The air is coming out of the balloon. Or as John Mayer might put it, gravity is working against the commercial real estate industry. Price growth is faltering across all property types and is becoming more pronounced as each month’s data rolls in.
What is behind this “gravity” working against the industry? Commercial real estate is one of the most capital-intensive businesses to operate in, and today, capital is more expensive. Treasury yields have risen 3.70%, 2.80% and 2.50% for one-, five- and 10-year Treasuries respectively in the past eight months. Spreads have risen approximately .25% to .45% in the same period, according to the John B. Levy & Co. Commercial Mortgage Survey. The combination has pushed interest rates from approximately 3.35% to 3.50% in March to 5.80% to 6.25% today.
To put things in perspective, holding everything else the same, that rate increase reduces debt proceeds by over 25% in a short eight months for a typical transaction. So, while there are plenty of all-cash buyers out there, this abrupt change in the debt market is sending leveraged buyers to the sidelines.
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Anecdotally, the industry is seeing a drop-off as measured by the time it takes to get an appraisal completed. Whereas it used to take three to four weeks, appraisers are not as busy now, and the time frame has been reduced to two to three weeks. Another indication is broken deals. Lenders have reported getting called back on deals where they weren’t previously competitive weeks after the potential deal was removed from their pipeline report.
Recent investment sales data from MSCI (formerly Real Capital Analytics) indicated year-over-year deal volume dropped 41% in August, but the data indicated deal volume is up year to date when compared with the same period in 2021. Likewise, in the debt world, Commercial mortgage-backed securities volume year to date is down 21% in the United States compared with the same period in 2021. It is expected “to slow to a trickle” through the end of 2022, according to a recent article in Commercial Mortgage Alert.
On top of the damage to date, the Federal Open Market Committee is meeting this week and again in December. It is widely expected to push the short-term rate higher by 1.25% to 1.50% by year end.
It’s not as if we haven’t had rates this high in the past. If you go back before the Great Recession, mortgage rates ranged from the mid-5% to mid-6% for most of 2006 and 2007, very active years in the commercial real estate world. The pain comes from the speed at which the upward changes have occurred and the continued battle against inflation by the Federal Reserve.
For now, in the Richmond real estate market, cap rates are holding or trending downward, according to data from commercial real estate analytics and research firm CoStar Group. Though office and retail cap rates are flattening, overall apartment and industrial cap rates are trending downward. The question is: For how long can that keep up when interest rates are still trending upward?
John B. Levy & Co. partner and investment banker Andrew Little can be reached at alittle@ jblevyco.com.
