An Open Letter To Commercial Real Estate Sellers In 2023

The commercial real estate market faces a unique set of challenges in 2023, causing a widening gap between buyers and sellers. On the one hand, sellers are used to compressed cap rates and historically high valuations and still expect to sell their property at no longer realistic values. On the other hand, current buyers have been constrained by the cost of capital due to fed rate hikes over the last year which have taken the prime rate from 3.25 to 7.75 and will likely increase to 8-8.25% by the end of the month.

These high rates, in conjunction with elevated valuations from sellers, put buyers in a position of negative leverage or, at best, getting a subpar yield of 2-3%, which compared to CapitalOne's 11-month CD rate of 5.15%, means buyers are better off holding capital rather than taking on exposure for a weaker return. Lenders, brokers, and buyers have fully realized the reality of the economic metrics and the overwhelming pressure placed on commercial real estate transactions in 2023. The seller is the only party yet to recognize they are still sitting at the wrong table.

Negative leverage is a term used to describe a situation where borrowing money costs more than the return on investment. In this case, the buyers are in a position where the cost of capital is high, and the potential return on investment is low, which puts them at a disadvantage. This situation is exacerbated by sellers still expecting to sell their properties at historically high valuations, even though the market has changed.

For example, a buyer is considering purchasing a property generating $150,000 in NOI annually. If the seller is expecting a 6% cap rate based on historically compressed cap rates, they may ask for a price of $2.5 million ($150,000 divided by 6%). However, suppose interest rates have risen to 7.5%. In that case, the buyer may be looking at a -5% yield on their investment, which equates to -$31,250 per year, A significant difference when compared to the yield they could achieve on a low-risk investment like that CapitalOne 11-month CD.

As a result, buyers are finding it increasingly difficult to justify investing in commercial real estate at historically high valuations. This puts pressure on sellers to adjust their expectations and price their properties more realistically. However, many sellers have yet to realize that the market has changed and continue to hold out for higher prices, which is creating a disconnect between buyers and sellers.

The commercial real estate market is a complex ecosystem that involves lenders, brokers, buyers, and sellers. The changing economic conditions and interest rates impact all parties in the market. The Federal Reserve's decision to raise interest rates is designed to curb inflation. However, it has consequences for the commercial real estate market, making it more expensive for buyers to purchase properties.

As interest rates rise, buyers have to pay more to borrow money, increasing their capital cost. This, in turn, reduces the amount they can afford to pay for a property, reducing their potential return on investment. This puts them in a difficult position when negotiating with sellers who are still expecting to sell their properties at the same price they came up with 12 months ago... or even 1 month ago.

The disconnect between buyers and sellers becomes more apparent as time passes. Sellers who are planning on divesting from a commercial real estate asset in the next 36 months, either because of lending constraints or they are hoping to retire, whatever the case might be, sooner or later, are going to have to face the fact that the asset that was worth X amount 12 months ago is valued significantly less today by everyone else, whether they like it or not.

The market is currently in a state of flux, with sellers holding onto their properties for higher prices and buyers unwilling to meet those prices. This leaves both parties in a state of uncertainty, with no clear direction forward.?

Another factor contributing to the market's current state is sellers' unrealistic expectations. Many sellers are still operating under the assumption that cap rates will remain compressed and valuations will continue to be historically high. However, this is simply not the case in the current economic climate. As interest rates rise, cap rates will inevitably expand, and valuations will come down. Buyers are not willing to pay prices that are based on outdated assumptions about the market, which further contributes to the current impasse between buyers and sellers.

Lenders, brokers, and buyers are all aware of the pressures currently impacting the commercial real estate market. However, sellers seem to be the only party that has yet to come to terms with the new economic reality -?Que the jokes about tax appraisers also being eager to seek higher valuations.?

In the coming months and years, we will likely see a significant slowdown in commercial real estate transactions for most markets and asset classes. A combination of rising interest rates and unrealistic seller expectations will drive this. As sellers with variable rate debt begin to reach their term deadlines, they will be faced with lenders who demand increased equity via capital deposits or risk having their loans called because their cash flow has been decimated by high interest, causing owners to be unable to meet underwriter's DSCR debt service coverage ratio requirements, to roll the loan over or refi.

For sellers who are planning to divest from a commercial real estate asset in the next 36 months, the reality is that they will have to come to terms with the fact that the asset they are selling is no longer worth what it was 6 months ago. They may have to accept lower prices than they were initially hoping for, but this simply reflects the changing economic conditions. Ultimately, the market will adjust to these new realities. Still, it will take time for buyers and sellers to find common ground and come to mutually beneficial agreements.

Thank you for joining us for this week's edition of?the Healthcare Real Estate Brief. If you liked what you read, follow?Zane McCartney, Healthcare Real Estate Advisor, for more insights and investment opportunities in the healthcare industry.

Additionally, if you want to explore scenarios and the potential financial outcomes of your specific situation, please reach out - [email protected]

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