By Derrick Barker, CEO and co-founder of Nectar
It’s a hard time out there for commercial real estate.
The main impact of the Federal Reserve’s interest rate hikes is that capital is harder to come by. That has resulted in credit standards tightening and fewer transactions happening in the market; according to CBRE, commercial real estate sales volumes were down 54 percent through the third quarter of 2023 on a year-over-year basis. As has been reported thoroughly, this will be a problem for commercial borrowers that are not well-positioned.
In terms of how we got here, in 2021 and 2022, many investors purchased properties at high prices, using two- and three-year bridge loans. They underwrote these deals with aggressive rent growth and price appreciation assumptions, which were occurring in real time, matched with cheap capital and allowed for record prices. Now these investors have to find ways to meet their obligations, which they took on by promising to achieve these aggressive assumptions.
When their short-term bridge loans come due, they will have to refinance or sell their properties in an environment where capital is scarce and expensive, if available at all.
Meeting their mortgage and investor obligations will be difficult for these aggressive operators. Some will make it. Many will underperform. And when their high-leverage debt obligations come due, they will have no choice but to recapitalize by paying down their existing loans or selling at prices in line with a more capital-starved market. When this happens on a large scale across the market, it is called deleveraging. After deleveraging has happened and leverage rates in the market are in line with current growth expectations, price appreciation can once again proceed.
There are many buying opportunities in a deleveraged market . However, the capital that is needed to facilitate this deleveraging will have to come from somewhere, and it will not be from traditional banks. Instead, such “rescue capital” has typically come from prudent equity investors who are well-positioned to take advantage of an environment like this.
There are many of these investors out there who have low-leverage, cash-flowing properties with low-interest-rate debt locked in place. Many of them are buyers, but they are underwriting deals based on new interest rate levels and pricing realities in the market. Many sellers are unwilling to accept these new market parameters unless they are forced to.
Biggest Risks
If you are a buyer in the current market, the good news is that downturns are typically the best time to buy if you are able to hold onto your property until more normalized market conditions return. However, holding on until the market has stabilized is not a foregone conclusion! Here is a list of risks to consider:
Property Condition
Issues such as structural defects, environmental hazards or unexpected maintenance costs can pose significant risks. Many current sellers have begun renovations but have run out of money prematurely as inflation has caused cost overruns and capital is less available to fund shortfalls. These sponsors may skip steps and cover up shoddy work. Thorough due diligence, including property inspections and assessments and adequate cash reserves are crucial to identify and address potential concerns.
Supply-Demand Dynamics
We are coming off of a construction boom where record numbers of multifamily units were built in the aftermath of the pandemic and are being delivered now and in the coming months. As developers deliver units, they will be motivated to fill up their buildings, even if it means cutting rents in order to do so.
Oversupply of properties in a given market can significantly impact the ability to maintain higher rents, occupancy and ultimately, property values. Understanding what other properties are coming on line and targeting similar renters in your market is essential for making informed investment decisions.
Interest Rate Changes
Interest rates play a crucial role in real estate financing, and rates are higher today than they have been in many years. This increase in interest rates will likely lead to higher exit cap rates when owners go to sell, as well as higher mortgage costs at acquisition.
This dynamic should reduce property values today, as buyers need lower all-in costs in order to make their targeted returns with higher interest expenses and exit cap rates in a “higher for longer” environment. Investors should conservatively underwrite how interest rates will affect their acquisitions.
Capitalization
The biggest mitigant to all of these risks is having the right capital stack. Having moderate leverage and adequate liquidity reserves allows investors to weather market volatility or any capital requirements that come along. In particular, having fixed-rate debt with plenty of time before maturity and adequate reserves to manage the inevitable surprises is advantageous.
Location, Location, Location
The adage holds true: Location is critical to real estate investment success. Consider the property’s proximity to amenities, transportation, schools and employment hubs. Research the neighborhood’s growth potential and overall desirability. Well-located assets will typically always have buyers. Now is the time to look for premium locations at more reasonable prices.
Market Pricing, Financial Analysis
The best way to mitigate risk is to buy at a low basis relative to other properties in the market and to buy at a price where your income at current market rents can generate adequate cash flow, even with current mortgage rates. That way, even if market prices drop in the interim, you will be able to maintain operations until conditions become more favorable.
Understand Risk Tolerance, Execution Capabilities
Define your risk tolerance and investment goals before shopping for properties. Do you seek to renovate a property to generate short-term gains, or would you like to purchase a stabilized property for long-term stability? That will guide your property selection and investment strategy. Be honest with yourself about your ability to execute on and tolerate the risk inherent to renovations or a value-add business plan.
Exit Strategy
Develop a clear exit strategy before making an investment. Whether it’s selling the property for capital gains, refinancing or holding for rental income, having a well-defined exit plan with conservative cap rate assumptions will help you make informed decisions throughout the investment lifecycle.
Network and Expert Team
Build a team of real estate professionals, including real estate agents, property managers and construction experts. Seek advice from experienced investors who can provide valuable insights based on their own successes and challenges.
Conclusion
Despite the current market volatility, there is a significant amount of potential in today’s market environment. It is in times of market dislocation and lack of liquidity that the best deals are made. Investing at a time with fewer competing market participants allows for better pricing, which is the ultimate mitigator of risk, assuming you have the team and diligence in place to manage typical pitfalls.
— Based in Atlanta, Nectar is a startup company that provides alternative financing solutions to real estate entrepreneurs.