by Neil A. Dolgin
Fall has arrived with an economy still finding its way. There is low unemployment which bodes well, but the challenges of high interest rates and inflation are increasing concerns about the possibility of a recession.
Interest rates are already up 2% this year, and inflation is still soaring despite a downturn from the peak of 9.1% on July 31st. According to Wolf Street, “inflation is getting increasingly entrenched in vast parts of the economy that have little or nothing to do with tangled-up supply chains and messed-up commodities, and that this inflation is getting worse, that it has been muscling into services for the 12th month in a row, and that the Fed will have one heck of a time cracking down on this raging inflation.”
How is today’s challenging economic climate impacting commercial real estate?
There are some great industrial buildings out there for sale. The problem is making the numbers work for owners and investors. Capitalization (cap) rates are used to value commercial real estate by estimating the rate of return on a building. For example, if you purchased a building for $10 million at a 10% cap rate, you would realize appx $1 million of net operating income each year. If that building was purchased for $20 million and it earned the same $1 million in net operating income, the cap rate would be 5%.
When the Covid-19 pandemic hit in March 2020, there was rising unemployment and everyone was working from home, except essential workers. The Federal Reserve acted quickly to support spending and they lowered the cost of borrowing for businesses by cutting interest rates.
By 2021, interest rates had dropped to as low as 2%. Investors were buying up industrial buildings for logistics and customer delivery operations at premium prices that were driven by high demand. With interest rates so low, investors were fine earning a 3% or 4% cap rate.
Now with interest rates approaching 5.5% to 6% or more, funds that were willing to accept a 3 cap or 4 cap a year ago today expect a 6 cap or 6.5 cap rate and even that is not enough because of rising interest rates. Owners will be underwater in operating debt with any type of financing, unless they need to buy another building and use a 1031 exchange; that’s how those buildings are going to get sold right now.
At the same time, some owners are seeking uncompetitive prices for their buildings, prices that sometimes exceed comparable valuations to those industrial buildings that sold at the peak of the pandemic.
We’re also unlikely to see growth in industrial building sales right now until there’s some relief by bankers in the form of reduced interest rates or ways of reducing a borrower’s risk, such as defeasance, a contract provision that would void a loan on a balance sheet when the borrower sets aside cash or bonds that are enough to service the debt.
NAR Realtor suggests that we will see upward pressure on cap rates due to rising interest though they expect the rise to be modest. If interest rates continue to rise, no one knows where this market is going to end up.
So I don’t see investors jumping into it right now. They are taking a step back. We see it in the housing market. The number of available homes has gone down because sellers are realizing they can’t get the dollar amount that they wanted, right now. And owners who might be looking to refinance are afraid to commit to a 30-year mortgage or a 15-year mortgage at today’s interest rates. Who will take a mortgage until we know where the rates are gonna to end up?
I’ve also spoken about the six month lag time between today’s economy when we will actually see impacts on the commercial real estate marketplace. If a recession really starts to take hold, investors are going to realize that their bottom line is much lower than they expected, and the earnings are just not going to be there.
A year or two years from now, we might be back down again to lower interest rates. Or we might see new, creative financing options in addition to defeasance.
The news is better for lessors. We see a lot of buildings on the market for rent and many still available for sublease. There are also more and more Amazon buildings that are being brought into the marketplace because Amazon is not taking possession of them or they are refinancing. When it comes to renting an older building versus a new one, there are better values in older buildings because owners are not dealing with higher interest rates, though they are still struggling with rising operating expenses.
Unfortunately, we are seeing very high prices on the rental market, prices that I don’t believe that owners can actually secure right now. The owners want and need the income. But I’m not sure that the tenants can actually pay for it. How much longer are owners going to hold at these high numbers before they realize that they have to drop prices a little bit?
There are some owners who are taking a creative approach to the economy by reimagining their properties in ways that drive more income, like moving from a single building tenant to multiple tenants. With multiple versus single tenant industrial buildings, owners can reduce their risk when one tenant goes out of business or moves out. If you are renting 4 smaller units and you lose one tenant, you’re still sitting with a 75% occupancy and a 25% vacancy. So you have enough rental income to cover your operating costs.
If you’re looking for a creative solution in today’s economy that improves your return on investment in a building or available rental, please feel free to contact me here.
Neil A. Dolgin is co-president of Kalmon Dolgin Affiliates. Founded in 1904, Kalmon Dolgin Affiliates (KDA) has grown into one of the New York metropolitan region’s leading commercial and industrial real estate firms. Kalmon Dolgin Affiliates specialize in all aspects of real estate services for developing, managing, selling, leasing and marketing commercial and industrial property. KDA’s highly-trained professional brokers offer clients a practical, street-wise approach to commercial and industrial real estate brokerage, leasing and sales, supported by the latest in real estate marketing, management and research technology.