Swings in the market are inevitable, but sometimes things change drastically and require a remarkable shift in strategy to navigate. The events of the past few years have created markedly different environments for investing in commercial real estate (CRE).
In 2023, not only are interest rates at their highest level seen in the last 16 years, the pace at which the Federal Reserve raised interest rates was one of the most aggressive hiking sprees that we have experienced in our U.S. history.1 The reason, according to the Fed, is quite simple: to battle high inflation and bring it closer to its 2% annual target over the long run.
We have long since exited the age of “free money”, where the Fed lowered interest rates to 0% to boost economic activity in 2020, and have entered a period of strict access to lending.1 After more than a year of tight monetary policy, not only has the cost of borrowing increased precipitously, but liquidity has also markedly decreased. In 2022, we witnessed major banks move to the sidelines starting in the second half of the year due to increased reserve requirements while in 2023 we are witnessing regional banks pull back further in the wake of a regional banking crisis.
We are observing that today’s high interest rate market environment is affecting deal pricing as groups are basing their underwriting assumptions on a significantly higher cost to acquire debt, to build new projects, and to maintain existing ones. Additionally, the current interest rate environment is generally leading to higher cap rate assumptions at exit.
Consistent with dwindling sources of capital, CRE prices declined roughly 13% in 2022 after rising by 24% in 2021.2 The majority of the price declines occurred in the second half of 2022, coinciding with the effects of deteriorating capital markets.
The rate at which prices are declining has since slowed down (prices down by only 2.2% in Q1 2023) for most asset classes, but we expect further declines to materialize over the course of 2023.2 As CRE property values are shifting, we have observed widening bid/ask spreads on deals depending on the property type, location, risk profile of the investment, and the motivation of the seller with significant discounts to peak pricing.
Unlike the stock market, which is by definition considered to be an efficient market, meaning that market prices reflect all available and relevant information, CRE is inherently an inefficient market, which basically means that assets may transact at prices that are higher or lower than their intrinsic value. This can be possible in the CRE market for reasons which may include a) information is not readily available to market participants or b) participants are interpreting information differently. It appears that high interest rates and the resulting uncertainty may have increased the CRE market’s “inefficiency”, so to speak.
Bidders in the market are going back and forth on pricing, which has opened up room to exploit mispriced opportunities, especially those where buyers can justify significant discounts to recent peak pricing. Uncertainty is the name of the game and no one can accurately predict when or if the economy will go back to a low interest rate environment and therefore are adjusting to the “new normal.”
