The commercial real estate market has been battered, fractured and left by Covid dead in 2020. It came back to life in 2021 with record sales of $809 billion, but like cops pulling into a roaring house all night, the arrival of unchecked inflation and high interest rates may signal the end of the party. . This has many real estate investors at a strategic crossroads wondering, “Am I buying, selling, or owning?”
Privately owned commercial real estate has historically provided a strong inflation hedge. Owners of properties with short-term leases such as apartments, self-storage and manufactured home communities can quickly raise rents to match inflation, according to the Consumer Price Index. This is an important advantage as the CPI hit 8% in March and April, and hit 8.6% in May, the highest rate since 1981. Then, like today, inflation was driven by skyrocketing oil and gas prices and the unfettered Treasury dumping the economy with money. In 1980, new Federal Reserve Chairman Paul Volcker responded by choking off the currency flow to the point that in December 1981, mortgage rates hit 20%. Inflation fell quickly, but at a cost of 10.8% unemployment, a 3% drop in GDP, and not one but two recessions. While inflation is a friend of many landlords, stagnation is not, and commercial real estate business has been in decline for a decade.
Recession has followed every sharp increase in inflation over the past 75 years, and the current gravity-defying trend shows no sign of fading. The producer index – what manufacturers pay for raw materials – rose 0.08% in May, doubling a 0.04% increase in April, at an annual rate of 10.8%. These costs will be passed on to the consumer, causing the CPI to rise. Gas is more than five dollars, and diesels are kidding more than six dollars. Given that sudden rises in energy costs preceded six of the last seven recessions, and the Commerce Department reported an unexpected drop in retail sales in May, another recession appears inevitable.
Real estate investment performance and GDP rise and fall together. A weak economy creates lower business and consumer spending, limiting landlords’ ability to raise rents. Resisting pandemics, investors strongly favor “core companies” such as Dollar General and Walgreens. However, with leases remaining constant for 10-15 years, landlords will lose money each year, as will large retail and office building owners with long-term non-CPI-indexed leases. More aggressive monetary policy by the Federal Reserve will lead to higher long-term interest rates, trigger a recession and tighten commercial lending requirements. Higher rates and loan equity requirements result in lower returns, causing investors to retrench and property values to plummet. For investors with such assets who are worried about the economy unraveling and are considering selling, it may be best to hold and wait for the inevitable recovery.
The cycle of decline and recovery often occurs over a decade or more. Homeowners under the age of 50 can wait for the next bullish cycle if the market sees a major correction. Commercial real estate has always trended higher for decades, and over 25 years has outperformed the S&P 500, with average annual returns of 10.3% and 9.6%, respectively. And unlike stocks, bonds, and cryptocurrencies, the value of real estate was not zero. For those younger investors, this might be a good time to buy. While prices are run higher as a deterrent to inflation, they are still historically low. Buyers who can install fixed rate debt on income properties at current rates of 5.5% to 5.6% today will be winners as those rates are likely to be the lowest they will ever see, said David Petty, president of Commercial Mortgage at TowneBank. Dubbed by Forbes the “Top Ten American Banks” in 2022, TowneBank is one of the leading commercial real estate lenders in Virginia and North Carolina.
What is the selling situation in the current market? Few would doubt that commercial property values have reached their cyclical peak after 12 years of climbing. Treasury Secretary Janet Yellen recently expressed concern to the US Senate Banking Committee that banks and non-bank lenders, such as insurance companies and hedge funds, may be over-indebted at a time when interest rates are rising. Knowing that cash is king, there is anecdotal evidence that portfolio owners are choosing to enhance liquidity through strategic actions in key pricing. In what may be a record sale for one such property, the Arizona company paid $363 million to Jamaica Bay, a factory home community in Fort Myers, Florida.
Many investors expect a wave of defaults when acquisitions at pre-COVID rates can’t cover debt service when their loans reset at higher rates. When real estate collapsed in 1973, legendary investor Sam “Gravedancer” Zell, the father of the modern REIT, acquired dozens of high-quality apartment buildings at a fraction of the replacement cost. Zell used the massive cash flow from those assets to buy office buildings at 50 cents on the dollar when the real estate market crashed again in the 1980s, and he became a billionaire. Today, the post-COVID “hybrid work” trend is driving tenants from city central office buildings to affordable suburbs. These remaining tenants demand strict rental concessions to stay.
Dozens of “struggled” real estate funds herald an upcoming market correction, raising billions of dollars. In 36 months, global investment firm Angelo, Gordon & Co LP has attracted $11 billion in investments for its “bad debt and special situations” platform. Investors are betting on a sudden rise in mortgage defaults, as banks are forced to sell their debt at steep discounts to maintain the FIC’s liquidity requirements.
What about the investor or the smaller owner/user? If you’re a physician over 60 and want to cash out the capital on your medical office building to facilitate a more comfortable retirement, now might be a good time to sell and release. The demand for these properties continues due to their resilience during economic downturns. Montecito Medical is one of the nation’s largest private companies specializing in healthcare-related real estate acquisitions and a leader in sale and leaseback transactions. Since its inception in 2004, Montecito has closed more than $5 billion in healthcare real estate transactions. “With the population of Americans over the age of 65 expected to more than double by 2040, medical office real estate fundamentals are extremely safe. This makes this category recession-resistant and a haven for capital at times when other commercial real estate sectors may struggle,” said Chip. Konk, CEO of Montecito: “This has been proven both in the Great Recession of 2008 and again during the COVID-19 pandemic.” “We built our entire business around the medical office and the market has validated this strategy over and over again. We remain optimistic as always in this sector.” Sale and leaseback are increasingly prevalent in other asset classes such as industrial property, which is perhaps the most popular commercial property category of all.
Owners with densely managed assets such as single-family rentals, manufactured home communities, and small apartment buildings may want to relax, travel, and enjoy the results of decades of hard work. They can use IRS code section 1031 to trade in an “absolute net” management-free, single-lease, enjoy historically low interest rates, avoid capital gains, and earn tax-free cash.
Being sensitive to economic cycles when buying, selling, or holding is essential to success in commercial real estate.
Chris Zarbas is a commercial real estate broker at SL Nusbaum Realty Co in Norfolk Virginia, one of the largest fully integrated commercial real estate companies in the Southeast.