To say that 2020 was a brutal year for the commercial real estate market due to the impact of Covid-19 would be an understatement. Everything changed once the calendar flipped to 2021: a vaccine was rolled out, businesses were able to eventually have full occupancy, and investor confidence quickly returned to the marketplace. Sales soared due to historic low-interest rates, and investors realized tremendous returns on their assets. Once the calendar changed to 2022, things yet again became murky. Rumors of the Fed raising the interest rates started to percolate into our daily dialogue. Some speculated the Fed Reserve to raise rates as much as 75 basis points, some as much as 150 basis points; all with the idea to help curb spending. As of today, the Fed has raised rates by 25 basis points in March, 50 basis points in May, an astounding 75 basis points in June (its single highest daily increase since 1994), and then followed that up with an additional 75 basis point increase in July. This is now the highest the Feds Fund Rate has been since December of 2018; the total increase this year thus far is 225 basis points or 2.25%, this up from roughly .5% or 50 basis points. In short, this is roughly a 450% increase in the fed funds rate in the last six months!
In looking back at the lending world, interest rates in 2020 were in the upper 4% to low 5% range. Typical lender charges were around a 0.5% fee, with equity in a deal at 25%. In 2021 rates significantly improved, dropping to the low 3% range with the same lender fees and equity requirement. To date in 2022, rates have shot back up to the high 5% to low-to-mid 6% range again with unchanged lender fees and more equity requirements. In a conversation with Dean Tutunji, Commercial Services Loan Officer 1st VP at GreenState Credit Union, he had the following to say: “The lending structure will not change, we will always require at a minimum 25% equity requirement and a 0.5% lender fee. Our rates at GreenState are currently in the low 5% range. I cannot believe that rates have gotten this high again. I think it is certainly possible that the rates could increase another .25%, but I feel that most lenders have already priced this into their rates for the anticipated inflation for the remainder of the calendar year.”
So how does all this correlate to commercial real estate?
Cap rates follow in the same direction as interest rates. When interest rates drop, so will cap rates. When interest rates increase, expect to see cap rates do the same. Some 1031 investors have been forced to decide if they want to pay the tax or purchase another asset with less favorable debt.
There are many compelling reasons to purchase a multi-tenant shopping center, one of them is the diversification in tenancy. If one tenant fails and has to close its doors, property owners will still have other tenants to rely on for rental payments. Whereas if a single-tenant is forced to close its doors, then that investor is now at a zero income stream until it leases that building again. Good real estate will always lease, and good real estate will always sell.
Some of the marketplace momentum occurring today is that investors seem to be seeking yield. Instead of chasing the A+ location that has a low cap rate, they are following the yield out to secondary and tertiary markets that have a higher cap rate. As brokers, we are selling cash flow, so the leverage or debt plays a critical part in the cash flow or return on investment. One other component to consider is that when the stock market declines, high net worth individuals will pull money out of the stock market and place it into real estate or hard assets.
Overall, this downturn in the economy with high inflation will not last forever. The advice I have been giving my clients lately is to wait to transact if they can. If there are extenuating circumstances that require a client to either sell or buy, then that client should transact. But if a client is looking to achieve an income stream, they should wait until the cap rates move in a manner that is commensurate with interest rates. If an investor must purchase an asset now, they can always refinance the debt once rates decline in order to improve any returns they’re looking to make. Your broker should be able to advise you as to where rates are and where cap rates are headed. Sellers will attract more buyers when they are priced right, especially with debt becoming unattractive to buyers in today’s economic climate.