A macro perspective of CRE finance

Finance is a hot topic industry-wide, and while much of the concern concerns volatile economic factors, it’s more so the lack of clarity surrounding them. Everyone has different opinions regarding what might or might not happen, but it’s essential to look at the macro picture to find a solution.

Illinois Real Estate Journal recently spoke with Patrick Tuohy, Senior Vice President at Marquette Bank, to discuss the past, present, and future related to multifamily finance.

Past
Before joining Marquette Bank 40 years ago, Tuohy managed interest rate and equity risk for Merrill Lynch, after which he decided to hone in on the middle-class business. Why? Tuohy said that these markets are poised to weather economic downturns, and they’ve done so since 1982.

To save money during an economic downturn, Class A renters tend to move to Class B, Class B renters move to Class C, and so on. The opposite happens when it turns back around: Class D moves to Class C, Class C moves to Class B, and Class B moves to Class A, exemplifying an unwavering demand for middle-market buildings.

Yet COVID-19 affected all sectors, not just multifamily, and hotels, restaurants, and entertainment venues were most directly impacted. To assist the owner/operator during this period, Marquette Bank gave the option of interest-only loans, which turned out to be very successful, meaning no defaults, and businesses could get back on their feet as the world transformed into our new normal. At the same time, $4 trillion was printed and spread around the U.S. to keep the economy from crashing.

But the future effects were misread, and inflation isn’t transitory as predicted. Inflation skyrocketed in 2022 as the pandemic moved toward an end, resulting in multiple 75-point basis point jumps. Rates in the last 60 days have jumped to 5.5–6% after hovering between 3.5–4% for the previous decade, Tuohy said, and a significant consequence, as it relates to the multifamily market, is a disconnect between the bid, the ask, the offer, and the sale.

Present
Sellers still want the inflated value for their building, based on a rate of 3.5–4%. A buyer, at this rate, could put 25% equity down and have the adequate cash flow to operate the building plus a decent return—but this is not possible at the adjusted rate of 5.5–6%, and today’s buyers must put down 30–40%, resulting in a disconnect between the buyer and seller. Because of this, the multifamily volume in Chicago and across the U.S. has decreased considerably for potential sellers. However, Tuohy said there is still a large buyer pool because the money is there, and buyers are willing to shell out additional equity for a suitable building in the correct location.

Tuohy said the same is happening within the single-tenant, triple-net market.

Future
No one is certain how or when this stalemate will go back to normal, but Tuohy said it’s only a matter of time. Sellers will have to sell at some point—for some reason—and as the economy slows and we enter a recession, rates will again reach a low- to mid-4%.

The is-it-isn’t-it recession is a topic of conversation itself, but for clarity, one must look at the fundamentals.

The U.S. is 70% consumer-driven, and when consumer sentiment, which is still reasonably strong, starts to decline rapidly, the average consumer starts to cut back on nonessential items like electronics. When this happens, manufacturers stop buying chips, and Tuohy said it’s because the chip industry is usually the first to feel the burn in times of financial uncertainty. When credit card rates exceed 20% in a credit-driven economy, consumers will think twice about putting debt on their balance sheet.

But consumer behavior is less predictable following COVID-19. People have not lessened their spending on luxuries like dining out and traveling, affecting other markets like single-family and homes have dropped 70–80%. Like multifamily, Tuohy said with a mortgage of 3.5–4% or lower, homeowners have no incentive to sell to buy a new home at a rate of 6%, ultimately leading to a mortgage industry layoff.

It’s a domino effect, starting with the housing industry as the backbone of our economy. When people are hit pause on homebuying, they’re also slower to buy furniture, appliances, etc.—all affected by increasing rates.

“It’s a prolonged process, and we’re still waiting to see,” Tuohy said. “Interest rate hikes set in motion a domino effect, but we’re only in the first stage.”

And then there’s inflation, which is affecting replacement costs for multifamily. Marquette Bank saw the cost of construction increase 20–30% for new projects, impacting the underlying value of apartment stock.

The average cost to replace a single unit in Chicago is $400,000, and in Chicagoland, $250,000.

“If existing apartment stock is half of that cost,” Tuohy said, “it makes for an attractive long-term investment. Buying an apartment unit for $250,000 or $300,000 in Chicago is significantly less than replacing that building when you factor in the cost of materials and labor.”

The same goes for single-family homes: Marquette Bank has 18 three-bedroom, two-bathroom townhomes under construction, for which prices recently jumped 25% on construction costs, turning $290,000 into $370,000. Marquette had to raise the price to around $490,000, yet they still sold.

That is to say; everything is interconnected. Across the U.S., replacement costs of single-family have a direct effect on the rental market, and the cost of replacing or building a home affects whether people can afford to buy—and the difficulty of this transition has only solidified the multifamily market, as the vacancy rate is less than 5% in Chicago.

And while it’s true that rental rates are increasing due to renters being priced out of the housing market, Tuohy said there’s another side to the equation. Insurance costs are up 7%, utility costs are up, and taxes have increased, as multifamily is considered a go-to sector to raise taxes because of the perception that more profit is being made.

“We have buildings that doubled in taxes this year from $40,000 to $80,000,” Tuohy said. “Because of these things, the margins have shrunk, and the owner/operators have to pass a portion of that cost onto the tenant. It’s no longer a matter of whether or not landlords want to raise rents—they have to break even.”

Tuohy said that Multifamily is not a “get rich” business but a long and challenging ride, now more so than ever. “It works well for people long term,” he said, “but it’s not for those seeking a short-term return.”

 

Source: A macro perspective of CRE finance with Marquette Bank – REJournals

https://www.creconsult.net/market-trends/a-macro-perspective-of-cre-finance/

Multifamily sellers: How to qualify a buyer before going under contract

Multifamily sellers: How to qualify a buyer before going under contract

Don’t waste time and opportunities: learn how to select the right buyer every time

As the seller of a multifamily asset, it’s crucial that the buyer you select is the best possible prospect for your property. Don’t waste time, money, and opportunities: you must ensure they’re qualified and can close and execute the contract as signed.

Keep reading to learn why it’s essential to qualify a buyer before going under contract on your multifamily property and how to do it.

Why do I need to qualify a buyer?

It’s important to close with the first buyer you select. If you don’t, each buyer after that will ask themselves, “What did that other buyer discover about this property that I am missing?”.

When you enter into a contract with a refundable deposit, you’re basically giving your chosen buyer a free option on your property for a period of time, typically 30–60 days. Before you proceed, you must be confident that they can close and execute the contract as signed.

What’s more, your tenants and staff will be disturbed throughout the contract process. To minimize the period of disruption, you should do all you can to ensure the transaction will close successfully at the end of the contract process.

As a seller, you’re required to provide due diligence information to the prospective buyer. When you qualify your buyer, you’ll greatly reduce the risk of wasting a lot of time and doing a lot of work only to not close on the property.

How do I qualify a buyer?

Before you sign the contract, make sure that your prospective buyer can provide certain items. Always ask them for the following:

– Proof of funds

– Lender pre-qualification

– A list of the other properties they own

– A list of the sellers and agents that they have worked with

For added reassurance, it’s recommended that you call the buyer’s lender to confirm their pre-qualified status. You can also call the agents, sellers, and buyers they’ve closed with in the past to enquire about how the transactions went.

Has the buyer toured the property in person before making an offer? Have they reviewed the due diligence information beforehand? If they have, this is a great sign. It’s proof that they have seen and have taken into account any issues with your property, and this greatly reduces the chances that they may later want to back out of the sale, saying they were unaware of the building’s condition. Be very wary of a buyer who doesn’t tour your property in person.

A prospective buyer who shows they’re motivated and wants to move quickly is also a great sign for a successful closing. The shorter the due diligence period, the better, and the larger the deposit, the better.

When you spend the time making sure your prospective buyer fulfills these criteria, you’ll put yourself in a great position to close successfully and ensure a quick and smooth transaction.

If you need help selling your multifamily property, eXp Commercial is here. Our objective as your multifamily advisor is to help you achieve your investment goals: from determining the listing price to selecting the best buyer and handling the sale process through to the closing, we’ll facilitate a smooth transaction for you.

 

Source: Multifamily sellers: How to qualify a buyer before going under contract

https://www.creconsult.net/market-trends/multifamily-sellers-how-to-qualify-a-buyer-before-going-under-contract/

Renovation nation: Why multifamily rehabs can resist economic turmoil

Though demand among apartment renters remains steady, economic headwinds and weakening multifamily fundamentals are having an effect. Given this situation, the stage is set for more apartment owners to undertake renovations to stand out. However, this strategy is not without its challenges.

According to a Q4 2022 Growth Report compiled by Apartments.com, multifamily fundamentals weakened at the end of last year with supply-demand imbalance, higher vacancy rates, and marginal absorption. The report showed that the vacancy rate rose from 5.7% in the third quarter to 6.2% in the fourth quarter, due in part to 96,000 new rental units coming online. As a result, national asking rents fell to 3.7%, a 740-basis-point decline from one year prior.

However, the quarterly snapshot of these figures doesn’t align with a long-term trend. A recent U.S. multifamily capital markets report by Newmark found that new housing completions – which include single-family and multifamily properties – have not kept up with household formation since 2018, resulting in a 400,000-unit shortfall in 2021. Meanwhile, mortgage applications fell by more than 65% in third-quarter 2022 compared to one year prior. This was due in no small part to an astonishing 122.6% year-over-year increase in the average 30-year fixed rate.

A Dodge Data & Analytics report showed that year-over-year multifamily construction starts grew by only 1% in November. While this is far better than the 9% decrease in single-family construction in that period, it shows that, in the coming years, supply will not keep pace with demand.

This is a sentiment shared by builders. In a recent outlook survey by The Associated General Contractors of America, contractors provided their expectations for project value growth across multiple sectors in 2023 compared to last year. The share of respondents who anticipate expanding the multifamily industry edged out those who foresee contraction by only 1%. This is a steep 31 percentage-point drop from the 2022 survey.

The Apartment.com report forecasts 2023 will see the highest new supply totals since the 1980s as underway projects catch up to market conditions. However, the majority of these will be luxury units. This fact, combined with higher interest rates pricing, would-be buyers out of homeownership, and an eventual tapering off of new construction starts, means that demand for many renters is not going away.

Many commercial property owners are seizing the opportunity to renovate their buildings and tap into this demand, updating units and common areas to enhance marketability and profitability. However, one issue is that materials remain more expensive and more complicated to obtain due to ongoing supply chain issues. While this has created challenges for apartment owners looking to modernize their buildings, intelligent procurement decisions can keep a project on target without significant cost overruns.

Knowledgeable contractors collaborating closely with ownership can find the right balance between scope and budget. This includes advising on what alternative materials can be substituted without compromising quality and which projects should be prioritized to maximize ROI.

My firm, Motus Construction, recently completed renovation work on a six-unit apartment building in Forest Park, Ill. The building needed extensive repairs to the existing hot water boiler, plumbing, and electric system. While these capital expenditures came at a considerable cost, we identified ways to make the client’s desired aesthetic changes to all units while staying under budget.

For example, we selected high-quality vinyl plank flooring for the project, which comes at about half the cost of newly installed hardwood. Not only is it cheaper, but vinyl flooring now comes in a broader range of finish options, has better durability, and is often more accessible to the source.

Another strategy we employed at the Forest Park project was painting the impression of a black wainscotting on the white walls in all common areas. This required no additional materials; with a simple paint selection and application, we could give the entry and laundry spaces an elevated, contemporary feel that appears to be more expensive than it is.

The best way to save on material costs is to use what’s already in place. For example, if existing cabinetry or doors are outdated but otherwise in good shape, paint or refinishing can give them a new life, especially combined with updated hardware. Similarly, leaving exterior brickwork or ceiling spaces exposed can provide a room with a modern, industrial aesthetic without needing to buy drywall and framing. However, this only works on specific projects, so it’s best to assess on a case-by-case basis.

Even in the face of higher construction costs, longer lead times, rising interest rates, and tightening lending standards, apartment owners can still maximize the value of their properties through thoughtful renovations. Those who rely on the expertise of skilled contractors are best positioned to maximize their return on such investments at a time when every dollar counts.

 

Source: Renovation nation: Why multifamily rehabs can resist economic turmoil – REJournals

https://www.creconsult.net/market-trends/renovation-nation-why-multifamily-rehabs-can-resist-economic-turmoil/

Multifamily Rent Growth Ends 5-Month Streak Of Declines

A new report says that rent growth continues steady in Orlando even as it drops in other Sun Belt cities.

Nationwide multifamily rents in January rose from the prior month for the first time since August 2022, growing by 0.4% nationally, new data shows.

The jump comes after rents decreased during Q4 across all 40 of the top markets tracked by Apartments.com, a CoStar-owned company. That drop was a reversal from the trend seen throughout the pandemic, and executives say it remains to be seen whether growth continues this year.

“While snapping the five-month negative rent growth streak is a positive start to the new year, it remains to be seen whether or not demand has truly accelerated,” CoStar Group National Director of Multifamily Analytics Jay Lybik said in a statement. “Year over year rent data continues to decline, highlighting the market’s weakening position.”

Monthly rents rose by $7 nationally, Apartments.com found. But national year-over-year rent growth is different from monthly rent growth, falling from 3.6% in January 2022 to 3.2% last month. Rent growth was far timider than previously, sticking between 10 and 30 basis points and resulting in a hesitant reversal of the weak rent growth seen toward the end of last year, according to the release.

Midwestern markets led the nation in the percentage of rent growth, with Indianapolis, Cincinnati, I, and Columbus among the top five, including Miami and Orlando. Fort Lauderdale and Orlando had the highest rent increases on an absolute basis, rising by $21 — 1.2% and 1%, respectively — in both cities.

Sun Belt cities fared the worst overall, continuing a trend that began in Q3 2022. Rent growth slowed dramatically in Las Vegas and Phoenix, with year-over-year asking rents plummeting from the low 20% range in the final quarter of 2021 to minus-1% in January this year.

Atlanta and Austin may follow similar trajectories, with absolute rents dropping by double digits so far in 2023, Apartments.com said. Month-over-month rents in Austin dropped by 0.1%, and yearly rent growth fell 170 basis points to 1.7%.

“If the positive rent growth trend persists, year-over-year data may finally change its course, signaling supply and demand are closer to regaining equilibrium,” Lybik said.

However, the release said a record number of apartment units are due to come online in 2023 across 13 markets, potentially increasing competition and bringing rents down.

 

 

Source: Multifamily Rent Growth Ends 5-Month Streak Of Declines

https://www.creconsult.net/market-trends/multifamily-rent-growth-ends-5-month-streak-of-declines/

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Is Commercial Real Estate Really In A Recession? Kind Of, Economists Say

When the CEO of Boston Properties, the largest publicly traded owner of U.S. office buildings, said last week that "commercial real estate markets are currently in a recession" regardless of the resilience of the broader economy, it reinforced the tired cliché of the past three years: This is an unprecedented market cycle.

Regarding economic growth or deceleration, commercial real estate has historically been a lagging indicator, taking longer to slow than other parts of the economy, economists told Bisnow. But this time, CRE values are dropping before the job market has cooled and consumer spending has fallen.

Even in that context, whether there is a recession in commercial real estate — or whether one is coming for the U.S. economy — depends on where you're standing.

"We are in somewhat of a unique time, to the extent that there does seem to be a wedge in between a very, very healthy job market and how that translates into demand for specific types of commercial real estate," said Victor Calanog, Moody's Analytics head of CRE economics. "To say that it is a recession for a sector as a whole, I think, at this point, is a bit of a stretch."

Recessions are deep, sustained,d and broad pullbacks from economic activity, marked by two consecutive quarters of falling gross domestic product, Calanog said. From that perspective, CRE is going through asset-specific, localized recessions, especially in the gateway cities where giants like Boston Properties have invested billions.

"I think we want to be careful and nuanced about the conversation," Calanog said. "Is there a localized recession for office properties in dense urban areas in the Northeast? I'd say that perspective is probably valid."

The four indicators that usually signal a recession — employment, spending, industrial production,n, and incomes — are holding steady in the U.S. Employers added half a million jobs in January, last week's jobs report showed. Even amid the tens of thousands of layoffs announced recently, unemployment is at its lowest point since 1969. Consumer spending fell by just 0.2% in December, and U.S. GDP grew by 2.9% in the fourth quarter.

At the same time, commercial real estate has been stuck in the mud, at the mercy of the Federal Reserve's aggressive interest rate hikes.

More than 65% of respondents to a Bisnow survey from the summer said they believed the U.S. economy was already in a recession as their deal flows stalled. By the end of the summer, Cushman & Wakefield was projecting a 20% decline in property values by the end of the year.

In the months since transaction volumes have come crashing down. Investment sales in the U.S. fell by 64% year-over-year in the fourth quarter of 2022, according to CBRE data. Bloomberg reported that approximately $175B of global real estate debt was already in distress last month.

Victor Calanog, head of commercial real estate economics at Moody's Analytics.

Lawrence Yun, the chief economist at the National Association of Realtors, told Bisnow that commercial real estate recession talk is warranted by one measure. He said that the development of everything from office towers to retail stores and industrial spaces has slowed.

“[Commercial real estate has] been subtracting from GDP figures. So in that sense, it is a recession," Yun said. "Commercial real estate is not contributing to GDP growth."

Much of the sentiment around CRE's downturn is a direct result of the rise in interest rates and the corresponding increase in capitalization rates, which drags down values. But prices hit all-time highs in 2021 when interest rates bottomed amid the pandemic, resulting in investors turning to assets like CRE that typically yield higher returns.

Commercial property sales hit a record $809B in 2021, per Real Capital Analytics data from The Wall Street Journal, beating the previous record by more than $200M.

The average price per unit on multifamily properties rose 21.6% in 2021, outpacing that year's record rent growth of 14% — which was twice the previous record, according to Yardi Matrix data.

There were $125.7B of industrial sales in 2021 and $88B last year, driven by value appreciation previously unheard of — the average price per SF for industrial properties increased by 57% between 2019 and 2022, according to CommercialEdge.

With growth like that, a correction was inevitable, Yun said.

"There was an over-optimism in commercial real estate," he said. "Now it's just coming back down to earth."

Property values peaked in March 2022, according to Green Street's Commercial Property Price Index, and have dropped by 14% since.

That reset is due to investor reactions to last year's interest rate hikes, which left developers and investors unsure how they would finance future projects and effectively ended the run of cheap money that has encouraged CRE investments over the last decade, S&P Senior Director Ana Lai told Bisnow.

"The tide has turned for the real estate sector," she said. "I think the key difference here is the interest rate level is much more elevated than the past couple of recessions. The market is resetting expectations here. So what's causing a slowdown in transaction activity."

What is happening now across asset classes is a reset on fundamental values, Yun said. However, the mismatch between what sellers believe they can get for assets and what buyers are willing to pay will mean that prices will continue to lag.

He added that if commercial real estate were broken down into asset classes, multifamily would still be considered in growth mode because the overall supply-and-demand dynamics still favor landlords.

"Definitely in the office sector, it is clearly in a recession," Yun said. "[There's a] major contraction in building new office spaces. Who would want to build office space with rising vacancy rates  and  reduced rent?"

Owners unsure about the remaining value of their office assets — and unable to secure new loans without additional equity — have started handing the keys back to lenders or considering conversion. Some lenders are looking to sell the loan onward.

Office assets may have a further fall, Calanog said. Despite being the darlings of the office market before and during the pandemic, tech companies like Facebook, Microsoft,t, and Amazon are scaling back their real estate plans. Like real estate investors, tech companies have spent the last decade or so growing due tof to access to cheap debt.

"They are a little bit of a canary in the coal mine as to the future of commercial real estate demand," Calanog said.

Outside the office market, there are indications that commercial real estate's downward trajectory amid economic growth could be short-lived.

"While appraisals are likely headed lower, the real-time picture of property pricing shows a market where we've either reached the bottom or are very close to it," Peter Rothemund, co-head of Green Street strategic research at Green Street, said in a statement.

The most recent jobs report and the Federal Reserve's slowing of interest rate hikes have bred optimism that the economy might avoid the same contraction in CRE values. But if unemployment rises and energy prices spike again, Calanog said real estate performance could take another, more resounding hit.

"That's when you kind of pull back on consumption; that's how the dominoes are kind of connected," he said. "And if one of [the economic indicators] falls — sentiment, jobs, consumption, so on and so forth — then we are in deeper trouble."

 

 

Source: Is Commercial Real Estate Really In A Recession? Kind Of, Economists Say

https://www.creconsult.net/market-trends/is-commercial-real-estate-really-in-a-recession-kind-of-economists-say/