contracted 12.92 percent) and the Dow Jones Industrial Average (declined by 8.73 percent).

A history of performance

Bezinga data says: “The FTSE Nareit All Equity REITs index has outperformed the S&P 500 in total returns during 13 out of the last 20 years with an average total annual return of 13.1% versus 11.1% for the S&P 500 over the same time period”.

REITs use case

As an investment vehicle type, REITs are considered one of the most accessible ways for individuals to buy into commercial real estate (CRE), which has long been the terrain of institutional investors.

Although regulation changes have opened up this category in recent years, REITs still enjoy popularity with retail investors for the above reasons, and the relatively high dividend yields.

Takeaway

Although we do not offer this as financial advice and individual investment products must be reviewed on their own fundamentals, REITs are still largely considered an inflation hedge when rents are rising – making them one fascinating asset type to watch in 2022.