Investors Shift Focus from Higher Returns to Stability, Proven Cash Flow
By Tyler Dingel and Blake Bogenrief, CBRE | Hubbell Commercial
COVID-19, and the immediate uncertainty that came with it, slowed investment activity in nearly all markets.
The transactions that have closed since March, and those that will follow in the coming months, are changing. Investors and lenders alike are more thorough in upfront analysis, more selective in tenants, and overall, trending more conservative. The vision is now long-term oriented, and the spotlight is shining brightly on essential goods and services as well as investments with proven track records. Slow and steady is winning the race.
Over the last 12 months, a common concern for real estate investors has been what the future holds for capital gains taxes. Many sellers are contemplating and opting to “take the hit” now as opposed to down the road when capital gains tax could be replaced by the ordinary income tax rate.
In addition, the Biden Administration seeks to increase individual tax rates while the U.S. continues to deliver financial aid to the masses. Nearly nine months following the CARES Act, Congress agreed on a second, $908 billion stimulus package. Many expect that taxes will do one of two things in the future — increase or skyrocket.
The elimination of 1031 exchanges could also be on the horizon. This has impacted the decision-making of investors when it comes to acquisitions. Investors are looking for the generation of income by way of solid rent growth, strong tenant creditworthiness, essential industries and proven track records.
Increased demand for essential retailers such as grocery stores, drive-thru restaurants and pharmacies has increased the total retail investment market share of the net-lease market by 5.4 percent since the third quarter of 2019 despite the general retail headwinds.
Charlotte’s Kitchen, a favorite Des Moines-based food truck serving all things chicken, recently decided that now is an ideal time to expand into brick-and-mortar as long as its new space features a drive-thru. The owner will soon be opening his first permanent location in a former Dairy Queen restaurant and is confident that the drive-thru business will perform very well regardless of whether things return to “normal.”
In the last few months, our team has sold several retail strip centers for sub-8 percent cap rates despite retail trouble because the tenant mix consisted of many essential services. For investors, the desire has been to own a strong, long-term asset should the 1031 exchange dissolve. Average cap rates for commercial and multifamily have decreased from 5.98 percent in the third quarter of 2017 to 5.52 percent in third-quarter 2020. Less risk is worth more.
Investors are not the only ones thinking ahead and adjusting appetites in risk level accordingly. Interest rates are low, but underwriting has also been more conservative since March. Financial institutions are less willing to lend on retail and office investments that are trading at low cap rates.
Of the deals that are closing, lower than normal loan-to-value ratios (LTVs) are required. The average LTV for permanent, fixed-rate commercial and multifamily transactions closed by CBRE Capital Markets was 61.5 percent in third-quarter 2020, the lowest it has been since the Global Financial Crisis. Debt service coverage ratios have been trending upwards since.
Another asset class that has received greater attention and demand has been investments that have a greater value through cost segregation. The 2019 Tax Cuts and Jobs Act extended the ability for investors to use bonus depreciation on property that has a useful life of 20 years or less.
Through cost segregation, an investor can carve out items of qualifying properties and use those deductions to lower their overall tax liability in the first year of ownership as opposed to using the standard 39-year schedule for real property.
Convenience stores, which are classified as “retail motor fuel outlets” as long as more than 50 percent of their gross revenues are derived from fuel sales, have benefitted through this rule.
For one client, Kum & Go Convenience Stores, we saw a decrease of over 30 basis points on the average capitalization rate.
While 2020 did create difficulties for the commercial real estate industry, there were many bright spots. In 2021, we expect the trends of 2020 to carry over and demand for essential-service investments to remain robust.
Investors will likely continue the search for safer, established assets. Suburban and rural areas may become more relevant once again after seeing somewhat of an exodus of the workforce from the downtown core. Investors should continue investing as the money supply is at an all-time high.
Tyler Dingel is senior vice president and Blake Bogenrief is a sales associate with CBRE | Hubbell Commercial in Des Moines. This article originally appeared in the January 2021 issue of Heartland Real Estate Business magazine.