Boots on the Ground Perspective on Today’s Commercial Real Estate Market
The fear is palpable. I have not felt this level of negative sentiment amongst the investor community since the fall of Lehman Brothers in 2008.
Instead, we wanted to take this opportunity to provide a snapshot of what we are seeing and feeling within our own portfolio today and how we are evaluating new opportunities given the current landscape.
Leasing velocity within our flex, industrial and medical office buildings continues to be brisk. While there has been an uptick in overall leasing activity, new leases and renewals have been challenging to execute, due in large part to pricing pressure on materials and supplies which continues to cause delays for build outs and tenant improvement projects. The majority of new leases are outperforming pro-forma rents, and there is a continued appetite for flex industrial space from the tenant side.
Leasing momentum within our legacy office assets acquired pre-Covid continues to be largely stagnant. However, we do believe that recessionary fears, household level inflationary pressures, the market selloff and the expiration of Covid-era stimulus will create leverage for employers to demand employees return to the office in order to increase productivity.
We are seeing less activity and lower transaction volume compared to the beginning of the year. Though there’s potential for an increase in cap rates in the near term, we do not believe this will be substantial or long lasting.
Securing attractive debt is the biggest inhibitor to executing on transactions at the moment. Lenders are cautious across all asset classes and focused on preferred sponsors, as they adjust to uncertain valuations in an environment of dramatic and compressed increases in mortgage rates. Leverage ratios have decreased with Loan-to-Value moving from 65% to 55% over the course of the last six months.
The current debt market is making it especially difficult to buy deals with upside or value-add characteristics because of in-place debt-service coverage ratio (DSCR) requirements (shifting from 1.3 to 1.4 DSCR with significant structure, which ultimately eats into investor returns). Bank lenders are stressing the importance of DSCR (NOI / Debt Service) and Debt Yield (NOI / Total Loan Amount).
There are still deals to be had but it takes a reasonable seller with a deadline or sense of urgency; otherwise, sellers are on the sideline and typically only willing to negotiate if NOI has increased dramatically or they are tired of managing the asset. Anecdotally, we have seen an uptick in the volume of Baby Boomer sellers that have owned through the Great Recession and COVID and don’t want to stick around to see if we do in fact endure another potentially deep recession.
In general, there’s a disconnect between brokers, sellers, buyers and lenders in the marketplace, which poses challenges to execution, but also provides for pricing dislocations and, therefore, opportunities to find value for nimble sponsors with deep debt relationships.
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