The Real Estate Capital Scoreboard® – December, 2022

 

Chicago, Illinois, December 1, 2022 –  Last month, the Fed increased the benchmark interest rate to 4%, representing the sixth straight rate hike this year.  Rates now reflect the highest borrowing cost in fourteen years.  The Fed’s goal focuses on taming inflation to a more acceptable range of 2% to 3% per year.   In the meantime, the inverted yield curve continues to narrow, indicating that investors expect slowing inflation and dropping interest rates.

Given the uncertain capital environment, many investors stay on the sidelines waiting for more clarity in pricing based on the following funding trends:

More Financial Cushions:  Fewer investors see opportunities for substantial income growth and upside for most traditional property types (office, retail, industrial).   Instead, longstanding profitability benchmarks reign based upon current income rather than reversionary profits due to uncertainty in predicting project appreciation.  For example, income growth rates of 3%-5% per year may be replaced with flat projections and even outpaced by higher growth rates for expenses.  Return-on-cost ratios, too, reflect higher spreads of 100 to 200 basis points over un-trended exit capitalization rates.  Such underwriting indicates that developers demand higher premiums for construction risks, especially as markets are perceived as slow growth opportunities.

Solid Multifamily Sector:  Apartment properties continue to dominate capital market demand.  In general, multifamily properties perform exceptionally well, as pent-up demand for housing exists amid a supply shortage.  Even as growth rates slow for rental increases, the pool of renters remains robust.  Potential home buyers are sidelined and must continue to rent, as high mortgage rates cause havoc in the single-family housing sector.

Evolving Lending Sources:  As many banks retreat from construction and short-term development loans due to market concerns, alternative funding sources emerge for such types of debt.  Select life companies, for instance, capture attractive yield opportunities by funding construction loans at floating rates of around 7% based on conservative loan-to-cost ratios below 60%.

Mr. John Oharenko, Director of The Real Estate Capital Institute ®, advises, “Most investors follow a wait-and-see strategy for seeking new opportunities.  ‘It feels early’ to jump into aggressive buying positions as many sellers’ pricing expectations don’t reflect current cost-of-funds.”

 

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