The Hunter Becomes The Hunted

As seasons change and year-end approaches, many investors shift their focus to positioning their portfolios to harvest losses and protect gains in an effort to memorialize how great they have been for their annual reporting.?

For a number of commercial real estate investors, 2023 will likely be their first worst year, as the Hunter Becomes The Hunted.?

Highlighted in the previous post, the repercussions of negative leverage are quickly increasing and under-capitalized, poorly under-written, and weaker-performing operators will surely become someone else’s next meal.?

Recall that negative leverage occurs when the cost of funds (debt) exceeds the return on the investment (cap rate).?

In the graphic below from Bloomberg, the scenario is colorfully laid out why investors would not be interested in ‘riskier’ assets when risk-free assets are yielding better returns.?

Given a choice between investing in a short-term U.S. government security and investing in the S&P index whose rate of return in slipping, a prudent investor with a shorter term focus will surely take the higher performing asset.?

As noted in the graphic below from the prior post, cap rates have steadily declined (yellow arrow) despite variability in the 10-year Treasury (recent high, recent low and prior high).??

In past economic cycles, the cap rates generally display some, if not significant, reaction to changes in the underlying securities AND stay higher than the yield on 10-year Treasuries.?

Due to unexpected systemic shocks, significant accumulation of capital, and investor flight to capital, both domestically and globally, cap rates HAVE NOT RISEN despite the significant rise in the 10-year Treasury.

Therefore, an experienced investor who has multiple opportunities to invest in assets to produce a return, seriously has to ask themselves why would they invest in commercial real estate if the yield on risk-free assets is at parity or exceeds the return on commercial real estate.

An experienced investor, unlike an inexperienced, or unsophisticated, investor is regularly assessing their options for where to invest that provides a sufficient return relative to other investment options.??

One of the tell-tale signs of a market shifting is when experienced investors are exiting and less-experienced and inexperienced investors are entering, typically heralding a brand-new day.?

Recall 2006 and 2007, when it seemed that every stay-at-home adult was getting their real estate Broker or Salesperson license because being a Realtor was the promised land of commissioned opportunities.??

So how do you like them apples???

For more than 2 years, ongoing conversations with attorneys who specialize in restructuring, workouts and bankruptcy noted that business has been unexpectedly slow for them.?

In Q3 2023, that all started to change for these attorneys as real estate investors, operators and speculators were starting to bristle under the weight of floating rate debt and interest-resets on their mortgages.?

While they noted the floodgates have not burst open, the trickle of activity is increasing and concerns are rising.?

The quantity of commercial real estate operators who are fortunate enough to have assumable mortgages on their past investments, are coming to market in an effort to monetize their investment (read recoup their equity and salvage investor capital) before conditions worsen and they get wiped out, the Hunter Becomes The Hunted.

Many of those former hunters are also the same pied-pipers predicting interest rate decreases in 2024 in hopes that someone will listen to their calls for rescue and effectively bailout their deteriorating investments.?

Those calls will not be heard and those commercial estate investors with more patience, more perspective or simply more experience are preparing their next meal of gorging on poorly underwritten investments whose operators cannot sustain their existence.

As the Hunter Becomes The Hunted in an economic environment of negative leverage and flight to quality, what happens to these assets??

More about that in our next post.

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