“We’re going to see interest rates below 10% for a prolonged period, and maybe even down into the 8% range.”
I remember hearing predictions like this early in my commercial real estate career and thinking they were fanciful. After all, I entered the business in 1984, when the bank prime rate averaged just over 12% and briefly reached 13%. For someone learning how to sell industrial buildings in that environment, the notion of borrowing money at 8% seemed awfully optimistic.
Of course, it happened.
By 1986, prime had fallen below 8%. It climbed again, reaching 11.5% in 1989, before beginning another descent. By 1992, prime was 6%, and by the late 1990s, rates around 8% seemed entirely ordinary. The Federal Reserve’s historical data show prime averaging 8.35% in 1998.
Then the definition of normal changed again.
Following the financial crisis, we entered an extraordinary period of inexpensive money. The federal funds rate remained near zero for years and returned there during the pandemic. In 2021, the effective federal funds rate averaged a microscopic 0.08%.
Think about that for a moment.
Someone who entered commercial real estate when I did learned the business with double-digit interest rates. Someone who entered during the decade following the Great Recession learned the business when money was historically cheap. Both generations could be forgiven for believing the conditions surrounding them were normal.
Neither was correct.
And therein lies a lesson for owners and occupants of commercial real estate. We have a tendency to define normal by what we have recently experienced, even though commercial real estate is cyclical and the conditions affecting it are constantly changing.
Interest rates provide the most obvious example, but hardly the only one.
Consider industrial vacancy.
During the years immediately following the Great Recession, plenty of buildings were available and occupants could negotiate aggressively. As the economy strengthened and e-commerce accelerated, vacancy steadily declined. Then came the pandemic, supply-chain disruption and an extraordinary appetite for warehouse and distribution space.
Suddenly, availability became scarce, rents escalated and landlords enjoyed leverage that would have been difficult to imagine only a few years earlier.
That became normal, too. Until it wasn’t.
Property values followed a similar path. When borrowing costs declined, investors could pay more while still achieving acceptable returns. Capital poured into industrial real estate, capitalization rates compressed and values rose dramatically. Owners became accustomed to increasingly aggressive pricing, while buyers became accustomed to financing that made those prices possible.
Then inflation intervened.
Beginning in March 2022, the Federal Reserve embarked on one of the fastest tightening cycles in decades, moving its target rate from essentially zero to more than 5% by the summer of 2023. Suddenly, debt cost more, refinancing became challenging, investment returns had to be recalculated and some transactions that worked beautifully on a spreadsheet two years earlier no longer penciled.
Once again, normal had changed.
So where does that leave an owner or occupant today?
Perhaps with a better question.
Rather than asking, “When will the market get back to normal?” we should ask, “What do today’s conditions allow me to do?”
For an owner, higher borrowing costs and fewer competing buyers may create an opportunity to acquire a building that would have attracted multiple offers several years ago. For an occupant, greater availability may provide choices and negotiating leverage that simply didn’t exist during the frenzy. For a seller, limited supply of quality owner-user buildings may still create an attractive exit. For a company facing a lease expiration, today’s environment may favor an early renewal, relocation or even a purchase.
The answer depends upon the circumstances.
What doesn’t make much sense is waiting for some mythical set of conditions we call normal.
As I look back over more than four decades in commercial real estate, I’ve experienced double-digit interest rates, cheap money, recessions, recoveries, tight vacancy, abundant vacancy, rapidly rising rents, falling rents, lending crises and periods when seemingly everyone wanted to own industrial real estate.
Each condition felt permanent while we were living through it.
None was.
Maybe that’s the point.
Commercial real estate doesn’t return to normal because normal is constantly being redefined. Markets move, capital adjusts, supply responds, demand changes and opportunities migrate from sellers to buyers, landlords to tenants and back again.
Our task isn’t to wait for normal.
It’s
to understand the market we have and make the best decision it allows.
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.
