Rising Interest Rates, Other Economic Challenges Plague Commercial Real Estate Nationally

By Ryan Ori | CoStar News
August 23, 2022 | 10:53 AM

Summer lulls are nothing new in commercial real estate, but this year’s slowdown in deals is more pronounced because of one word that has defined the season: repricing.

Rising interest rates, inflation and worries of a recession have caused a reset on prices, prompting sellers to accept a less satisfying price or pull properties from the market in hopes of a better offer later.

The result has been a drop in deals this spring and summer, with no clear timeline for when the market will recover.

“The lender pool isn’t as deep, the buyer pool isn’t as deep and everyone’s being cautious about making a move,” said Jim Postweiler, a Newmark broker who sells office buildings in the Chicago area and throughout the Midwest.

U.S. transaction volume fell in all three months of the second quarter after the Federal Reserve began raising interest rates, according to a CoStar report.

Transactions involving real estate investment trusts fell to $11 billion in the second quarter, down from $16.7 billion in the first quarter, according to Nareit, a trade group for the U.S. real estate investment trust industry. That slowdown happened despite REIT-owned properties reaching all-time highs for funds from operations and net operating income.

That separation of pricing from fundamentals has made recent months stand out from other periods of real estate volatility, such as recessions, according to property owners and investment sales brokers.

Brokers say deals that are closing are frequently at a discount to the initially anticipated price. Postweiler said he’s been involved in deals with price drops of 10% to 15% during the marketing process, and he’s heard of deals being priced down more than 20%.

Market Repricing

Rampant repricing is a twist on the age-old real estate term of “retrading,” in which a firm tries to negotiate a better price after being chosen as the buyer.

“The word retrade has a negative connotation, like they’re being opportunists,” Postweiler told CoStar News. “This is more a repricing of the market. It’s not bad behavior by buyers. They have to deliver certain returns and they can’t do that when interest rates are rising and there’s inflation.”

Even small bumps up in interest rates can increase the cost of a deal significantly. Often, sharp upticks in borrowing costs have been coupled with a lower percentage of debt that a property buyer can take on, creating a double-whammy of needing to raise more equity for the deal and taking on less favorable borrowing terms.

Deals have been affected from Los Angeles to New York.

In one dramatic example, Innovo Property Group forfeited a $35 million deposit when it walked away from a deal to buy HSBC’s headquarters in midtown Manhattan for $855 million, the Wall Street Journal reported in June. The seller, Landlord Property and Building Corp., turned its attention to refinancing the office tower after the sale fizzled, and Innovo didn’t comment.

In Los Angeles, Harbor Associates’ $165 million deal to buy the 40-story Union Bank Plaza fell apart in June amid rising interest rates. Owner KBS struck a new deal to sell the office tower to New York-based Waterbridge Capital for $155 million, far below the $208 million KBS paid for the building at 445 S. Figueroa in 2010.

In other cases, sellers are pulling properties off the market.

“I’ve seen groups fall out of contract and then there’s a new watermark,” said NAI Hiffman industrial broker Adam Roth, who specializes in land sales and leasing in the Chicago area. “If a property was about to sell for over $50 million and now it’s worth maybe just over $30 million, some owners are just deciding to wait before putting it back on the market.”

That was the case with a large development site Roth had a deal to sell in Chicago’s northern suburbs before the buyer backed off.

Higher Costs

Rising borrowing and construction costs and shortages of construction materials are causing developers to be more cautious about buying land even amid historically strong demand for a completed warehouse.

“There’s capital out there, but it’s going to be more selective, particularly if it’s land that’s not a true infill location,” Roth said.

Even for existing warehouses, one of the hottest sectors since the onset of COVID-19 in early 2020, pricing has cooled.

“Investors were underpricing risk at the end of 2021 and early 2022 and now the market appears to be over-adjusting for risk,” said Colliers industrial investment sales broker Gian Bruno, who is based in Orange County, California, and sells properties from Denver to the West Coast.

“This is the first time we can really remember, especially in industrial, where the fundamentals don’t line up with the capital markets,” Bruno said. “The leasing fundamentals are very, very strong and there’s a disconnect with the capital markets.”

Before the recent slowdown, there had been little difference in rates of return between top-tier industrial markets such as California’s Inland Empire and secondary markets like Phoenix; Denver; and Portland, Oregon, Bruno said.

“Now you’re seeing an outsize reaction where investors are pulling back substantially on those markets that haven’t seen the rent growth,” Bruno said.

Multifamily Sales Affected

Multifamily is another high-performing sector in which some sales have stalled despite rent growth and overall strong fundamentals.

Even so, developers such as Crescent Heights say deals will continue to happen despite the challenges.

“The positive fundamentals still outweigh the negatives of the interest rates,” said Jason Buchberg, a Chicago-based vice president of acquisitions at Crescent Heights. “Capital ultimately has to be invested.”

Miami-based Crescent Heights recently sold the 39-story Echelon apartment tower in Chicago to Canada’s Morguard for $133 million. It was an off-market deal by the Canadian buyer, which already owned the neighboring Alta at K Station two-tower residential property.

Strategic acquisitions, 1031 exchanges — transactions allowed by U.S. tax code in which an investor defers capital gains taxes from a property sale by quickly buying another property — and deals in which an owner has reasons to sell in the near term are the most likely to proceed, real estate professionals say.

Permission to transfer a property’s low-interest mortgage to a new owner also adds to a sale price and increases likelihood of a sale, Buchberg said.

“Assumable debt is now accretive to a deal,” he said.

Buyers on Sidelines

One of the biggest challenges for sellers has been watching many big buyers stay on the sidelines, said Mike Condon, a Cushman & Wakefield broker based in Los Angeles who works on land, hotel, office, industrial and apartment sales.

“We got to a point in the summer where it feels like a lot of institutional capital decided to take the summer off,” Condon said. “There was a big vacuum of the more traditional buyers, who have put their pencils down and will be assessing the market after Labor Day. I think this will be one of the slowest summers for deals in years because of what’s happening with rates.”

Condon is one of the brokers representing Waterbridge in the Union Bank Plaza deal in Los Angeles. That is one example of opportunistic buyers stepping into the void.

“There’s more activity and interest from the private client and private capital side, recognizing there’s a vacuum of traditional investors,” Condon said.

Buyers that can still underwrite deals could come out on top years from now, he said.

“If you’re telling me I can buy a great asset in Manhattan or downtown San Francisco or downtown Los Angeles and I can buy it for hundreds of dollars per square foot and the replacement value is $1,000, there’s intrinsic value in doing that,” Condon said. “There’s a tremendous opportunity to make money on the buy.

“Buy low, sell high. It’s the oldest adage in real estate, but it’s true.”