When it comes to understanding capital markets movement, it helps to visualize Newton’s cradle pendulum, the classic desk toy made of a series of metal balls suspended by wire. Hear the rhythmic clicking and clacking as the device demonstrates the conservation of momentum and energy. 

Right now, there is a lot of noise permeating from the pendulum as rising interest rates, higher cap rates, continued supply chain disruptions, talent shortages, and the like spark a swinging pattern of motion – back and forth, back and forth. But basic economic theory supports the idea that the real estate market – through both booms and busts – will move to correct itself as time passes. 

As we move to address some of the biggest challenges the U.S. is actively facing, real estate will be an integral component of setting sustainable economic conditions. Read on to revisit which of these factors should be seen as fleeting versus true, lasting movement – and how to make sure you and your enterprise are prepared to harness the opportunities they may hold.

State of real estate capital markets

While the media tends to focus on market uncertainty, there are many opportunities on the horizon for the industry at large, too. The high-level trends currently impacting investors and developers, in particular, include:

1. Inflation: While inflation may be higher than it has been in decades, interest rates are nowhere near the record highs of the 1980s. Still, the current rates are both deterring new investments and impacting or even derailing deals that penciled out at lower rates and did not account for the recent surge. Real estate insiders have said that uncertainty on where borrowing and construction costs will land means less CRE financing in the short term.

2. Cap rates: Rising cap rates, plus a cooldown in transaction activity, have led to drops in asset prices and tempered rent gains. Two asset classes that are particularly feeling the impact are multifamily and industrial. More multifamily developers are choosing to wait on the sidelines to see how cap rates change before starting new projects, and expressing caution about entering new deals until they can gain greater clarity. As for industrial, while industrial growth in the U.S. has soared during the past 18 months, major industry players are pausing on speculative projects due to lack of institutional capital, which is expected to cause a reset on the price of land.

3. Supply chain challenges: Supply chain disruptions, which were brewing long before the pandemic but have reached new heights in the past few years, will continue to impact the real estate industry. Continued material shortages, paired with rising inflation and interest rates, have caused project costs to skyrocket, and the issue is expected to persist well into 2023 and beyond. Beyond the pandemic, senior business decision-makers in logistics and supply chain strategy report global political unrest as the current main cause of supply chain issues, followed by lack of raw materials and rising fuel and energy costs, according to an SAP SE survey released in October 2022. The top three supply chain disruptions they predict will occur in 2023 are reduced availability of raw materials in the U.S., a slowdown in the construction of new homes, and disruption to public transport due to lack of drivers.

4. Changes in where people live and work: Many Americans have returned to the office, but the real estate landscape has been permanently impacted by two years of millions of employees working from home. Across the country, office vacancies remain high while interest in flexible office space has soared as companies rethink where and how people work. Even states with fewer large metro areas like Nevada, Minnesota, and Utah are ranking among the Top 25 markets with the most coworking spaces. However, there has also not been a mass exodus from cities, as many predicted. While moves out of the densest parts of big cities – with more than 10,000 people per square mile – jumped 17% during the first year of the pandemic, those numbers have since stabilized to pre-pandemic levels, according to Pew.

5. Multifamily rents: The U.S. saw a 22% increase in asking rents since January 2021, but the trend finally hit a wall in Q3 2022. This deceleration was expected, however, as the rent growth we’ve seen over the past 18 months was significantly higher than at any time in the market’s history.

6. Foreign investment: Despite current economic uncertainty, U.S. commercial real estate is still attractive to overseas investors. Foreign investors purchased an estimated $57.7 billion in American CRE properties in 2021, up 49% from 2020, according to NAR’s 2022 Commercial Real Estate International Business Trends.

And the money…

1. Equity: In December 2021, Bloomberg reported (citing Prequin data) that private equity investors had a total of $287.8 billion to invest in commercial real estate, up 11% from a year prior and, more dramatically, up 57% from 2019. While the market may have changed in the past year, as of September 2022, private investments were up 7.4% year-to-date, according to The National Council of Real Estate Investment Fiduciaries. Clearly, private equity remains strong, and may help pull the industry through potentially difficult lending times ahead.

2. Debt: Debt markets, however, are less stable. As we’re writing this in Q1 2023, numbers have not been finalized; however, a dip in transactions is expected considering that the number of investment sales transactions nationally fell 50% year-over-year in August. Speaking to the Commercial Observer in November, Aaron Jodka, national director of capital markets research at Colliers, remarked, “Lending has become more challenging in the last few months, not because the capital isn’t available, but that borrowers are readjusting to a higher cost of capital. That is causing friction in the investment sales market, where buyers are no longer able to pay 2021 pricing here in 2022.”

Embracing the movement

These industry and national finance factors are not new. And while we haven’t exactly experienced today’s realities before, there are enough examples in U.S. real estate history to deduce that as an industry sector, real estate stakeholders are adaptable. As the markets correct, savvy investors and innovative leaders will uncover opportunities before them. Consider these seven strategies to embrace now while navigating the movements currently underway.

1. Don’t attempt to time the market. There are too many factors contributing to inflation that fluctuations in interest rates just won’t cure. The continued war in Ukraine, OPEC’s pull-back on oil supply, and other energy and sustainability concerns come to mind. Rather than trying to predict where interest rates will land, focus on the fundamentals of a deal and its long-term potential. There are no crystal balls here.

2. Get creative with deals. Times of uncertainty call for creativity – and as such, we’re seeing more unconventional approaches to deals. Owners are nearing retirement and seeking private equity for their exit strategies. Additionally, some owners are reverting to seller financing, which is more frequently creeping into the mix to make the capital stack work.

3. Consider other asset classes. Investors and developers show continued interest in expanding their portfolios to include a more diverse mix of asset classes, hedging bets on the next hot market, and diversifying risk. In line with this, there has been increased interest in affordable housing – a sector that has been stable and performing well for decades, not just recently. As a result, the market continues to see strong interest from family offices, private equity, REITs, and the like looking to become owners and operators of affordable housing. Along with this, there is rising interest in investing in tax credits, existing tax credit deals, former tax credit deals and other naturally occurring affordable housing, HUD deals, and similar pursuits. 

4. Embrace mixed-use, because it’s here to stay. As flexible work schedules continue to unfold, developers, operators, landlords, and tenants need to reassess how they use their space and how much is actually needed. The move toward flex-space build-outs and even transitioning to mixed-use buildings is a long-term play anticipated to deliver more agile business strategies and dependable returns. Couple this with smart building strategies to deliver the experiences tenants demand from the spaces where they live, work, and play.

5. Lobby for change. Together, private businesses must take a longer-term look at the future of the industry and what is needed to get there. As the housing crisis persists and supply and demand dynamics reshape asset-class needs, businesses and governments must revisit zoning regimes and federal incentives to build for the needs of local communities.

6. Consult your tax advisor. No, this is not a shameless plug. With years of increased rents under their belts and high net operating income rates, investors are afforded the ability to refinance at higher interest rates without having to go into pocket. These businesses are able to refinance for more than their original mortgage, and are benefiting from taking out money on a tax-deferred basis. Recent legislation has added many tax incentives to several types of real estate developments. The Inflation Reduction Act of 2022, for example, extends and creates energy tax credits, and modifies the existing Section 179D deduction that enables building owners to claim a tax deduction on energy-efficient improvements such as interior lighting, a building envelope, or heating, cooling, ventilation, or hot water systems that reduce energy and power costs. Put simply, there is a lot of available capital for owners looking to improve the efficiency of their assets. 

7. Don’t put ESG on pause – it’s time to double down. Environmental, social, and governance (ESG) efforts were propelled and prioritized as a feel-good initiative during difficult times. But strip away the marketing behind the notion and it is clear that ESG focuses on three basic principles that have always been foundational to the business strategies of real estate owners, operators, and investors. What ESG did deliver to the market was an incentive not to simply view real estate in terms of your rent roll, but to understand that each asset is a long-term vehicle of change for its surrounding communities. Allow ESG to serve as a framework for business strategies that will ultimately instill longer-term value by helping to curtail risk, attract and retain both investors and talent, and make buildings run better – and that will create widespread opportunity for all stakeholders, not only owners and operators but also tenants, neighbors, and generations to come.

Waiting for the pendulum to swing back

There’s (going to be) more where this came from

Over the next few months, we’ll be rolling out additional articles on movement in the real estate industry, exploring supply chains, operating models, and more. Subscribe now to make sure you don’t miss a word.

Contact

Ronald A. Kaplan, CPA, Partner, Commercial Real Estate Industry Leader

646.834.4179

Beth Mullen, CPA, Partner, Affordable Housing Industry Leader

916.930.5750