Yes. I believe we are at the very beginning of a slowdown in the real estate market. Actually, it probably started about a year ago, but we are just now beginning to feel the effects. So what has happened in the last year to cause our current situation?
Evidence of a real estate market slowdown
- The dramatic increases we’ve seen in rents the past three years have begun to level off. No longer is the market getting double digit rent increases. Rents are still increasing but much more modestly than in years past.
- New product, which takes a minimum of 18 months to come on line, is beginning to flood the market putting downward pressure on rents and the strong likelihood of higher vacancy rates.
- Interest rates have risen significantly. Exactly one year ago today, the 10-year treasury was at 2.14%. Today it is currently trading at 2.90%.
- In spite of higher interest rates, capitalization rates have remained about the same.
Disconnect between interest rates and cap rates
There is an ever growing disconnect between interest rates rising and cap rates remaining the same. If interest rate continue to rise, at some point there will be an adjustment in property values. There has to be because interest rates and cap rates are connected at the hip. If interest rates go up, cap rates will eventually follow.
Why you ask? Because investors are seeking a specific return on their real estate investments. And higher interest rates inevitably result in higher mortgage payments which reduces an investor’s cash-on-cash return. If investors do the math and they’re not getting the return they want, they have one of three choices:
- They can accept a lower desired return on their investment or
- They need to negotiate a lower price to get to their desired return or
- If they aren’t willing to accept a lower return or are unable to negotiate a lower price they need to walk away from doing the deal.
It’s as simple as that.
What about sellers? They too have decisions to make, don’t they? Of course. Sellers decide what the asking price should be for their property. How do they determine a property’s market value? Many will use the time-tested approach of a property’s pro forma net operating income divided by what they believe is the current market cap rate for their property type. And this is where the disconnect between reality and la-la land happens.
Most sellers ignore the impact that rising interest rates have on property values. The reality of the situation is that the value of their property has slowly deteriorated right before their eyes as interest rates have slowly but steadily risen. The cap rate their property had a year ago is not the cap rate it has today. The second decision sellers make is whether to negotiate on a reasonable counter offer from the prospective buyer. Do I really want to sell this property at a lower price than it was worth a year ago, or do I more or less stand firm with my asking price? This is the dilemma that sellers are having at the moment.
Which choice is winning out?
So which choice is winning out? Anectdotal evidence suggests that sellers are remaining firm on their asking prices and that buyers are choosing to walk away from the deals. Why do I say that? Because my phone has stopped ringing for acquisition financing. And the phones of several of my commercial real estate peers have also been quiet of late. I don’t have the latest sales figures but I’m guessing the number of real estate transactions has slowed in recent months. We are no longer in a frothy real estate market. The market cycle has moved on to the next phase.
Gradual decline or precipitous drop?
If we are now beginning a downward market cycle, as more and more evidence is indicating, does the cycle pattern ahead look like a gradual decline or a precipitous drop? I don’t know what your crystal ball is forecasting but I’d be interested in your perspective. I talk with numerous buyers, sellers, real estate brokers and lenders. The majority believe we are approaching a gradual decline, not a cliff. But remember, most of these CRE professionals have “glass half full” personalities and view the world through rose colored glasses. So take their opinion with a grain of salt. Where do you think the real estate market is headed?
Need financing? As I said, most of the financing I’m doing this year are refinances. Many are investors planning to hold their properties for a little longer than originally expected. Or they are taking out recently created equity for their next CRE purchase or resetting the clock on their fixed rate mortgages. Email me today at [email protected] to schedule a time to discuss your financing need.