A lot has changed in the past few months. Interest rates have spiked, inflation is reaching levels not seen since the late 1970s, and there are concerns that we sit on the precipice of a possible recession.
The commercial real estate (CRE) market has already begun adjusting to myriad factors in the capital and labor markets and subsequently, so has our deal review criteria.
The agile nature of our Marketplace allows us to pivot in the face of change, enabling us to select the projects which we feel do a good job of “baking in” the risk of the times. We took a similar approach during the COVID-19 pandemic, and by quickly adjusting our deal pipeline, we successfully navigated the massive uncertainty of the early phase of the pandemic. Although deal flow slowed in those early months, we rebounded by summer 2020 and, ultimately, have launched hundreds of deals since then.
While other marketplaces are locked into one strategy, the flexibility of our deal review process allows us to have more refined and nuanced standards that may help protect the quality of our deal flow.
While today is a different environment that requires a slightly different approach, we are navigating the challenges of 2022 with this same mantra–why this deal, and why now?
As we search for the best types of opportunities we see in this emerging real estate market dynamic, here are the five key concerns we’re factoring into our analysis.
1. Changes in interest rates
Interest rates are higher today as compared to last year but, more importantly, from a valuation perspective, they may remain higher for years to come. Factoring in the higher current interest rates at acquisition on fixed rate deals is relatively straightforward, but we also want to account for the downstream effects of a changing interest rate environment on variable rate deals over a multi-year holding period. If a 6% variable interest rate rises to 9% in three years, what could that mean for investors in the deal?
For now, we are requiring interest rate caps or excess interest rate reserves on all variable interest rate deals. Typically, the more reserves, the better sponsors can help mitigate future interest rate risks.
At the end of the day, sponsors have to balance out the cost of fixed-rate debt (generally more expensive than variable rates) versus the certainty of interest payments in an uncertain interest rate environment. There is no one single correct approach, so we’re evaluating every deal as a unique situation and collaborating with sponsors to determine the most viable interest rate approach.
2. Decreases in debt proceeds
As interest rates rise, the cost to borrow a dollar also rises. In many cases, the amount of debt proceeds, or the percentage of the purchase price or development cost taken on as debt, has decreased this year. And in an environment where rents are increasing rapidly, future net operating income (NOI) may appear more than sufficient to cover the debt. However, many lenders are hedging in the current environment by lowering the amount they are willing to lend. While reducing the amount of debt in a deal is generally considered a good thing from a risk perspective, it also typically comes at the expense of targeted leveraged returns.
We are baking in the assumption of a lower percentage of total debt on our deals and paying close attention to the debt service coverage ratios (DSCR) in our underwriting. We are then analyzing the targeted investor level returns with the reduced leverage and determining whether or not the risk-adjusted returns are still competitive, all else equal. If not, we seek adjustments in deal structures to bridge that gap. Compared to the pre-pandemic market climate, a 75% levered deal was common on our Marketplace. While 75% leverage is still possible, it is more likely to now see leverage down in the 60-70% range.
3. Increases in project costs
The volatility in construction costs right now–including the hard costs of materials like lumber, concrete, and steel and the availability and cost to hire construction labor–coupled with pandemic-related shutdowns created supply chain shocks that impacted the supply of materials to its end-users. The cautiously optimistic good news is that with some easement in the supply chains, lumber prices have since decreased to $581.10/1000 board feet (from record levels of $1,500/1000 board feet in 2020) which brings this unit costs closer to the pre-pandemic levels. But as hard costs level off a bit, construction labor shortages continue to be an issue. Increases in expenses can countertop line rent growth and create a drag on NOI growth.
Right now, we’re adding layers to our review process by asking additional questions, including, “How is the sponsor sourcing their materials, and what level of certainty does the sponsor have today in its pricing?” or “Does the sponsor have a go-to supplier and is this supplier proven to be reliable?” These questions are important to ask because even a core deal has exposure to increases in operating costs.
Considering the risks, we’re also baking in increased total project costs on certain development deals. And in a tight labor market, we prefer deals where general contractors have relationships with subcontractors and can therefore negotiate on construction prices, as well as adhere to estimated construction timelines.
4. Next buyer analysis
When conducting a next-buyer analysis, we consider the current project’s business plan, take the assumed exit price, and then “wear the hat” of a potential next buyer. In essence, we work to determine if the exit price we’ve assumed for five years from now would make sense. Given that debt is projected to become more expensive, not only must we now assume more expensive borrowing costs for the next buyer, but it is also prudent to believe that the next buyer will not pay a compressed cap rate for the property as we’ve continually witnessed over the past decade.
If a potential deal only assumes a flat or compressing cap rate environment and/or which cannot sustain a higher borrowing cost for the next buyer, we decline the deal and move on.
5. Changes in market fundamentals
As we speed towards what we ultimately believe will look like a more normalized market, multiple changes in market fundamentals must be taken into account. First, we assume slightly to moderate cap rate expansion over the next five years. Second, while we assume that rents can continue to grow from their current levels, we assume their rate of growth will decrease down to levels consistent with long-term trends. Third, some of our deals sit on ground leases, and, as goes interest rates, so go ground lease rates. As a result, we are updating our beginning ground rent assumptions and assuming future growth rates.
We are baking in more modest rent growth assumptions, cap rate expansion, and increases in ground rents.
What does this mean for Marketplace deal flow?
As we mentioned, the flexibility of our Marketplace allows us to evolve with the changes we are witnessing. Our goal is to maintain the volume of deal flow–giving you ample opportunities to invest–while protecting overall deal quality by constantly updating our assumptions based on the risks and opportunities we see, both current and future. When you invest in private equity real estate on our platform, know that the proposed offering is already considering the risks of the times by “baking in” or considering downside scenarios when it was approved for the Marketplace.
Investing in commercial real estate entails substantive risk. You should not invest unless you can sustain the risk of loss of capital, including the risk of total loss of capital. All investors should consider their individual factors in consultation with a professional advisor of their choosing when deciding if an investment is appropriate. An investment in a private placement is highly speculative and involves a high degree of risk, including the risk of loss of the entire investment. Private placements are illiquid investments and are intended for investors who do not need a liquid investment.
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