By Brennen Degner of DB Capital Management
The early part of the real estate industry’s “conference season” brings many quality catch-up conversations, and those talks have included concerns. The biggest takeaways from the expert exchanges regarding the broader market are stagnation in transaction volume, office becoming a four-letter word and, most worrying, the limited number of active deals getting re-traded as though it were the new industry standard.
Regarding transaction volume, the majority of individuals I had the pleasure of connecting and reconnecting with maintain that the first quarter will be slow as all eyes are on the February and March moves to be made by the Federal Reserve. The consensus seems to be a couple additional 25 basis point rate increases — modest compared to what was seen through the second half of 2022 — and then some pricing stability while the Fed monitors the impact now making its way into the capital markets from its 2022 moves.
Brennen Degner, DB Capital Management
Once that leveling off occurs, transaction volume should increase rather quickly as there is significant idle capital that needs to be put to work, along with sellers sitting on the sideline waiting for capital market stability.
Regarding office real estate woes, it doesn’t take a sector expert to understand the position that it’s in. Unlike other asset classes, office faces the one-two punch of general macro-economic headwinds and, more importantly, a lack of liquidity in the capital markets. This troubling confluence leads one to believe the pain will continue until the sector has enough contrarian investors jump in, which should happen once the basis becomes attractive enough, similar to what transpired in retail a few years ago. Strong locations and business plans will survive while the rest will get eaten alive.
If misery loves company, then those commercial real estate investment pros plagued by deal re-trades will at least take solace in finding many sympathetic ears. Hearing the different stories of pricing re-trades has been all too common given the unprecedented volatility in 2022, especially the second half. That period saw the underwriting goal post for both debt and equity move on an hourly basis. During this stretch it was not uncommon to see groups walking away from seven-figure deposits.
It’s understandable that pricing adjustments were necessary for transactions that went under contract in the first half of 2022 but ended up closing in third or fourth quarter, as we know now those were two separate worlds. Even with an unwavering commitment to transparency and communication, we couldn’t close some deals, but thankfully many we did.
The most surprising thing from my personal interactions is the number of sellers that continue to experience the re-trading trend into 2023. It seems like because pricing adjustments were necessary during peak volatility the strategy made its way into how some groups do business.
Here’s a recent example: the buyer of a Provo, Utah asset priced the deal in October and officially put the deal under contract in early December. The fact that over this period of time the 10-year Treasury dropped approximately 70 basis points represented a major win in the capital stack for a deal being financed with an agency loan.
With 15 minutes to go in due diligence, we received a letter that either acted as an amendment adjusting the price if signed or a cancellation if not. The buyer made claims to justify its position, but none of us were born yesterday.
This story, which represents such a common investment theme in the past half year or more for the commercial real estate industry, brings us to my key takeaway from catching up with so many accomplished peers in the industry: Now more than ever it is vital to vet and truly understand the business plan, capital structure, decision-makers and closing track record of who is sitting on the other side of the table.
When the market is going up like a hockey stick, you have hard money on day one, back-up buyers nipping at the heels of the purchaser and the infamous broker threat of blacklisting a partner group that does not perform to close the deal. When that isn’t the case, it’s absolutely critical to know the partner relationship you’re entering into with so much deal time and resources hanging in the balance.
— Brennen Degner is co-founder, CEO and managing partner of DB Capital Management, a Los Angeles-based real estate investment group with more than $400 million in assets under management.