How Sky High Mortgage Rates Slow Commercial Real Estate

Welcome to our glorious SoCal fall! As days shorten, leaves crunch underfoot, and temperatures cool - our commercial real estate market faces several headwinds. Hamas’ blatant attack upon Israel, the ouster of our House speaker, and the ten year bond yields at twenty year highs headline the obstacles. The first two - Israel being attacked and patticake in the House of Representatives create uncertainty. As I’ve said here many times - in the face of uncertainty, long term decisions are postponed or scrapped entirely until things level. But mortgage rates at highs not seen since the financial meltdown of last decade creates gridlock in the housing market. As residential transactions ebb, we feel it commercially. How you may be wondering? Allow me to expand a few scenarios. 
 
Turnover generates commerce. My mind is drawn to the pre-pandemic spate of deals in our small enclave of houses in East Orange. On our street, my wife and I have owned our address second longest. Kitty corner to us are original owners since 1984. Their multi-generational set up remains today - only with a new gen. But lately, several of our neighbors tapped out for assisted living or passed away - leading to four homes changing hands. Also, one rental converted into an ownership. In every instance a dramatic interior redo occurred followed by a freshening of the outside as well. So let’s break this down. First, a transaction happened. In the process, real estate agents were deployed for the buyer and seller. Staging, signage, glossy brochures, and touch up repairs preceded the sale. Maybe a lawyer or two got a look at the contract. Then escrow officers, title representatives, and lenders were engaged. Home inspectors, termite companies, and moving vans were hired. Insurance for the new digs was a closing component. And let’s not forget the bump in property taxes which funds our county government. Once the deed records and title transfers - an army of contractors descends upon the early 1980’s structure. Paint, flooring, kitchen upgrades, bathroom remodeling, wall removal, additional square footage built, etc. occur in earnest. The old furniture surely can’t be set inside this pristine interior. So a trip to Living Spaces, Daniels, or Mathis Brothers follows. Now an elderly couple - with limited consumption - is replaced by a family of four or five. Groceries, gasoline, dry cleaning, sports equipment, school clothes, orthodontics, urgent care, pets and pet supplies, and Amazon home deliveries are all fueled by the new residents. Commercial real estate activity is bolstered by the sale of houses! Please take a moment to review the steps above. In every case - office, industrial and retail are enhanced. Officed are residential real estate agents, escrow and title plants, lawyers, physicians, and insurance brokers. Moving and storage, all facets of contacting and landscape companies ply their trades in industrial buildings. Finally, buying stuff. Yes! Retail storefronts or online portals. Absent the turnover in houses, these businesses are forced to downsize, close their doors, or look elsewhere for new work. 
 
Rate shock. The ten year treasuries eclipsed 4.8% last week for the first time since 2007! Great news for savers but lousy for those looking to buy a house, refinance a mortgage, expand a business, or purchase commercial real estate. Two years ago today, that same yield was 1.61%. Yes. Yields today are roughly three times where they were two years ago. Savers in 2021 - in order to get a reasonable return on their investments were forced to seek riskier assets such as stocks, commodities or real estate. Now, backed by the full faith and credit of the United States government, passive investors can make a nice risk free return on their money. Avoided are the gyrations of the stock market or the downside of real estate ownership - losing a tenant. However, this astronomic rise in rates makes borrowing more expensive. Therefore, affordability in house purchases becomes less so. If you’re among the unfortunate few who have maturing loan balances to refinance - brace yourselves. Finally, expanding a business becomes richer. Here’s what I mean. Banks price loans based upon their cost of funds and the strength of the collateral. As we just discussed, a saver can make 4.8% in treasuries so banks must raise certificate of deposit rates to attract new money into their bank. Expanding an enterprise into an uncertain economy could be viewed by some lenders as risky. Therefore, to hedge against default, the rates charged must compensate. And the circle continues. For those hoping to secure ownership in a location to house their operation - many will encounter a debt service too expensive compared to a rental. More will find leasing to be more affordable. 
 
This year, I’ve been quite bullish on our economy and the resilience of the consumer. When others predicted a slowdown, I took the contrarian position. Now, with student debt repayment ramping up after pandemic hibernation, home savings balances declining, the government money spigot ending, high interest rates ramping plus some new global unrest - I’m afraid a recession is inevitable. When, how deep and how long remain questionable. 
 
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.blogspot.com.
 

Three Things I’m Hearing

As I’ve written before - we as commercial real estate brokers generally serve three types of clients - investors, tenants, and owner-occupants. Unlike our residential colleagues who represent buyers and investors - and the occasional tenant - many in our industry do quite well only servicing folks with leases.
 
We can be on either side - the owner side or occupant side. So our days are filled in one of six pursuits - three types of clients but working on either side. Clear as mud? Allow me to provide details. Number one and two. Investor hires us to find them something to buy or to fill a vacant building. Number three and four. Tenant engages us find them a location to lease or to sublease excess space. Number five and six. We work to locate a parcel for an occupant to buy or they ask us to sell their company’s address.
 
With that as a backdrop - you can appreciate we have our “ear to the ground” and are a great source for what’s happening. I’ve distilled this down to one thing for each genre - investor, tenant, and owner-occupant.
 
Investors. Our industrial market crossed a pivotal point in the middle of 2020. For the first time I can remember, the occupant premium disappeared and investors started paying more for offerings than those who bought them to house businesses. Deep pools of capital, a rabid appetite for return in a stable asset class, and skimpy supply caused pricing to hit a crescendo in May of 2022. With all the world happenings - inflation, recession, global strife, and rising interest rates - investors, especially institutional investors, have hit pause. Private folks are proceeding quite cautiously. Many require debt to acquire income properties. As rates have now eclipsed 5.5% - the resulting capitalization must be north, lest negative leverage will occur (return on invested dollars less that cap rate). So with fewer buyers and higher rates - yep. Prices have started declining.
 
Tenants. The period between 2016 and 2019 found record numbers of leases originated or renewed. These are typically 3-10 years in length. Baked into the agreements are annual increases. Up until 2021 - these hovered between 2.5% and 3% per year. Around July of 2021 - we saw a big push for increases to proximate 4%. We even saw a couple of deals with 5% yearly kickers. But even with the hefty adjustments, lease coupons didn’t keep pace with inflation. Consequently, come renewal time - many tenants are greeted with rate increases of 50% -100%. Folks who lease industrial buildings are concerned with how their bottom lines will be affected and how to counteract a whopping bump in rent.
 
Owner-Occupants. Distinction is drawn between two commercial real estate owners - occupants and investors. The difference? Occupants also own the operation residing in the facility. Before June of this year, many owner-occupants received unsolicited offers from investors seeking to deploy capital. In general - these offers were at eye popping numbers and included a provision to avoid a costly move. Many carpeyed the diem and sold. But others got tangled in the two issues that arose - Uncle Sam and sky high rent.
 
The balance of 2022 should prove interesting as we navigate this changing market. As an aside, I did see a Santa display in a Lowes yesterday. Earliest I can recall. Merry Christmas!
 
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.blogspot.com.