LaSalle is expecting a high-impact second half of 2022, according to its Mid-Year Update.
The firm provided the top 10 issues it believes could steer commercial real estate’s direction, including those related to bonds, returns, capital flows, expenses, energy, construction and central banks.
GlobeSt.com on Tuesday highlighted LaSalle’s top issue, cost of debt. Following are the others that made its list and LaSalle’s assessment, as well as commentary from others in the industry.
- Rising corporate bond yields. Upward pressure on discount rates and exit cap rates.
Jon Spelke, managing director of LFB Ventures in El Segundo, tells GlobeSt.com, “Cap rates will continue to follow interest rates upward trends to avoid negative leverage situations.
“It will be difficult to underwrite a deal with negative leverage and relying on rent growth to bail out the deal. Especially while expense growth continues to trend and at an equal rate as rents.
- Higher required returns. As a corollary of No. 2, investors will seek slightly higher returns from real estate, given that alternative credit market products will now be priced at higher yields.
Spelke added, “Unlevered yields will continue to follow interest rates and as asset pricing adjusts to the new financing norms (i.e. sellers come to grips with the current asset pricing versus what they thought they could get 90 days ago) deal flow will resume.
“This economic situation was/is not caused by the real estate industry, (i.e., over building, etc.) so real estate remains a healthy asset class in most regions and submarkets. Once values adjust, the deal flow will resume with strong fundamentals following.”
- Capital flows to real estate. Despite the mixed impacts listed above, real estate’s reputation as a better inflation hedge than fixed income will likely maintain its status as a favored asset class while the securities markets experience volatility.
Eli Randel, chief operating officer, CREXi, tells GlobeSt.com that increasing costs of capital will likely result in expanded yields and softened values, however, large supplies of capital seeking deployment may help sustain current asset values.
“Commercial real estate, even at compressed yields, remains a more attractive investment vehicle to many relative to cash, bonds, and equities and as a result quality assets in quality markets will find abundant capital demand even at still high-prices,” Randel said.
“Look for low-leverage, negative-leverage, and all-cash deals to become more prominent with pricing on those deals reflecting sub-optimal levels.
“An institutional flight to quality will create a bifurcation in the market where core deals will trade at aggressive pricing with suboptimal deals seeing a decline in value.”
- Capital market shifts. Investor demand moves away from fixed long-term leases and toward shorter indexed leases.
Jeff Needs, director, Moss Adams Real Estate Advisory, tells GlobeSt.com, “As markets continue to search for price stabilization, expect to see shorter-term leases, reduced capital improvements and negotiating leverage continuing to tip to tenants.
“Vacancies that are best suited to be used in ‘as-is’ condition will lease first, and some landlords will do minor tenant improvements upfront to be more competitive. Though individual markets perform at their own pace, we haven’t reached the bottom yet so expect this to continue until there’s a turning point.”
- Rising cost of construction. Chilling effect on construction, wherever rents can’t keep pace.
“As the market slows, the upward pressure on cost (labor and materials) should ease for a bit,” Spelke said. “Subcontractors looking to keep crews engaged will look to be more competitive as projects are put on hold and shelved.”
- Higher energy prices. Higher occupancy costs will erode tenants’ ability to pay higher rents.
Marilee Utter, CRE, global chair of The Counselors of Real Estate, tells GlobeSt.com the consequences building and that business owners are facing – and need to consider in business continuity and resiliency planning – include rising insurance costs and increased investment in on-site energy resilience.
- Slowing demand. While central banks attempt to cool off overheated sectors, broad-based tenant demand will likely step down a notch because monetary policies are blunt instruments that don’t distinguish well between sectors. In some parts of the world, ‘recession’ danger signals are flashing.
- Currency movements. Differentials in interest rates/inflation will favor currencies with rising interest rates and could raise hedging costs for currencies with lagging interest rate increases.
- Rising expenses. Just about every expense category associated with operating a property will be under upward cost pressure. Operational-intensive properties that require a lot of headcount or energy consumption could be most affected.
As a corollary to No. 5, LaSalle said net leases will be preferred by investors, but tenants will be under new cost pressures that could affect their ability to renew or to expand. Long leases to real estate operators whose margins could be squeezed by both rising occupancy and labor costs are an example of the kinds of risk to avoid.
Michael Busenhart, Vice President Real Estate at Archer, tells GlobeSt.com that with the recent inflation increases, owners are feeling the benefit on the rental income side, but also feeling the pressure on the expense side.
“As multifamily owners look to maximize LOI, many are seeking an edge to curb expense spending,” Busenhart said. “To do this, they can review financials internally to notice increased trends, or use data that enables asset managers to benchmark their properties/portfolio against the competition to seek areas where they can improve against the overall market.”