Capital Market Forces No Longer a Tailwind

The forces driving the success of a commercial real estate investment are changing. Few professionals active in the market today have previously faced the challenges that the market has been experiencing over the last two years. Unless there is some drastic, downward change in the interest rate environment ahead, success for a commercial real estate investment moving forward will come from focusing on issues impacting cash flow at the property level.

Capital market forces were a headwind to commercial real estate investment in the late 1970s and early 1980s. When I talk about this topic in presentations at industry conferences, it is the rare professional who raises their hand to show that they were working in those years. There is generational knowledge that, as an industry, we are losing daily. Visit with these people, share a cup of coffee with them, listen to their stories.

What they will tell you about investing in the late 1970s and early 1980s is that using debt for an investment was challenging. The high rate of inflation pushed the 10yr UST up to double-digit rates and anecdotes suggest that commercial mortgage rates were higher. Data from NCREIF for the late 1970s and early 1980s shows that cap rates were often lower than the 10yr UST as investors were underwriting stronger income growth at the time given the inflationary pressure. The reality is that this sort of underwriting was likely the only way they could get a deal to pencil given the cost of capital.

The secular state of decline for the 10yr UST from the mid-1980s to 2021 provided a boost to investment performance.

For every deal that came to market in that time period however, buyers faced a challenge of replacing the comparatively cheap debt that the sellers had in place. Looking through our MSCI Real Capital Analytics transaction data, the average holding period for a commercial real estate investment in the U.S. is seven years. Buildings sold in 1980, for instance, transacted in a period where the 10yr UST was more than 600 bps higher than the environment seen seven years earlier. Sellers will be fixated on yesterday’s price and their current cost of debt, but new buyers will need to underwrite to current conditions.

There is not a one-to-one move between cap rates and interest rates, but these measures can rhyme. A commercial property bought in 1980 likely had a higher cap rate than when it was last sold in 1973 (if only we had started tracking this market back then). Convincing an owner who bought, say, at an 8% cap rate that they had to sell at a 9% cap rate could not have been easy.

In the current market, the 10yr UST has pushed above the 4.5% level the week of April 15th. Seven years earlier, in April of 2017, the 10yr UST averaged 2.3% for the month.

The investor who sold that asset in 2017 did great. Had they purchased the asset seven years earlier in April of 2010, the 10yr UST was at an average 3.85% for that month. That 155 bps decline in the 10yr UST meant that at sale, the mortgage rate that the next buyer faced could be lower. The cap rates for transactions fell over that time frame as well. An investor who had mismanaged the income fundamentals of a property bought in 2010 could still eke out a positive return simply because of the benefit of the capital market forces at their back. These forces are no longer at play.

If I could reliably forecast interest rates, I would be a very wealthy man. I do not pretend to know where the 10yr UST is going to go. I will say though, I hope that the 10yr UST does not return to the 0.6% low seen in July of 2020. When the cost of capital is that low, it is indicative of an economy in shambles with investors afraid to invest in anything and few prospects for growth.

Rather than base an investment decision off of a point-level forecast of where one expects an instrument like the 10yr UST to end up, calculating how an acquisition might perform under a range of scenarios can give one a better sense of the range of possible outcomes for an investment. If the 10yr UST simply stayed at the 4.5% level for the next 10 years – a wild assumption as this measure has never been this stable – the capital market forces will always be detracting from investment performance.

So what is an investor in commercial real estate supposed to do in this environment? Rather than focus on the home run of buying at a 9% cap rate and selling at a 4%, the fact that capital market forces are now a headwind suggests that success will come from focusing on the singles and doubles. One could make mistakes on leasing decisions in the past and paper over those mistakes with a falling cap rate environment. The margin of error that is acceptable for such mistakes is now narrower. Making sure that one has the right asset management team in place with the right brokerage contacts to lease space will be critical to driving performance.

Understanding the risks of the tenants themselves will be important. Like a bad marriage where being tied to the wrong person drags you down, being tied the wrong tenant can drag down your income. Some tenants are going to be riskier than others, but it is not just a credit rating story. Chasing the hot new tenant in the market might be a recipe for disaster with a constant flow of tenant defaults.

Spending appropriately to keep an asset alive will be key. If your capex spend is above market through higher-than-average leasing commissions or over investment in the physical plant of the asset, the returns generated are going to lag the market. Tracking and managing that capex spend properly will be a key component of performance.

Times are changing. When I guest lecture at universities, I tell the young real estate students in these programs that I am excited for them. I tell them that their predecessors had it easy. They made money as interest rates fell. The financial engineering skills that served market professionals so well from the mid-1980s to 2022 are no longer the key driver to success. I tell these students that to win moving forward, they need to be real estate people and focus on the basics of managing properties.

For Further Reading:

Determining Tenancy Risks

Understanding Components of Risk to Property Income ?