Multifamily Fundamentals Are Still Fairly Strong Say Panelists

The GlobeSt. Multifamily national conference kicked off with standing room only, complete with a new agenda at a new venue as some of the most influential dealmakers in multifamily came together to discuss the state of the industry.

LOS ANGELES—The GlobeSt. Multifamily national conference kicked off this morning with a state of the industry panel that brought together the most influential dealmakers in the U.S. multifamily real estate market. The panelists discussed key trends, major market shifts, the impacts of inflation on the multifamily sector, the road to economic recovery, and their expectations for another record year in multifamily.

Moderated by John Sebree, SVP and national director of multifamily at Marcus & Millichap, the panel kicked things off by making one thing clear: while many are trying to figure out if we are in a recession yet or not, fundamentals in multifamily are “still fairly strong.”

Still, it is undeniable that the sector is facing some headwinds.

According to panelist Robert LaFever, managing director of development at Greystar, the company is still actively pursuing deals and are studying macro locations, he said, but is being “much more selective.”

Chad Sanderson, senior principal of business development and acquisitions at the Bascom Group, advised that the industry needs to “buckle up, because there will be pain, but you have to do what you have to do.” He also said it has never been more important than ever to study the characteristics of a particular deal because there are so many moving pieces. “A lot of things coming out on the market right now are just not trading. There are times when you can have a macro approach to markets…you have to be mindful of supply, are there specific sectors that have higher unemployment. If those things are in check, then you are looking at the specific deal… Just getting a loan right now has changed so dramatically and that is driving your underwriting.”

Sanderson added that you have to think about your strategy, think about how to mitigate risk with uncertainty and figure out how to manage your investment portfolio. “Everyone had their thoughts of how things were going to unfold. One camp said that inflation and rates will come back down but then inflation took off even further.”

Next year, the environment should stabilize, especially as interest rates are expected to level off, said panelist Jeff Adler, VP of Yardi Matrix and industry principal of self-storage at Yardi. On the rental front, panelist Adler also recently told GlobeSt.com that “Suburbs in major gateway metros and migration market favorites have seen greater rent growth since the start of the pandemic, but that the direction going forward is more balanced.”

He says that there has been a recovery in the downtown areas back to pre-pandemic levels (except for San Francisco, although rents have rebounded from their previous lows). The spread between urban and suburban living (monthly rental rates) has narrowed, as well as the spread Between Gateway and Sunbelt cities, “although it still exists,” Adler says.

We have seen an incredible shift of people to these tertiary markets, added Sanderson. “I think inflation really caught a lot of people by surprise,” added Sanderson. “We are in this new paradigm where everyone’s mood has really changed.”

We are not going back to the way things were in terms of return to office and renter profile, explained Adler. In terms of demand, it has started to tail down, as the absorption-to-completion ratio in 2022 is a sharp reversal from the strong levels of household formation a year ago. “Many of these renter suburbs belong to the Miami, Washington, D.C., and Los Angeles metros… Suburban living has been rewritten throughout the past decade.”

Kitty Wallace senior executive VP at Collier's, says that while there have been many people leaving the state of California, they are now coming back. “Los Angeles, New York, and San Francisco, have always been top markets but during Covid, they went to bottom markets,” she said. “I look at my international investors, and they might take a lower market return with less risk to be where they want to be…while we have seen movement out of state, many have come back.” She added that “We had unfortunate legislation here in California that impeded our growth during the beginning of Covid, but some of that is coming back because it is where people want to be. We are working with about 15%-20% of buyers now as compared to before.”

 

Source: Multifamily Fundamentals Are Still Fairly Strong Say Panelists

https://www.creconsult.net/market-trends/multifamily-fundamentals-are-still-fairly-strong-say-panelists/

Rising Cost of Capital Squeezing Multifamily Cap Rates

The increasing cost of capital and mounting concerns about ex-ante exit cap rates will ultimately drive buyers’ bids lower.

The increasing cost of capital is squeezing multifamily cap rates, which have been on a steady decline throughout the course of the pandemic.

According to a new analysis from Moody’s Analytics, that will ultimately pressure property values in the sector — and “without continued unprecedented rent growth, the darling multifamily asset class likely carries the most risk of value decline while the benchmark US Treasury rate is on the rise,” analysts say.

“Although Q3 has finally started to show a slight increase for industrial, office, and retail, cap rates have remained sticky. For multifamily, cap rates have continued to decline, which, along with tremendous rent growth, has propped up multifamily values compared to equities and other investments,” Moody’s Kevin Fagan and Xiaodi Li write. “But the increasing cost of capital and mounting concerns about ex-ante exit cap rates will ultimately drive buyers’ bids lower and property yields higher for the multifamily sector. So, multifamily property values will face pressure from both the Fed pushing rates and banks following suit with loan interest rates.”

The Moody’s economists note that rising 10-year treasury rates have pushed CMBS loan interest rates much higher than in recent months, and both are predicted to continue to climb. But while industrial’s cap rate started to climb up in Q3 2022, multifamily continued to decline. As of Q3, spreads between cap rates and loan interest rates for the sector clocked in at 0.76% — and Fagan and Li say that “cap rates with tight spreads are highly likely to increase under the upward pressure of rising interest rates.” That begs the question, they say, of how much rent growth is needed to curb a decline in value.

“Assuming the initial cap rate as 5%…if a CRE investor wants to exit in five years and the cap rate rises from 5% to 6.5%, the average annual rent growth needs to be higher than 5.4%,” they say. “Otherwise, the exit value will be lower than the current value. Though annual growth rates were 8.2% for multifamily from Q3 2021 to Q3 2022, a sustained average growth rate of 5.4% is well above any historical precedent.”

Ultimately, the pair say tight cap rate spreads and rising rates are “warning signs.”

“We will keep a close eye on those numbers,” they say.

 

Source: Rising Cost of Capital Squeezing Multifamily Cap Rates

https://www.creconsult.net/market-trends/rising-cost-of-capital-squeezing-multifamily-cap-rates/

US Economy Grew at 2.6% Annual Rate in Q3 GDP Report Shows

U.S. Economy Returned to Growth in Third Quarter

Gross domestic product increased 0.6 percent after two quarters of decline, but key components continue to show an economic slowdown.

The U.S. economy grew slowly over the summer, adding to fears of a looming recession — but also keeping alive the hope that one might be avoided.

Gross domestic product, adjusted for inflation, returned to growth in the third quarter after two consecutive quarterly contractions, according to government data released on Thursday. But consumer spending slowed as inflation ate away at households’ buying power, and the sharp rise in interest rates led to the steepest contraction in the housing sector since the first months of the pandemic.

The report underscored the delicate balance facing the Federal Reserve as it tries to rein in the fastest inflation in four decades. Policymakers have aggressively raised interest rates in recent months — and are expected to do so again at their meeting next week — in an effort to cool off red-hot demand, which they believe has contributed to the rapid increase in prices. But they are trying to do so without snuffing out the recovery entirely.

The third-quarter data — G.D.P. rose 0.6 percent, the Commerce Department said, a 2.6 percent annual rate of growth — suggested that the path to such a “soft landing” remained open but narrow.

“It’s just a very hard needle to thread,” said Diane Swonk, the chief economist at the accounting firm KPMG. “The cracks in the foundation have already begun to show.”

President Biden cheered the report in a statement on Thursday morning. “For months, doomsayers have been arguing that the U.S. economy is in a recession, and congressional Republicans have been rooting for a downturn,” he said. “But today we got further evidence that our economic recovery is continuing to power forward.”

By one common definition, the U.S. economy entered a recession when it experienced two straight quarters of shrinking G.D.P. at the start of the year. Officially, however, recessions are determined by a group of researchers at the National Bureau of Economic Research, who look at a broader array of indicators, including employment, income and spending.

Inflation F.A.Q.

Card 1 of 5

What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar will not go as far tomorrow as it did today. It is typically expressed as the annual change in prices for everyday goods and services such as food, furniture, apparel, transportation and toys.

What causes inflation? It can be the result of rising consumer demand. But inflation can also rise and fall based on developments that have little to do with economic conditions, such as limited oil production and supply chain problems.

Is inflation bad? It depends on the circumstances. Fast price increases spell trouble, but moderate price gains can lead to higher wages and job growth.

Can inflation affect the stock market? Rapid inflation typically spells trouble for stocks. Financial assets in general have historically fared badly during inflation booms, while tangible assets like houses have held their value better.

Most analysts don’t believe the economy meets that more formal definition, and the third-quarter numbers — which slightly exceeded forecasters’ expectations — provided further evidence that a recession had not yet begun.

But the overall G.D.P. figures were skewed by the international trade component, which often exhibits big swings from one period to the next. Economists tend to focus on less volatile components, which have showed the recovery steadily losing momentum as the year has progressed. One closely watched measure suggested that private-sector demand stalled out almost completely in the third quarter, and some forecasters expect G.D.P. to contract in the final three months of the year.

“Ignore the headline number — growth rates are slowing,” said Michael Gapen, the chief U.S. economist for Bank of America. “It wouldn’t take much further slowing from here to tip the economy into a recession.”

Consumer spending, the bedrock of the U.S. economy, rose 0.4 percent in the third quarter, down from a 0.5 percent increase in the quarter before. Spending on goods fell for the third consecutive quarter, while spending on services slowed but remained positive.

Consumer spending has continued to increase despite higher interest rates and rising prices, as consumers have drawn down savings to keep spending on vacations, restaurant meals and other in-person activities that many missed out on earlier in the pandemic. But it is unclear how long that can last. Americans saved 3.3 percent of their after-tax income in the third quarter, the smallest share since 2007.

“‘Borrowed time’ is how I would describe the consumer right now,” said Tim Quinlan, a senior economist at Wells Fargo. “Credit card borrowing is up, saving is down, our costs are rising faster than our paychecks are.”

Inflation slowed in the third quarter, as oil prices fell. That led to an increase in inflation-adjusted personal income, after a decline in the second quarter. But oil prices have since rebounded somewhat, and prices for food, rent and other essentials continue to rise.

The impact of rising interest rates is clear in the housing market, where home building and sales have both slowed sharply in recent months. The housing sector shrank 7.4 percent in the third quarter, subtracting 1.4 percentage points from the annualized growth rate in overall G.D.P. Businesses also cut investments in commercial and industrial buildings, and separate data released on Thursday showed that a key measure of business investment fell in September.

The slowdown in housing is likely to lead to a further pullback in consumer spending as homeowners feel poorer and as fewer people buy homes and need to fill them with furniture and appliances. Mortgage rates passed 7 percent on Thursday, their highest level since 2002.

“Housing is just the single largest trigger to additional spending, and it’s not there anymore; it’s going in reverse,” Ms. Swonk of KPMG said. “This has been a stunning turnaround in housing, and when things start to go really quickly, you start to wonder, what are the knock-on effects, what are the spillover effects?”

Thor Kitchen, a seller of stainless-steel kitchen appliances, saw strong demand early in the pandemic as families, stuck at home, were eager to upgrade their living spaces. Meeting that demand was a bigger challenge: Snarled supply chains made it hard for the company to get its products from its factories in China to its customers in the United States.

Understand Inflation and How It Affects You

Now, those trends are reversing. Supply chains are beginning to return to normal, and Thor Kitchen’s warehouses are beginning to fill up with inventory that the company ordered months ago. Demand, however, is falling: The steep drop in home sales means that fewer people need new stoves and refrigerators, while fear of a possible recession is leading people to pull back their spending.

“A lot of companies are going to be sitting on a lot of products that are now not moving,” said Timothy Lee, the company’s marketing manager. “We made those orders when demand was really high and continuing to increase in June.”

The company, which is based outside Riverside, Calif., has been cutting spending on advertising, among other areas, and has scaled back hiring, moves that Mr. Lee said were made early in expectation of a slowdown. It also recently began offering a 10 percent promotional discount, even as costs continued to rise.

So far, however, the discount has failed to do much to increase sales. A recession, Mr. Lee said, is “already here in our eyes.”

Many Americans share that pessimistic outlook. After gasoline prices shot up this year, measures of consumer confidence plunged, and they have remained low. Companies have begun preparing for a recession, pulling back spending on advertising and discussing contingency plans with investors.

Still, the economy still has important areas of strength. The job market is strong, and although hiring has slowed somewhat, layoffs remain low in most industries. Many households were able to build up a cash cushion early in the pandemic — a result of reduced spending and increased government aid — which could help them keep spending even if their incomes stagnate.

Those factors give the recovery a bit of a cushion, but they also make the Fed’s job harder by making the economy less responsive to higher interest rates. At the same time, the Fed can do little to control the prices of oil and food, which are influenced by global events such as the war in Ukraine.

“The problem is that there are many forces that are pushing for high inflation right now,” said Carola Frydman, an economist at the Kellogg School of Management at Northwestern University. “Not everything is easy to address with monetary policy.”

The third quarter was in some sense a mirror image of the first quarter, when G.D.P. shrank but consumer spending was strong. In both cases, the swings were driven by international trade. Imports, which don’t count toward domestic production figures, soared early this year as the strong economic recovery led Americans to buy more goods from overseas. Exports slumped as the rest of the world recovered more slowly from the pandemic.

Both trends have begun to reverse as American consumers have shifted more of their spending toward services and away from imported goods, and as foreign demand for American-made goods has recovered. Supply-chain disruptions have added to the volatility, leading to big swings in the data from quarter to quarter.

Few economists expect the strong trade figures from the third quarter to continue, especially because the strong dollar will make American goods less attractive overseas.

 

Source: US Economy Grew at 2.6% Annual Rate in Q3 GDP Report Shows

https://www.creconsult.net/market-trends/us-economy-grew-at-2-6-annual-rate-in-q3-gdp-report-shows/

Appraising Change

Climate change, shifting criteria, and growing complexity in assets are facilitating an evolution in commercial real estate valuation.

By K.C. Conway, CCIM, MAI, CRE | Fall 2022

Not since the passage of Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) in 1989 has the valuation of real estate come under such scrutiny and disruptive change as it has in 2022. For much of the past 30-plus years, commercial real estate valuations were credible, even during the COVID-19 pandemic. But commercial real estate valuation has become more complex due to the introduction of three factors:

1. A blurring of real estate and business enterprise value.
2. Environmental, social, and governance (ESG) and diversity, equity, and inclusion (DEI) constraints along with a new set of proposed appraisal guidelines and credentialing that may replace the Uniform Standards of Professional Appraisal Practice (USPAP).
3. Practical Applications of Real Estate Appraisal (PAREA), which is the probable replacement criteria/methodology to overhaul current USPAP and appraisal guidelines.

More than three decades ago, the motivating force in the appraisal industry was a lack of public trust in appraisals resulting from a deregulated savings and loan industry that led to egregious overvaluations and eventually a collapse in the ability to properly analyze asset value. The savings and loan crisis lasted a decade and led to the creation of the Resolution Trust Corporation and USPAP, which were needed to restore the structure of the real estate valuation industry.

Is your valuation knowledge up to date with these three factors?

Complexity from a blurring of the business value (going concern elements of valuation) to the pure real estate fee-simple property rights of value. Today, this blurring of property and business values extends to all property types and industry sectors, including hotels and hospitality variations (including timeshares and Airbnb/VRBO), self-storage, manufactured housing and for-rent subdivision communities, REITs with NNN-lease structures for big-box retail stores, e-commerce warehouses, and mixed-use adaptive reuse projects.

Brokers, investment advisers, and appraisers are quickly realizing an ESG score may become more impactful on valuation than the selection of a cap rate.

ESG/DEI as a valuation element to address climate risk and diversity impacting every aspect of the CRE industry and today’s economy. ESG is no longer an acronym that operates as a substitute for climate change. And along with DEI, the two concepts are now mainstream policies that influence capital allocation and valuations at the property level for both investment advisers and individual CRE professionals. How so? ESG scoring criteria and capital allocation implications based on these scores are transaction determinants. A less-than-favorable ESG or DEI score can derail a REIT merger or debt/equity capital allocation to a property. Brokers, investment advisers, and appraisers are quickly realizing an ESG score may become more impactful on valuation than the selection of a cap rate.

PAREA providing an alternate pathway for aspiring appraisers to fulfill experience requirements. The Appraiser Qualifications Board (AQB) created PAREA with the objective to “create an alternative to the traditional appraiser supervisor/trainee model for gaining appraisal experience.” PAREA was influenced by a 2020-2021 U.S. Department of Housing and Urban Development investigation by The Appraisal Foundation, an entity created by the 1989 FIRREA legislation.

The AQB adopted the criteria and guide note for PAREA in 2020, with both going into effect Jan. 1, 2021. PAREA, related to new appraisal credentialing, are guidelines currently under development by the AQB with aim for release and public comment in late 2022.

A sales comparison approach to value that uses cap rates from comparable transactions without adjusting for going concern would be like comparing apples and oranges.

My perspective as a 35-plus year appraisal veteran — and speaking independently from my role on the board of trustees for The Appraisal Foundation — is that PAREA advocates for a less-demanding path for the credentialing of state-licensed appraisers. With the goal of boosting diversity so “the appraisal profession [reflects] the population of the United States,” PAREA will significantly modify mentoring, supervision, and apprenticeship programs. Currently, USPAP 2020-2021 has been extended through 2022 and will likely be further extended to a fourth year in 2023. As PAREA is finalized in 2024, The Appraisal Foundation will determine the future of USPAP, which may become “USPAP Light” or, effectively, “USPAP Goodnight.” Any fundamental change in appraiser credentialing could be a déjà vu moment that potentially results in another appraisal crisis.

Few commercial real estate property types escaped significant changes in the COVID-19 era. These changes impact not just the use and operation of the physical commercial real property, they impact the understanding of market value by blurring the physical “sticks-and-bricks” fee-simple market value with going concern or business value. The going concern represents the value of the total assets of the business including tangible (the real estate — land, sticks, and bricks), intangible, and financial assets. This blurring of value comes into focus through the graphic in the most recent publication of “The Appraisal of Real Estate, 15th Edition,” by The Appraisal Institute, along with case studies involving timeshares, manufactured homes, and self-storage property types.

Timeshare Industry and Property. The timeshare industry has been moving from the traditional weeks-based system to a points-based system. While the new system allows flexibility for individual owners, it also creates operational and going concern complexity. The weeks-based system gives an owner the right to a unit in a specific resort during a specific week each year. However, in the points-based system, the owner’s rights to a specific resort show as points that can be exchanged for use at a different time during the year or at other resorts in a company’s network. This gives the points-based owner more use options — options that also translate into value. There is increased value in having this flexibility, especially amid COVID-19. Appraisers and brokers should consider precisely how the change from this traditional week-based system to one based on points accrues to the business value of the timeshare property — not the real estate market value. Weeks versus points is a change that blurs the market value of real estate with the going concern of a timeshare property. The physical property may look the same, but the revenue and operational costs of such a change are quite material.

 

Manufactured Housing. Manufactured housing communities have evolved tremendously since their inception and subsequent 1976 regulation. The early years in this industry sought to address the nation’s housing shortage after World War II. Today, they are positioned to play a key role in addressing today’s ever-increasing shortfall. The dated neighborhoods that were initially the norm, leaving negative connotations aside, are not comparable to the manufactured housing of the last two decades. They are no longer referred to as trailer parks, and these new communities share more with traditional single-family neighborhoods in both layout and home design. They offer amenities such as fitness centers, dog parks, pools, pavilions, pickleball and shuffleboard courts, storage facilities, community centers, gated entrances, and increased management services. Many of these changes are due to the consolidation of ownership, largely from institutional investors or REITs, because larger institutional owners have more resources to improve these assets.

Self-Storage. The self-storage industry is another example of a property type that has undergone considerable change. Like manufactured housing, the influx of institutional capital (REITs) — along with the evolution of design, services, and operations — has made this property type more of a business than an assemblage of storage lockers on a tertiary piece of land with limited highest and best use. The self-storage market of today is far removed from the mom-and-pop-owned sites with design features like single-story elevation, non-climate-controlled units, unappealing steel buildings with drive-up exterior access with limited or no security, and no on-site resident management.

The facilities are now more typically acquired and owned by institutional capital and professionally managed, with facilities featuring climate-controlled units, interior secure access, elevators, and drive-thru access. They also offer more services that accrue to the intangible assets of the going concern or business — services such as extensive security systems, and online lease and bill pay — plus, on-site management that operates a moving store offering supplies and rental trucks for use. In essence, these properties house a going concern that has all the characteristics and operating costs of a hotel. Institutional capital has transformed this property type so much so that self-storage as a CRE asset category experienced the highest value appreciation in 2021 over the past 12 months from before COVID-19, jumping 28 percent, according to Green Street.

The evolution of the self-storage facility is leading to the bifurcation of the classification of these facilities between institutionally owned, Class A properties, and the remaining 70 percent of inventory owned and managed by mom-and-pop entities. Self-storage facilities are generally categorized into Class A, B, or C properties, which correspond to the facility’s age, condition, location, quality, amenities, and level of management. According to the 2020 Self-Storage Almanac, six public companies control 31.2 percent of the nation’s self-storage supply, and the 100 Top Operators (including these six public companies) represent 47.7 percent of the nation’s 2020 self-storage supply.

Class A self-storage facilities attract a particular group of owners who are institutional in nature (REITs) and are investing in both the business enterprise and the going concern versus solely the real estate. As a result, transactions of these type of self-storage facilities represent sale of a going concern and not just the real estate. Such transactions are typically based on a price-earnings multiple. The inferred cap rate applies to the going concern business sale and not the real estate. The real estate (land and building) are just one of the three types of assets contributing to the value of a going concern, and care needs to be taken not to ascribe personal property, intangible assets, or financial assets to the real estate. A sales comparison approach to value that uses cap rates from comparable transactions without adjusting for going concern would be like comparing apples and oranges.

The emphasis on class type for self-storage properties parallels that associated with flagged hotel properties, franchised restaurants, etc., in that all are professionally managed businesses operating within a real estate asset that have elements of going concern.

Pulling It All Together

The complexity of going concern and business enterprise is embedded in more CRE property types than just hotels and restaurants.

When determining the market value of commercial properties, care needs to be taken to ensure that the calculated valuation reflects asset components specific to the real estate itself and not the elevated value of the going concern. The following are some recommended adjustments to separate real estate market value from the going concern. It’s not just a legacy hotel or restaurant with business enterprise value to consider in 2022. The breadth of property types with going concern value has expanded and some adjustments are required, including:

1. Extract Non-Realty from Sales Transaction Comparables. When determining the real estate market value, non-realty components — such as the cost of moving trucks or fixtures constructed for specific uses — must be adjusted for or extracted from the total transaction sale price.
2. Market Rent and Occupancy. The objective in a market value determination is to estimate the average market rent and occupancy versus a specific property’s operating rent and occupancy that could be influenced by other factors, like “weeks versus points” pricing in timeshares or inferior or superior amenities and services as in the case of climate- versus non-climate-controlled self-storage.
3. Management Fees Don’t Capture All the Going Concern. Consider the revenue contribution and expense-side accruing to going concern value from any additional off-site services (advertising, IT and tech support, accounting, security monitoring, etc.) that may be above what is generally seen in the market. A general 3, 5, or even 10 percent overall management fee often doesn’t cover the expenses for the business services not related to the typical 3 to 5 percent property level management for physical maintenance and on-site management.
4. Distinguish the Going Concern Cap Rate in a Transaction. Selecting a cap rate requires judgment and a breakdown between the asset classes (tangible real estate, intangibles, and financial assets). Of significant note on this point is Chapter 37 in “The Appraisal of Real Estate, 15th Edition.” REIT and portfolio transactions often utilize a purchase price allocation (PPA) to segregate the non-realty, property-by-property market value for the real estate and use these transaction price allocations for SEC and GAAP accounting reporting. Be sure to inquire about the PPA with the buyer so as not to misrepresent a pro rata of the portfolio sale with non-realty attributed to an individual property in the aggregate transaction.
5. Don’t Overlook the Cost Approach. The cost approach is integral to the principle of substitution and is a reliable method to value just the real estate assets. Note the following from “The Appraisal of Real Estate, 15th Edition”:

In situations where the cost approach can be developed reliably, it can be useful in determining the appropriate allocation of value to the different asset classes. A common strategy is to use the cost approach to value only the tangible asset classes (land, sticks, and bricks). The value indication from the cost approach can then be compared to value indications from the sales comparison and income capitalization approaches to highlight the inclusion of non-realty and intangibles to the going concerns.

 

ESG/DEI as a Valuation Element to Address Climate Risk and Diversity

As mentioned earlier, ESG and DEI initiatives are now critical CRE factors. ESG scores by proxy advisers such as Glass Lewis and ISS — as well as CRE debt monitoring companies like Trepp — can make or break a transaction. Several top-10 banks with CRE concentrations now incorporate a level of ESG underwriting to the commercial real estate credit approval process. A credit request based on a less-than-favorable ESG score influenced by a single tenant (such as a firearms maker or fossil fuel company) or a property ownership structure that lacks diversity can result in a negative credit approval decision.

Brokers, CRE investment advisers, and appraisers collectively need to understand how ESG scoring is going to impact all aspects of the CRE transaction process.

The nationally recognized CRE debt-monitoring company Trepp has published extensively on ESG scoring and developed its own modeling that translates down to the individual property level. Trepp has also partnered with RMS, a Moody’s Analytics Company, to create a new composite environmental risk score based on the integration of RMS’s climate catastrophe risk models with Trepp’s CMBS and CRE products. This partnership will provide both a physical risk score and a business interpretation to properties listed in Trepp’s database. In the future, the partners plan to bring new scores and metrics focusing on enhanced risk measurement and add more granularity to facilitate analysis.

Brokers, CRE investment advisers, and appraisers collectively need to understand how ESG scoring is going to impact all aspects of the CRE transaction process from underwriting to capital allocation to market value. The ESG score may become more impactful on value than the selection of a cap rate.

Conclusion

From the embedding of going concern and business value within more property types to the evolution of PAREA that could potentially replace the USPAP, a lot is changing in how commercial real estate value is determined. Whether you are a broker, appraiser, or investment adviser, how commercial real estate value is determined is more in focus in 2022 than at any point dating back to 1989 and the passage of the FIRREA legislation.

Don’t get caught off guard. Start getting prepared today for how CRE valuation will be conducted tomorrow.

 

 

Source: Appraising Change

https://www.creconsult.net/market-trends/appraising-change/

eXp Commercial Economist KC Conway Offers Insight and Tips on How to Pivot During Strong Economic Headwinds

As the U.S. confronts inflation and, increasingly, signs of a recession, eXp Commercial called on economist and futurist KC Conway for his take on what’s ahead. With 2022 Q4 in the headlights, and instability forecasted for 2023 and beyond, Conway delivers a master class on current and coming market conditions. His advice serves as a blueprint for all real estate agents – commercial and residential – on signs to look for and steps to take to navigate strong economic headwinds.

The following are key excerpts from this dynamic Q&A between eXp Commercial President James Huang and KC Conway:

There’s No Sugar-Coating It: A Challenging Period Is Ahead

The Federal Reserve is in panic mode on inflation. The inflation metrics are all coming in hotter and indicators for inflation are double the expectation at 8.5%. It would be a lot worse if we hadn't tapped the strategic petroleum reserve to bring gas prices down.

But inflation is not abating, mortgage rates have risen to 7%, throwing cold water on the residential real estate market. On the commercial side, banks are essentially being told by the Federal Reserve to quit lending. So you’re starting to see deals being canceled.

“I think we face a very, very challenging fourth quarter ahead of 2023. We're going to have to dust off some skills that take us back to the 1980s. How do you finance and get the market moving in a high inflationary market?

“This is only about the fifth time since post-World War II that the global GDP is down to the 2% range. Each of those times has been very serious times not only for the global economy but for us here in the U.S. So the kind word to say is ‘it is not great.’ ”

Inflation Impacts Urban Retail Most, Multi-family Least

Residential real estate leads in a recession and commercial real estate follow because they are dependent. And right now “the rooftops” of residential real estate are telling us their problems.

So commercial lags. We're just starting to see all of the commercial property price indices starting to turn downward. In fact, they essentially were about 0% in the latest month. Other takeaways:

Urban areas that have not gone back to work at 50% post-pandemic are being hit harder. That’s the barometer for a better urban commercial retail market: Workers back to the office at over 50%.

The office is healthy in the suburbs. Smaller chunks of office space and adaptive reuse of a branch bank to an office building, for example. Smaller chunks of about 4,000 to 6,000 square feet where employees can come in, and meet with a client, it’s in and out.

Big pension funds are starting to sell their office assets. They've already lost 15 to 20%. They don't want to lose 40% so they're moving aggressively to try to sell. That will be interesting to see how that plays out.

Suburban Commercial Markets Can Better Sustain Inflationary Forces

There is a term that influences density. It’s where you have a density of housing in the suburbs where the houses are actually occupied, and you have households that have good jobs. People can work and they’re doing pretty well. It’s in those pockets where you can do quite well in retail.

Supply Chain Rebuild Helps Defy Inflation in Certain Corridors

A shift is taking place from a West Coast-centric model to a supply chain that moved to Chicago and the East, and to a more North-South concentration. The Port of Savannah and other East Coast, Gulf Coast, and South Atlantic ports are seeing the great expansion of ships and goods.

Long Beach and Los Angeles used to dominate but that’s not the case now. We’re seeing shippers use the Panama Canal and come into Savannah and Charleston. We’ve also seen New York overtake California ports as the busiest container port in North America.

Additionally, those container ships are leaving East Coast ports loaded with grains, agricultural goods, durable goods, and manufactured goods. That mitigates shipping costs vs. 60% of ships leaving California ports empty.

Highlights of Commercial Sectors That Can Do Well in 2023

The efficiency of e-commerce facilities as big as 1 million square feet can close 100 stores. That’s the metric that moves the needle as they build more of these.

Multifamily is going to stay strong. The reason is, it now costs over $300,000 a unit to build a new stick-built apartment. Three years ago, that was the median price of a single-family home in the United States.

Housing Shortage + Young Workforce = Need for Housing Innovation

The young workforce – the Millennial workforce, the Gen Z – cannot buy housing. They have student loan debt. They don't have the credit. They don't have cash savings, and they can't afford a 7% mortgage.

We're going to have to see some innovation on the mortgage side to bring them into housing. The supply will add maybe 450,000 to 470,000 new apartments this year, and that'll be a record since 1980.

But if you look at the top 50 markets, that's a thousand units that do not make a dent in the supply shortage. So rents are going to continue to rise 6-8% and 10-12%, especially in markets like Texas and Florida and other inland markets where the workforce is going.

The Home-Building Industry Is In a Full-Out Recession

“They are shut down. They can't sell the homes because of the mortgage rates. They can't build them at the cost and the price point that work. So housing is completely shutting down. Look at the big public builders, especially with a lot of speculation inventory. They're in a lot more trouble.”

Foreign Money Will Continue to Flow to the U.S.

The United Arab Emirates, Israel, and South Korea continue to look to the U.S. for cash, 401K, and other asset investments. They are in a position to buy for cash deals that are falling out of escrow here.

“What's happening is that with our stronger dollar and because we're raising interest rates … our 4% looks very attractive to other parts of the world paying 1% or less. So we're seeing more of that money go into U.S. dollar denomination, and that further drives the demand for U.S. assets with such a strong dollar.’’

The Fed Needs to Be Careful With Europe

Conway on Europe’s woes: Europe is going to be very, very challenged. They're looking. Where can they go to a safe haven? They're going to have a tough winter this year with the energy issues and companies having to idle plants.

“The Fed has put the UK in the same position that we were in in 2008 and Lehman Brothers. They've locked up the capital market side, so we better be careful because Europe is a very important customer and ally for us. The Fed needs to take on a third mandate, which does not destroy Europe.”

There Will Be No Soft Landing

There’s a lot of talk about a soft landing, about whether or not we’re already in a recession. There’s talk about two more quarters before some of these measures start to unwind inflation and housing costs. That’s not going to be the end of it.

“I don't think a soft landing is in the cards, and anybody that keeps talking about it, I think they're being very disingenuous, to be honest with you.’’

Steve Forbes in the 1970s invented a phrase called the “Misery Index.” He took unemployment and inflation and put them together and we got to a peak of about 13%. That formula has been modernized. They added the S&P 500 because now almost 60% of American households own stock in some capacity.

“Right now, you end up with a Misery Index of 29 compared to 13 in the 1970s.”

What the Federal Reserve does in November and December, depending on whether energy costs go back up after the November midterm elections, and what kind of increase there is in unemployment:

“I think there is more pain ahead. There will be no recovery in 2023. We can get a real shock in mid-2023 and see we’re now 6-8 quarters into negative GDP. We’ll see the damage we've done to the housing industry, which is 40% of our GDP. We’ll see the damage we’ve done to our retail industry and to the consumer.”

“Maybe at that point, both political parties in this country will come together and say we’ve got to deal with this. Maybe they put things in place in early ‘24 or late 2023 to give us some hope. But the best case is the second half of 2024, but I honestly think we’re really at the year 2025 or 2026 before we start to see recovery.”

Conway’s Suggestions on Safe Places to Go and Opportunities

REITS

Workforce growth in places where companies are relocating: Tractor Supply in Little Rock, Arkansas; Hyundai going into Montgomery, Alabama.

Florida: The rebuilding is going to be phenomenal.

The Carolinas continue to be strong. Toyota, EV batteries, high tech, biosciences.

South Korea and Vietnam are moving manufacturing away from North Korea due to threats to U.S. plants.

What eXp Commercial Agents Can Do In the Meantime

Clean energy: Investigate states that have passed property assessments for clean energy. These assessing authorities have capital to tap for updating HVAC and other energy-efficient improvements.

“That underutilized or vacant retail or restaurants that – if you had a little bit of capital and you could cloak it under a clean energy upgrading for efficiency. You can get all the capital, fix the building, never have to go to a bank and get turned down or wait six months”

Reassessments: Big box retailers finally realized they're not worth 200 bucks a square foot, and the assessments are now in the $50 to $75 square-foot range. They're coming after the big industrial buildings and e-commerce. They're coming after the full-rent subdivisions and self-storage, which was up 60%. So that’s going to be another pivot.

ESG pressure: Every public company has to get an ESG score. They have to show what they’re doing. They have to deploy capital. An organization’s ESG score is a measure of how the company is perceived to be performing on a range of environmental, social, and governance (ESG) criteria.

 

Source: eXp Commercial Economist KC Conway Offers Insight and Tips on How to Pivot During Strong Economic Headwinds

https://www.creconsult.net/market-trends/exp-commercial-economist-kc-conway-offers-insight-and-tips-on-how-to-pivot-during-strong-economic-headwinds/

Multifamily's Prime Target Aging Millennials

Multifamily’s Prime Target: Aging Millennials

Aging millennials make up the largest renter cohort, so why aren’t developers and investors taking their preferences into consideration?

A number of factors have contributed to making multifamily the hottest commercial real estate asset in the U.S. over the past few years. A chronic lack of housing combined with steadily rising rents and declining vacancy rates have more investors and developers targeting the sector.

As rising interest rates and inflation make it more expensive to purchase homes, the national demand for rental housing is expected to remain strong for the foreseeable future. To capture this demand, multifamily owners and developers must focus on delivering properties that cater to evolving consumer preferences.

However, recent development trends suggest that the needs and preferences of the market’s biggest renter cohort — aging millennials — are not being considered in critical design decisions. As a result, more product is being delivered that is unsuited to renter needs, creating a supply and demand imbalance.

Evolving Housing Preferences and Development Trends

With more than 72 million members, millennials (ages 26 to 41) are the largest age group in the country. Many millennials are finally entering the stage of life where they are forming and growing families, maturing in career positions, and building wealth. This has historically been a catalyst for evolving housing preferences, including single-family homes in more suburban environments.

However, this phenomenon is being curtailed by significant barriers to homeownership, including lasting impacts of the global financial crisis, student loan debt, and a lack of savings, as well as the differentiated values held by millennials that tend to support the renter-by-choice phenomenon. This group is generally attracted to the flexibility, access to amenities, community feel, and lack of maintenance costs that comes with renting an apartment.

One would expect that multifamily owners and developers are taking the preferences of the nation’s largest renter cohort into consideration. However, recent residential development patterns demonstrate that this is not the case.

The urban core has seen historically massive construction activity in the past decade, growing the existing base by more than one-third since early 2010. Annual inventory expansion rates have remained at 3.5% or higher in the urban core since 2014 while remaining at 2% or less in the suburbs. With most multifamily development concentrated in dense urban core areas with smaller units, aging millennials looking to access the suburbs find themselves with much less optionality.

Most of this development has resulted in efficiently sized studio and one-bedroom units designed for a younger, more affordability-driven generation. Over the course of the past decade, the share of deliveries in two-bedroom configurations has declined to 38.5% from 45.4%.

Although these smaller units appear to be more attractive to developers and investors as they achieve higher value on a per square foot basis, thus offsetting high construction costs, they miss the mark when it comes to attracting aging millennials who need more space to accommodate their lifestyles and growing families.

Capitalizing on the Imbalance

Savvy investors and developers who look beyond rent per square foot and focus on millennials’ preferences are poised to deliver stronger returns. Typically, as units get bigger, rents per square foot get smaller, resulting in the studio and one-bedroom units achieving a higher value on a per-square-foot basis.

Although this would appear to be attractive to developers and investors, rents on these units can only be pushed so much, as they are an affordability play and only cater towards a specific renter profile. In markets that are inherently affordable, where you don’t have as many renters needing to give up space for location, rent per square foot actually trends back upwards as units get bigger. Once you surpass that 1,200-square-foot threshold, you are dealing with a different renter pool: the aging millennial, which is a large, growing and underserved population.

At Palladius, we are already seeing evidence of this play out. On average two- and three-bedroom units are seeing 200 basis points higher annual rent growth than studio and one-bedroom units. As demand shifts to larger units, capital should, as well. Larger unit renters aren’t as affordability driven, suggesting that most of our renovation dollars and luxury finishes should be focused on these units. Not only do we optimize renovation scope based on the unit type, but we also assign different annual rent growth projections for each.

With more capital continuing to be committed to multifamily development and investments, data shows that the bulk of investors are targeting the new renter generation presumably with the goal of generating higher returns on smaller formats. While it is tempting to avoid high overhead costs by creating smaller products marketed toward new renters, stronger returns await those who can meet the shifting demands of aging millennials.

 

Source: Multifamily’s Prime Target Aging Millennials

https://www.creconsult.net/market-trends/multifamilys-prime-target-aging-millennials/

Don't expect home prices to come crashing down soon

What's happening: Home prices were up 18% in June compared to a year ago, with Tampa, Miami, and Dallas reporting the highest annual gains, according to the S&P CoreLogic Case-Shiller Indices

That was a slower pace than in May when they rose 19.9% annually. But the bottom line is that prices are still going up a lot, even as home sales have declined from their peaks.

So are we in a housing bubble?

Economists at the Federal Reserve Bank of Dallas examined this very question earlier this year, noting in a blog post that home prices were rising faster than market forces would indicate they should, and were becoming "unhinged from fundamentals."

That isn't just a big deal for buyers and sellers. The housing market is an important economic indicator and a reflection of how interest rate hikes by the Federal Reserve are playing out.

Watch this space: The market is changing as the Fed's efforts to cap inflation take effect. Climbing mortgage rates are making it more expensive to buy a home. In theory, that should cool demand and prices over time.

And to the extent we are in a bubble, economists think it will slowly deflate rather than suddenly pop. The team at Goldman Sachs predicts that home price growth will slow sharply in the next couple of quarters and eventually flatten out.

"We expect home price growth to stall completely, averaging 0% in 2023," Jan Hatzius, Goldman's chief economist, wrote in a recent research note. "While outright declines in national home prices are possible and appear quite likely for some regions, large declines seem unlikely."

That said: There's a reason prices have shown more resilience. Supply is still constrained.

Pandemic-era shortages have limited the pace of new home building. In the past, downturns in housing have been accompanied by economy-wide recessions, leading to a flood of existing home inventory. Recession leads to unemployment, and cash-strapped homeowners are forced to sell.

Today's labor market is robust, and that influx of housing seems unlikely to happen in this cycle — further prolonging the lack of inventory.

On the radar: Unfortunately, Goldman reports that the slowdown in home price appreciation isn't likely to impact shelter costs, which are a crucial component of the Consumer Price Index tracking inflation.

That's because as higher mortgage rates increase the cost of buying a new home, more people will be inclined to rent, boosting prices in that market.

What job openings data could mean for Fed rate hikes

Companies are hiring, but Americans aren't biting. The latest: The number of open positions in the United States ticked up in July, surprising economists.

There were close to two jobs available per job seeker in July, up from 1.8 in June, according to the latest Job Openings and Labor Turnover Survey, or JOLTS, data.

That's not what the Federal Reserve was hoping for. The Fed is worried that

near-record job openings

are helping to drive wage increases, which in turn can prop up inflation, reports my CNN Business colleague Alicia Wallace.

"The Fed will not be happy with this report," Mark Zandi, senior economist for Moody's Analytics, told CNN Business. "It is critical that the job market cools off, and this report suggests that it remained very strong in July." The takeaway: A strong labor market is likely to encourage Federal Reserve officials to continue aggressive interest rate hikes in an attempt to cool the economy. Fed Chair Jerome Powell reiterated his resolve to bring down inflation and to "keep at it until the job is done," last week, even though that plan — which involves a series of hefty interest rate hikes — will bring "some pain to households and businesses."

It's all about oil

US markets tumbled to their third straight day of losses on Tuesday. And while it might be easy to blame Wall Street's bad mood on Fed Chair Jerome Powell, reports my

CNN Business colleague Paul R. La Monica, the most likely culprit is actually falling oil prices. US crude dropped 5.5% to settle at $91.64 a barrel, marking its worst day in five weeks.

The drop is good news for consumers. It could mean that prices at the pump keep falling and that a key measure of inflation — energy prices — continues to recede.

On the radar: The national average for a gallon of regular gasoline hit $3.84 on Wednesday, according to AAA. That's down from $4.22 one month ago.

But what's good for consumers isn't always good for markets. The drop in oil prices led to a big sell-off in energy stocks. Shares of Chevron (CVX) fell more than 2%. The S&P 500 (INX) was down 1.1%, and oil stocks were the biggest losers. The S&P Energy Select Sector SPDR Fund slid 3.4%.

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Source: Don’t expect home prices to come crashing down soon

https://www.creconsult.net/market-trends/dont-expect-home-prices-to-come-crashing-down-soon/