Fresh from two-plus years of the COVID-19 downturn, our economic woes don’t yet seem to be over. Just as the color seems to be returning to our economic cheeks, we get hit by the one-two punch of rising inflationary troubles—which always carries with it the promise of rising interest rates. And this year we can add to the mix the unknowns associated with the escalating Russia-Ukraine war.
Which, of course, translates into a continued bumpy ride for U.S. commerce. But there’s a major difference between our current fiscal hardships and those brought on by the pandemic. While COVID-19 was a prolonged event like no other, SIOR members remind us that inflation and foreign unrest are threats we’ve all dealt with before.
As in previous times of economic threat, “You price it all in,” says Gary Ralston, SIOR, managing partner of SVN | Saunders Ralston Dantzler Real Estate in Lakeland, Fla. When it comes to capital risk, “You typically allocate a little higher spread because of what you perceive to be the risk.”
Jeremy Freid, SIOR, does the math for us, explaining that such proactive pricing “dates back to the historical bid-to-ask spread dilemma that happens in any recalibration/major change in the market. If the cost of debt was 4% and is now 4.75%, it’s going to have an impact on the buyer’s return,” says the senior partner and cofounder of 128 CRE in Boston. “The buyer needs to be willing to accept a more conservative return than he was anticipating. Otherwise, the seller is going to have to be willing to lower their expectations on pricing.”
In short, someone will have to give a little. Sounds simple enough. But we all know it never really is.BREAKING IT DOWN
“Economists have seen inflation coming for months now,” says Memphis, Tenn.-based Landon Williams, SIOR, Cushman & Wakefield Commercial Advisors’ senior vice president of Capital Markets. So, the re-pricing should be more straightforward since “by this point, the data is out there.”
As long as we can keep track of interest rates, that is. The Federal Reserve’s strategy to stem inflation is well documented. For example, in March, The Wall Street Journal reported that the Fed voted to start raising interest rates and follow up with six more hikes through the year. The report called the “escalating effort to stem inflation” the most aggressive in 15 years. It’s most recent increase was a half percentage point—to as high as 1%—early in May.
It’s a cure that carries its own side effects, of course, certainly for capital-market pros. Williams tells of a recent deal where the parameters changed midstream. The $15-million office deal “successfully closed,” he says, “but the loan terms we were originally quoted had changed, and the interest rate moved about 25 basis points. We had to re-underwrite it and get creative.”
Williams explains that the lag was due in part to the logjam typical to the end-of-year rush to close deals. But the inordinate six-week delay was more the result of “other borrowers trying to lock in interest rates for refinance” in an increasingly inflationary setting.
Then there’s the current global unrest. Although half a world away, the global outcry alone underscores the shrinking nature of our planet and the Gordian knot of our fiscal fortunes. As NextAdvisor reported recently in Time.com, “The war in Ukraine has introduced new uncertainty to a stock market that’s already had a shaky start to the year. The S&P 500 saw its most drastic one-day drop since May 2020, amid a war with no end in sight...As the war continues, so does the unpredictability of the consequences beyond the borders of Ukraine.”
Obviously, the banks are in the thick of it all, and they have varied approaches to handling the issue. “Bankers’ opinions of how they’re attacking the capital issue are diverse,” says Arlon Brown, SIOR, senior advisor for SVN Parsons Commercial Group. On one hand, some banks are taking what he calls a straight-forward “cookie-cutter approach, telling us what the five-year or 10-year money is and spelling out their parameters.”
Others are opting to customize their loan parameters for the benefit of known borrowers, a replay of their approach in the aftermath of the Great Recession, and still others are blending both approaches. “There are a lot of newbies chasing real estate deals right now,” says the Framingham, Mass.-based Brown. “This makes lenders nervous because of their lack of sophistication.”A TALE OF TWO ASSET TYPES
The question for market professionals is how long the inflationary period will last. “A lot of it is related to the labor situation,” says Williams. With companies competing for top talent, wages are rising, bringing with them the cost of goods and services. The duration of one, he concludes, will be dependent in large part on the duration of the other.
Whatever inflation’s duration, arguably, no industry is harder hit by what is commonly (and inaccurately) called “The Great Resignation” than commercial real estate. Ralston points to the 152.5 million jobs recorded in February 2020, just prior to the meltdown. This compares with the 151.3 million jobs tracked in April of this year.
“So, we’re still about 1.2 million jobs below the pre-COVID peak,” he says, pointing to the meaning of that shortage for real estate space. “So, we’re not totally COVID-recovered yet. Employment equals office demand. We’re in a riskier environment now, and a lot of that relates to those numbers.”
Of course, that dynamic shifts by location, as Freid makes clear: “That the office market hasn’t stabilized yet is another element of risk.” Depending on the metro area, office fundamentals remain “weird. If you had told me a couple of years ago that downtown Boston would have more holes in its occupancies than suburban Boston, I would have questioned your thesis.” He does add that the local market “weirdness” is decelerating, and the Boston CBD, more than other markets around the country, is beginning to rally.
If we dare to think that COVID-19 and its variant strains are at last behind us (a daring that waivers almost daily), the assumption follows that more metro markets will once again bound back. While most market reports have not yet caught up with the recent lifting of restrictions such as masking, the Q1 filings do support this assumption. As Cushman & Wakefield stated in January, “The worst appears to be behind us as signs of improvement continue to emerge. Most notably...new leasing activity continues to trend higher and Q4 2021 net absorption increased 33 percent quarter-over-quarter.”
The industrial market, hailed as a darling of investors during the pandemic, is clearly more insulated (but not immune) from the current woes, and investors, burning to place cash, are turning to the sector in droves. As long as demand keeps growing–and a recent JLL survey predicts a 7% rent growth in most markets. Their worry is availability, not of capital, but investible properties.
The burden of market risk right now is mostly on the tenant. “Most industrial leases are triple-net,” says Williams. “The risk of rising operating expenses is put on the tenant as opposed to the investor.” And ultimately, of course, the consumer will foot the bill. Hello, inflation.
"Ultimately, the tenant needs the space to produce or distribute its widgets. The right space in the right location is the number-one priority."
At the end of the day, the triple-net arrangement serves goose and gander alike. “Triple-net makes the deal more efficient,” says Ralston. While the cost increases are passed along to the tenant, they get, in return, the stability of a long-term lease.
Williams agrees: “Ultimately, the tenant needs the space to produce or distribute its widgets. The right space in the right location is the number-one priority.”
Tenants’ bigger issue—tied directly to both inflation and the war—is the cost of transportation. “People aren’t worried about this enough,” Ralston believes.
Which is another issue that we can’t directly control. But again, it’s nothing we haven’t dealt with before. And while we wait for the market and the greater economy to normalize—whatever that might mean today—buyers and sellers will deal with finding common ground in the bid/ask spread, “that funky little sweet spot between expectations,” says Freid.
It’s what we can control. And it’s what we do best.
APPLES-TO-ORANGES WON'T WORK IN CALCULATING INFLATION RISK
When it comes to interest-rate fluctuations, Gary Ralston, SIOR, leans toward caution in times of capital risk. He admits to being skeptical about the predictions put forth by the press, noting that comparing future performance against the aberration of the last year is a fool’s errand.
“What are they comparing?” he asks, pointing to the fact that the last two years were wildly counter-cyclical and therefore untrustworthy as a basis of comparison. “Comparing pricing during that event to a normal period simply isn’t a good metric.”
It’s the horse’s mouth for Ralston, who relies more on the daily Selected Interest Rate Report from the Board of Governors of the Federal Reserve Bank–FRBH15.
FRBH15 provides the difference between constant maturities in Treasury paper and inflation, “and they do so over the same time period, which helps establish rental increases among other things,” he says.
If you’re not familiar with FRBH15, Ralston provides a quick tutorial: Call up the document, search for the line marked “Treasury Constant Securities” and choose the bill duration, “Let’s say, the five-year,” he says. Now, scroll over to the desired date column. Do the same for the 10-year. “The difference is the inflation rate for the next 10 years.” Happily, he adds, the Fed is telling us, for one thing, that inflation will moderate over the next decade.
“Most people don’t appreciate what the market is saying about inflation for the future,” he warns, “and other numbers being bandied about are using benchmarks skewed by COVID. This is the index tool we should use.”
This article was sponsored by the SIOR Foundation - Promoting and sponsoring initiatives that educate, enhance, and expand the commercial real estate community. The SIOR Foundation is a 501(c)(3) not-forprofit organization. All contributions are tax deductible to the extent of the law.
Arlon Brown, SIOR
Jeremy Freid, SIOR
Gary Ralston, SIOR
Landon Williams, SIOR