What’s Next…
Entrenched into the 5th decade of my real estate career, I can’t help but think that I’ve read this chapter before, taken the same meetings and asked the same questions. Mark Twain said it best in that history never repeats itself, but it does often rhyme and so it does today.
Real estate cycles, as we have regularly experienced, are directly correlated to capital flows and their associated costs of debt and the yield expectations of equity. Real estate, due to its capital intensity, benefits from access to meaningful leverage but amidst volatile market conditions, is subject to the risk potential of mismatching that leverage to a project’s business plan.
Until today, the Global Financial Crisis (GFC) was the most recent cycle created by a perfect storm of circumstances which ultimately negated liquidity, imploded real estate equity values and reset capital flows to the asset class. The climb out was then led by a continued accommodative fed fund rate from 2009 to 2021 running between 0.05% and 2.42%, averaging 0.52%, with the ten-year treasury rate averaging 2.33% during the same time frame. This attractively priced leverage enticed record flows of value and opportunity capital for investors looking to take advantage of bargain basement pricing. The next 13 years were marked by inexpensive debt, easily accessible equity and growing inflation which provided an unprecedented run up of real estate valuations.
Not coincidentally, the industry’s robust expansion brought to us by this hyper-supply of low-cost capital has now landed us in a market malaise otherwise known as the next cycle. While maybe not a perfect storm, a storm nonetheless, activated by an unprecedented rise in rates coupled with a borrower and buyer exuberance that continued to utilize the cheap leverage. Yes, knowing the impermanence of both the pricing and availability of this capital looks like an easy read now so why didn’t more real estate owners f ix off these historically low rates? Answers are many, but experience should remind us that a great business plan or well-located piece of real estate can’t survive a bad capital stack or down-market cycle.
So, what’s next is the right ask and to Buchanan, and other industry veterans, a recognition that opportunities will exist for those who had the foresight to take advantage of balancing their portfolios with long-term permanent financing and continued access to new debt and equity.
New opportunities will surface from the approximate $4.6 trillion of outstanding debt which is expiring in the next 2-3 years with a lack of replacement lenders and the new pricing of these loans. Most troubling to this leverage conundrum is the recognition that the prior chapter’s interest rate costs are a thing of the past and not an accurate reflection of a longer look back to the real average cost of capital.
As we review history, let’s take a longer look back at permanent rates as a proxy to our going forward costs of capital. For example, the average pricing of 10-year treasuries over the past 35 years averaged roughly 4.4%; ironically as of this writing our 10-year treasury sits at 4.52%. In turn, cap rates, a mathematical value tool for pricing real estate, have sought an average spread over the past 10 years of 270 basis points (bps) to the risk-free 10-year treasury ranging from a low in 2007 of 30 bps to 442 bps in 2010, projecting an adjustment to today’s overall market pricing. Further substantiating this needed rate and pricing reset is the consideration of the current 10-year treasury forward curve which reflects a rate of 4.33% to 5.14% depending on how far out you utilize future projections. The industry at large is seeking a consensus of a needed rate stabilization, which will allow for cap rate predictability spurring transaction volume and liquidity.
This storm’s silver lining might be the surprising resiliency of the real estate market due to the strong economic backdrop vs prior cycles. However, the economy’s foundational stability cannot override the pending transformation of borrowers’ cost of capital and refinance mandates. Learning from past cycles, regulators are allowing banks to increase loan loss reserves as foreclosing on assets has proven to not be the best path for banks to optimize the repayment or liquidation of their loans. Further, transactions are now beginning to increase as borrowers and sellers look to satisfy loan repayment guarantees or conclude that some return of equity or reduced profit taking might be their best outcome. To align with this search for liquidity, the private markets are buttressed with dry powder, amassed from their previous anticipation of investment deployment and joined with an abundance of new value and opportunity funds successfully raising capital to take advantage of the illiquidity and value reset.
While it is convenient to utilize a cost of capital and valuation examination, these are simply mathematical equations, and we would be remiss to not incorporate the evolution of real estate’s functional usage or obsolescence into the next chapter. A recent conversation with noted real estate consultant Christopher Lee framed it well as he said, “today’s value is created by what’s inside the four walls and not just the four walls with real estate simply being a connector to the user’s expectations and needs”.
Mr. Lee highlighted that up to 70% of today’s office is or becoming obsolete with investors needing to focus harder on emerging trends. Digitization of work, artificial intelligence, work from home expectations and the generational transition of work patterns are creating significant development and redevelopment opportunities in the office space. The division between home, work and “in-transit” will become blurred as working from 9-5 disappears and many office buildings shift to 24/7 operating platforms with full suites of services, amenities, and tenant options. Mr. Lee further mused that future ramifications to office could include renting space by units of consumption rather than per square foot, major US central business districts banning or restricting downtown vehicle travel, the gig economy eliminating up to 50% of today’s jobs, and lastly that by 2040 there could be more robots than workers.
While history’s review of capital analysis has important applications to asset class performance, investors’ ability to navigate the less mathematically quantifiable and futuristic trends ultimately will provide the highest spread to that risk-free return. At Buchanan, we have continued to search for those investments that provide both locational long-term stability, business plan and liquidity optionality with an eye to a more historic and predictable project capitalization. Twain might just remark that while past capital cycles have a certain rhythmic cadence to them, the opportunity will lie in the steward’s ability to navigate and optimize the forever changing present circumstances.