Are you in for the long haul?
For commercial real estate investors, rising interest rates have changed the landscape of what their motivation is. We continue to see the fed raising rates in an effort to slow inflation. Right now, we are in a period of time where the higher rates have an immediate impact but the desired effect of lower property values has not evolved. So, if you are investing today you have to be willing to realize a much tighter cash flow.
In the years after the Great Recession, the Fed brought the federal funds rate near zero and did not let up even as the economy recovered. That brought a dozen years of artificially low rates, making properties more valuable and real estate investments more profitable. Higher interest rates in the last year have driven down the predictability of real estate cash flow and yields and upended owner-operator and investor strategies. The commercial real estate market is seeing a slow-down in transaction volume. As we journey through the transition from the artificially low rates of the last decade to a new, but still unknown, interest rate environment, liquidity will continue to pull back from property markets. Asset valuations are decreasing, but how far down will they go and when? Unfortunately, the reduction in transaction volume is likely to greatly extend the process of price discovery. The market will ultimately adjust to a new level of interest rates. Until then, it is the unpredictability of yields and valuations, today and at a deal’s projected exit, that is causing capital to seek alternative investments.
For the smaller investor, the first question to answer is, “What is your goal?” If your goal is to immediately realize income while also wanting to leverage the investment with as much debt as possible-this might not be the time for you to be investing. If your goal is to find assets that make good long-term investments, then those are still there. If you are an investor that has lived through the times of double digit borrowing, then this seems more like a normalization. If you are one of the people that predicts a recession is likely, then it is appropriate for investors to think defensively by focusing on resilient cash flows and capital value preservation. The strategic relative value of debt is very compelling. Yet it is also a time when nimbleness and the ability to identify relative values can be enormously beneficial. It is likely 2023 will be a year of playing both defense and offense, as market conditions change and evolve. Investors should consider an investment strategy that allows them to manage risks while also giving them the flexibility to pivot to higher risk when suited to their specific needs.
You have to dig a little deeper into every deal. Look at the leases and the tenants in more depth to truly assess risk. The general basic 101 on a safe bet is a property with a nice long lease, right? You have to look at a bigger picture-long-term leases with low fixed-rate increases or, even worse, no rental rate increases. These features were acceptable when inflation was mild and Treasury yields were depressed, but they could pose a threat in the current environment. If structured without any exposure to rising expenses, a triple net leased asset (i.e., where the tenant pays all expenses including tax and maintenance) to the right credit could be an opportunity even if the immediate cash flow seems modest.
The principles are basic-you can’t have everything. Ask yourself some questions.
Can you put more cash in the project to create more cash flow?
Can you live with a modest cash flow or no cash flow if you know the asset is a good long-term investment?
Can you take on more risk to achieve a higher cap rate or better cash flow?
Are you comfortable exploring a new segment of real estate? Maybe you have always invested in office, have you thought about industrial?
Nobody has a crystal ball to tell us what the future will bring and when. So you have to be realistic about the now, and if you are an investor make the best choices for your overall portfolio. The crazy low rate environment actually let investors make some bad buys and still come out okay; change means you have to be strategic and aware of your goals.
