With the recent announcement by the Federal Reserve of a 75 basis point raise in its benchmark interest rates, yet another variable has been thrown into the mix when it comes to trying to decipher what the future holds for commercial real estate. Although the hope for everyone is that this increase will work to cool the economy and bring down inflation, supply chain issues, the war in Ukraine, continued disruptions as a result of the Covid-19 pandemic, and oligopolies taking advantage of the situation continue to make the fight against inflation an uphill battle. As rumblings of a potential recession grow louder, financial uncertainty will continue to change the actions of consumers and lenders alike, leaving markets in flux and forcing us to brace for the unknown.
In the face of this disquietude, the best thing business owners and investors can do is play close attention to the shifting trends in their respective markets. For Stephen Bittel, founder and chairman of the real estate and private equity investment firm Terranova Corporation, changes to the commercial real estate landscape can still present significant opportunities for those able to take advantage of them. Bittel has over 40 years of experience in commercial real estate, starting his company with a single commercial property investment and growing it to an institution in Southern Florida that has served as the exclusive agent for more than $5 billion worth of commercial projects.
Over the course of his four decade career Bittel and his company have navitaged their way through a number of economic downturns. Below, we explore with him the direction the commercial real estate market appears to be heading for the rest of the year, as well as the potential larger implications these trends could have on the sector at large.
Federal interest rates will put more pressure on the industry
According to the Federal Open Market Committee, high inflation in combination with job gains, broad price pressures and the Russian invasion of Ukraine were behind its decision to again raise interest rates. While this most recent hike should not have come as much of a shock to those within the commercial real estate sector, it has created additional pressure on a market that has already seen a pronounced decline in transaction volume in the first and second quarter of 2022. Additionally, the inability of those who invest in commercial real estate to accurately determine market value of assets due to uncertainty around debt capital markets will induce caution amongst many investors, choosing to hold back on potential investment opportunities. Until there is more perceived stability, this trend will likely continue.
Bittel told the commercial real estate news website GlobeSt.com that a bid/ask gap is another factor behind the slowdown in sales activities. According to him, there is an impasse due to sellers wanting the price for the asset they were able to get last year while buyers are expecting a discount due to the higher cost of debt capital. When it comes to development, the higher cost of debt will further hurt development deals that were already facing higher construction costs due to supply shortages.
Banks are pulling back on loan issuing
Coupled with the problems to the market caused by interest rate increases is banks seeking to conserve capital and limit risk by refraining from issuing loans. Stricter credit requirements are seeing a smaller percentage of business owners eligible for loans, preventing progress and putting many commercial real estate investors without available capital in a tough spot. According to the data firm Trepp Inc., in the first quarter of 2022 banks issued $29 billion of securities backed by real estate loans, compared with only $20.6 billion in the second quarter.
Trepp also noted that after the large increase reported in the consumer price index by the Labor Department in June sentiments about the market have only gotten worse, with banks issuing less than half of the volume of collateralized-loan obligations that month when compared with February, down from $8.9 billion to $3.6 billion.
The “mass exodus” from urban centers has slowed
Commercial real estate trends tend to follow residential by 12 to 18 months, so it is important to take note of the state of the multi- and single-family markets when trying to anticipate what lies ahead. Multi-family sectors have recovered for the most part from the Covid-19 pandemic, reaching 4.6 percent vacancy rates in the third quarter of 2021 according to a market report assembled by Lee & Associates. Large cities such as Los Angeles and New York have similarly seen vacancies for multi-family properties return to pre-pandemic levels, and as the price of single-family homes continue to grow higher there has been an increased demand for larger rental units in urban centers that have the ability to accommodate remote work.
Conversely, sales of newly built homes have started to taper off due to rising mortgage rates. Freddie Mac has reported the average fixed rate mortgage has risen over two percent since the beginning of the year, from 3.1 percent to 5.23 percent. As rates and prices continue to climb, the rental market has seen a boost by those now priced out of home ownership at the moment.
Industrial assets are stars
In a presentation to Florida International University’s business real estate students, Bittel told them that the Covid-19 pandemic has flipped the commercial real estate market on its head. What was once an advantageous investment category today has minimal value, and categories that nobody saw coming have become hot commodities. Just as multi-family developments in key markets across the country are proving to be advantageous for institutional investors, so too are industrial assets according to Bittel. With the boom of online retail that is showing no signs of slowing, e-commerce distribution centers are doing very well, and self-storage facilities are in high demand as the pandemic caused many to rethink their current living situations.
The retail market is facing many challenges
However, while distribution centers for e-commerce may be seeing a boom, retail is suffering from the decrease in demand due to newly created online shopping habits as a result of the Covid-19 pandemic. Supply disruptions have not helped the matter, nor have rising labor costs or increased expenses as a result of inflation. Combined, these factors have led to a decrease in foot traffic that has made the retail market higher risk.
According to Bittel, it is retailers that were able to evolve that have been able to succeed in the face of these difficult conditions. Although as an investor he believes retail properties are messy, he told the students at Florida International University that suburban malls with supermarket anchors did well throughout the pandemic, and restaurants that adapted quickly to implement takeout and delivery options are often now making more money than prior to Covid-19 as a result.
Understanding the ebbs and flows of the market has rarely been as difficult as it is right now, but for those who were able to prepare for inflation and a potential recession don’t have to spell doom and gloom. In the fourth quarter of 2021 Bittel’s Terranova Corporation refinanced roughly $150 million of its properties, and according to Bittel the company has since been putting its balance sheet to work. The company has actively focused on making opportunistic acquisitions of distressed debt and equity, and business owners and investors should take a leaf out of Bittel’s book by keeping a close watch on capital markets.