Triple Threat Redux: The Factors Holding Back Real Estate Capital

A year ago we described the impact that the triple threat – inflation, higher interest rates, and a possible recession - would have on the flow of capital to commercial and multifamily real estate. 2023 will be a year most real estate investors will want to quickly forget. Those threats triggered a downturn in the real estate cycle, causing a steep drop in property values, capital illiquidity, and a shutdown of a large portion of the transaction market.

The outlook for 2024 remains threatening, although not in the same way as a year ago. Some threats have abated while new threats have emerged. The clarity that market participants were seeking in throughout 2023 remains blurred by volatility and growing distress. As in all real estate downturns, it will take time to find the bottom and regain the conviction to deploy capital.

Interest Rates

Higher interest rates, the threat with by far greatest impact on the industry, was realized in full. An abrupt and unpredictable 500 basis points lift of short-term rates wreaked havoc on existing investments and upended the potential for new investments. Investors with floating rate loans are hoarding cash to buy new hedges when the current ones expire, assuming the lender isn’t already sweeping all the property’s cash flow. Refinancing into this higher rate environment is extremely difficult and typically requires a capital infusion, particularly in the transition from construction or bridge financing to permanent financing.

Higher rates have changed the math of real estate investing, and most deals simply don’t work. As a result, capital has pulled back and transaction volume has fallen precipitously. Rent growth is no longer a reliable strategy in overcoming negative leverage. The rising cost of capital has lowered yields at the very moment when higher returns are required to compensate for the risk. Billions of dollars will be needed to fill the equity gap when trillions of dollars of mortgages mature.  Yet the new interest rate environment has shut down the market.

Inflation

Inflation is the one threat from last year that has abated, yet it’s impact on real estate profit margins will be long-lasting. Investors discovered that real estate is not always an inflation hedge, particularly when rent growth is decelerating. Rather than inflation lifting valuations, rising capitalization rates have caused property values to fall almost 20% since the peak reached in March of 2022, according to Green Street.

Rental growth is not keeping up with inflation in many property types and markets, either because of increased supply or decreased demand. Wage growth is now exceeding the inflation rate, and higher operating costs aren’t likely to fall anytime soon. Part of the inflation was caused by exogenous forces such as a breakdown of supply chain during COVID-19; while that has somewhat resolved, the costs of many materials remain high. Climate change has inflated insurance premiums by multiples in some markets. Weaker demand in many urban centers resulting from work-from-home is forcing some cities to raise property taxes to make up for the gap in sales tax.

Recession

The prediction that a serious recession would arrive by the second half of 2023, bringing with it lower interest rates and solving all of our problems, was perhaps the greatest miscalculation of the year. Instead, the economy has been chugging along just fine, achieving spectacular third quarter growth of almost 5% driven by a robust job market and a resilient consumer. We need to question whether the earlier recession forecasts were based on data analysis, which of course would have been next to impossible in the wake of the pandemic, or based on hope, which typically doesn’t work in an economic context.

Despite the economy’s remarkable performance, many economists are still predicting a recession, the delayed effect of the Fed’s relentless raising of rates. Even if the rate hikes are over, the recession threat remains, and we need to remember that if interest rates fall rapidly next year it would be a response to a severe economic contraction that would drain demand from the real estate sector.

Looking ahead to 2024, the triple threats of a year ago have morphed into new ones.

Illiquidity

The common denominator of all real estate downturns is a withdrawal of capital from the sector, waiting for the volatility to ease so that risk can be more accurately priced. Currently, both equity and debt players are taking a pause, and the underpinning of both is the lack of transparency of property values. Capital is the life blood of all commercial and multifamily real estate investments, and the sector needs liquidity to fund new investment and refinance trillions of dollars of maturing debt. Without liquidity there can be no recovery.

Property Values

In somewhat of a vicious cycle, capital providers can’t make bets without knowing the value of what they are buying, but the lack of capital in the system is putting further upward pressure on yield requirements and downward pressure on values. Many in the industry believe the rise in cap rates begun this year will continue, driven by both prolonged higher interest rates and illiquidity. Until we can point to transactional data, valuing property will be guesswork for investors and appraisers. To get there we will need to move past distressed fire sales to market-based transactions between willing sellers and buyers.

The Unknown Threats

It seems we are at one of those points in history when a lot of chaos having nothing to do with the industry can land at our doorstep. Setting aside global geopolitical tension and the upcoming election cycle, the real estate sector will be directly threatened by any further weakness in the banking system and the continued occurrence of severe weather. Banks have already pulled back, and an acceleration of mortgage defaults could significantly deteriorate the capital of those banks with large sector exposure -- think community and smaller regional banks. Some have warned of a real estate “doom loop” if more banks fail creating an economic crisis that further sucks liquidity out of the sector.

Each year we are reminded that the cost of climate change is growing faster than any might have reasonably predicted. Properties are physically vulnerable, and the demographics that fuel space demand are vulnerable to market migration. The overall short-term and long-term impacts cannot yet be measured with any accuracy.

Looking Ahead

The threats of higher interest rates, illiquidity, and falling property values continue to cast a shadow over the commercial and multifamily real estate investment market. But persistent threats bring new opportunities. Distress will continue to build, and new capital will find its way in to rescue borrowers and lenders and, perhaps, begin the long journey toward the discovery of a new level of asset pricing that is the necessary first step toward recovery.