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The Reality Of Today’s Commercial Real Estate Market

by | Jan 9, 2024 | 0 comments

A Framework For Multifamily Investing In Today’s Market

 

In the ever-evolving landscape of real estate investing, staying informed and adaptable is paramount. As we navigate the complex terrain of today’s market, several key factors are shaping the opportunities and challenges that passive real estate investors encounter.

In this article, we’ll tackle the reality of the current real estate market, exploring essential elements such as cap rates, interest rates, lending dynamics, and the potential for finding exceptional opportunities in a shifting landscape.

While the market may present hurdles, it also offers the chance to thrive through strategic decision-making and a proactive approach. Join us as we dissect the key components of today’s real estate market and shed light on how passive investors can make informed choices to protect and grow their investments.

 

The Reality of Today’s Market Fundamentals

It can be tricky to understand all the changing levers that go into a real estate purchase, especially at the commercial real estate level. The following primary fundamentals are the top culprits for shifting the market today.

 

Cap Rates

The fundamentals of today’s market start with cap rates. For a passive commercial real estate investor, the cap rate is a fundamental metric that provides insight into the potential profitability of an investment property. It’s calculated by taking the property’s annual net operating income (NOI) and dividing it by its current market value (or purchase price).

Expressed as a percentage, the cap rate essentially estimates the property’s potential return on investment in a single year, assuming it’s purchased with cash.

For a passive investor, a higher cap rate might indicate greater risk but also the potential for higher returns, while a lower cap rate could suggest a more stable, less risky investment. It’s crucial to understand the context of the cap rate: the local market, property type, and current economic conditions. Always compare cap rates with similar properties in the same market to get a meaningful picture.

In today’s market, cap rates have not changed. Sellers are expecting the same cap rate. In other words, they are not lowering their asking price due to higher interest rates.

 

Interest Rates

Interest rates have increased steadily throughout 2023, which is having ripple effects in the commercial real estate industry. Buyers have to pay increased expenses to commercial lenders as these rates rise. If properties are not decreasing in price, the numbers may simply not make sense – especially if rates continue to climb.

It can’t be stated enough that a deal must pencil out (or provide a solid projected return) with today’s interest rates. If it is assumed that interest rates will decrease, and a smaller number is used when analyzing performance for future years, your risk greatly increases. Additionally, an interest rate cap may also help minimize the risk associated with any investment further, offering more confidence to get your money working in real estate in today’s market.

 

Lending and Loan-To-Value

Lenders, whether agency lenders or life companies, have dramatically shifted expectations on loan-to-value. This means the amount of debt you can put against an asset. For instance, two years ago a lender may have provided 75% of an asset’s value, or a 75% LTV (loan-to-value).

In today’s market, the loan-to-value ratio is dropping. A lender may only be willing to loan 55% – 65% of a property’s value.

Let’s take a look at some simplified numbers to understand this point better. If a property is costing $10M total and a bank used to lend up to $7.5M, a buyer would have to come to the table with $2.5M to purchase the asset.

Today, that $10M apartment building may require $3.5M to $4.5M from the buyer. In order for the projected returns to remain desirable, both for the limited partners (that’s you, the passive investor) and the general partnership (that’s the sponsor entity trying to purchase the property), this property may not make sense to purchase at the $10M asking price anymore. This is the impact of a decreased loan-to-value ratio.

 

Will There Be Any Good Deals In 2023 and 2024?

The multifamily asset class will begin to shift. There will be good deals out there, but the velocity of sales transactions will be lower. This requires underwriters to triple check all their analysis.

Roughly 520,000 new units are coming to the market in the multifamily market as of the time of writing this article in Q3 of 2023. These deals started the construction process 2-3 years ago. For instance, there are 2 new properties that are 200+ unit projects being built in the Orlando Submarket, but there are no new construction permits and financing happening in that area. This means that a temporary steady pipeline of new buildings will continue, but there will be a sharp decrease in product coming out over the next 12-24 months.

This is a short decrease in the grand timeline of investors, especially passive investors in it for the long-term. While job growth and population growth continues to increase – such as in Orlando or Jacksonville, Florida, or Tucson, Arizona.

As interest rates remain high, homebuyers continue to rent rather than purchase a home. This further contributes to the strong demand for multifamily in the right markets.

 

How does the pause in the construction of new multifamily assets impact the passive investor?

With a decrease in the supply of apartment units and high-interest rates for the average homebuyer, demand for multifamily units will rise. This can cause an increase in the value of existing assets due to increased rental rates, which in turn brings in more cash flow and boosts the property’s net operating income.

 

Upcoming Loan Maturities And Impact To Passive Investors

There are $8 billion of loan maturities occurring in Q4 of 2023, with much more in early 2024. This includes interest rate caps that were purchased but are now expiring.

When a loan is expiring, an extension may be purchased. However, more often than not, the loan must be renewed or refinanced, or the property must be sold. These are often on properties that are performing well but will require an infusion of capital.

A deal sponsor may elect to do a capital call within the current ownership group. This means that limited partner investors would be asked to contribute more funds to renew the financing on an asset. While the term “capital call” isn’t always clear…

An infusion of capital can also come from institutional investors, or an outside group of investors, in the form of preferred equity. Typically, this investor group gets paid out similar to the bank.

 

Opportunities Are Being Created, Even In Today’s Market

With population and job growth continuing to increase, and a stalled construction pipeline specifically in multifamily assets, there will continue to be opportunities on the horizon. Reading flashy headlines about…

Underwriting is critical. Not every deal will work. Just because there is capital to invest and assets for sale, doesn’t mean we should invest in something. The numbers must make sense given this dynamic environment.

 

How Investors Can Find The Opportunities In A Downturn

Downturns in the market are great times to create opportunities and come out leaps and bounds ahead. Many investors hold steady or sit back to wait and see what will happen when the market shifts quickly. This happens while others begin to look for opportunities.

 

Work With Trusted Partners

First, it is imperative that investors work with a trusted partner when investing in commercial real estate. Every asset class, every market, every business plan is different. What should be consistent is the track record of your partners. A solid operator will know how to operate the properties and have existing experience.

 

Operators Must Be Skilled

Second, this isn’t the kind of market that assets will simply appreciate with decently strong occupancy and investors can see a return. Operators must flex their skills today. They have to know how to efficiently manage expenses, manage the people, they have to understand the top-end revenue, perform asset-level accounting, and more. With expenses increased due to increased lending costs, every expense must be carefully managed.

 

Question The Underwriting

Third, investors should inquire about the resilience of the underwriting. Investors can ask questions that help them understand how a potential deal sponsor would handle changing interest rates or an expiring rate cap. They can ask about current assets under management and how the team is handling any need for additional capital, insurance needs, or contingency plans. They can ask how any potential deal will perform if interest rates continue to increase.

 

Understand The Timing Of The Investment

Fourth, investors should understand the timing associated with their investments. In this market, a long-term view will help anyone come out ahead. If a short-term mindset is applied, then a deal may be sold too soon or purchased too quickly. However, if a deal can hold steady through a downturn, it is possible to come out farther ahead. Ask about the long-term view and expected timing on true cash flow on any individual deals. It may be a longer runway to begin seeing steady cash flow on any multifamily asset, especially in today’s market.

 

Think Creatively And Expect Opportunities

Finally, begin to think creatively about new deal opportunities. The deals may not look the same as they did 3 years ago. Then, it may have been that you invested in an asset that required simple unit renovations and in 3 years would produce great upside. Today, you may see different partnership structures or the restructuring of the capital stack to find creative ways to get cash flow to investors. Ask questions when you see anything new but keep an optimistic mindset that it could be the opportunity that puts you ahead in a downturn.

 

Conclusion

The contemporary real estate market is a dynamic arena where investors must navigate a sea of changes, from shifting cap rates and interest rate fluctuations to evolving lending standards. It’s a market that requires a keen eye for detail, a strong understanding of underwriting, and a commitment to working with trusted partners who have a proven track record.

While challenges abound, the silver lining is the potential for creativity and resilience to uncover opportunities even in the face of adversity. As the construction pipeline pauses, demand for multifamily units rises, offering a chance for value appreciation and increased cash flow. Moreover, as interest rates remain high and the rental market thrives, the allure of multifamily assets persists.

To succeed in this environment, passive investors must think strategically, consider the long-term view, and ask the right questions. By doing so, they can position themselves to harness the opportunities emerging in today’s real estate market and come out ahead, even in times of uncertainty. Remember, in real estate, as in life, with the right knowledge and a dash of creativity, opportunities are often waiting where you least expect them.

To learn more about real estate investing and syndications, reach out to us at https://investwithspark.com/contact/ today!

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