Reset for Real Estate

10/17/2022

The FED’s monetary tightening has left “easy money” far back in our rear-view mirror. Like other sectors of the economy, the real estate industry is feeling the pinch of higher borrowing costs. 

A year ago, commercial mortgages for a 10-year mortgage on a multifamily apartment community priced around 2.875% while 10-year Treasury yields were approximately 1.5%. Therefore, commercial mortgages were about a 1.375% “spread” over treasuries. Back then, buying a property at a “cap rate” of 4% and borrowing at an interest rate of less than 3% made for “positive carry” on the leveraged capital of a real estate investor. In those conditions, real estate buying appetite was robust. Closing prices often exceeded the “interest levels” set by the selling broker, sometimes by 10-15%. It was not unusual to see forty to fifty bidders participate in an auction with five “best in finals” bidders asked to “sharpen their pencils.” The bidder with the highest price usually won since the probability of a failed close was very low. 

Higher borrowing costs are behind the current reality that property prices are declining, bidding activity is waning, and only motivated sellers are engaging in a sales process. Now, the highest bidder often does not win if the seller feels more confident that another buyer is more likely to close. Practically every week, our real estate team hears of another deal that has failed because the buyer could not close, because they could not obtain financing, or decided to walk away from their earnest money because they could not make the numbers work. Today commercial mortgage quotes are nearing 5.75%, and 10-year treasuries are yielding almost 4%. This 1.80-1.90% spread has resulted in multifamily properties exchanging hands at considerable discounts to a year ago.

Our real estate team recently identified an established apartment complex that is now under contract following the breakdown of a previous contract which had been priced 12% higher. In another deal, our real estate team has seen a new multifamily property still in “stabilization” where the expected price has fallen 20% compared with the original contract. Discounted prices seem most prevalent in “pre-stabilized” properties where developers are more motivated to sell since the clock is ticking on the variable cost structures of their construction loans.  

With rising rates, bidding is drying up as the cost of borrowing rises above cap rates. It is hard to tell if we are transitioning from a “seller’s market” to a “buyer’s market” or just experiencing a temporary dip in prices as interest rates rise and resettle. Perhaps we’re still in the early beginnings of a reset period in real estate that will bring out more motivated sellers willing to transact at prices reflective of higher borrowing costs. How these higher costs impact the labor market and the demand for housing will have major consequences for rent growth and investor returns. This is a time for cool heads and nimble feet. 

Gary B. Martin