Investors Take On More Risk As Real Estate Cycle Nears Record Run
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Current macroeconomic trends coupled with billions of dollars in dry powder waiting to enter the market have pit commercial real estate buyers against sellers.
Property valuations, though cooling, are still hovering near cyclical highs, and buyers are balking at the price tags, taking into account the current length of the cycle, rising interest rates and future exit caps.
“The reality is, most of the acquisitions being made are really, in the long run, a losing proposition for the buyers,” Yardi Matrix Director of Research and Publications Jack Kern said. “The sellers are doing really well because they are getting a premium for their properties. Buyers are losing [and] buying something that will not gain a sufficient level of value to provide returns they're going to need.”
The current stage for commercial real estate transactions was set nearly a year ago, when President Donald Trump won the election in November, Ten-X Executive Vice President and Chief Economist Peter Muoio said.
Following the election, interest rates spiked and buyers began to take a wait-and-see approach before acquiring assets — treading lightly when negotiating deals, though always with cautious optimism about the state of the economy and the market’s response to Trump’s business-friendly agenda.
“What happens in each cycle is, as pricing increases, investors search more widely for potential investments that will meet their return requirements,” Muoio said. “They start out in big primary markets, then those get pricier, cap rates get compressed [making it] hard to get a good return.”
A year after the election, the setting is more or less the same. The 10-Year Treasury rate is hovering around 2.3% — higher than it was prior to the election — and cap rate movement remains minimal. What's more, a vast number of global investors are sitting on a hefty sum of cash — more than $540B according to JLL — many of whom are itching to get into the U.S. market.
The scene has left sellers with the upper hand and buyers with one of two options: exit the market or take on riskier assets.
As many sit on the sidelines in search of deals that offer better risk-adjusted returns, transaction volume has dropped. In Q3, U.S. investment volume totaled $114.2B, representing a 9.2% decline year-over-year, CBRE reports.
Other investors, particularly foreign funds and firms, are taking a chance on riskier U.S. assets in hopes that it will produce significant returns over time.
“I think a lot of investors are coming into the U.S. from Asia, and those investors are accustomed to lower returns on real estate. They are willing to buy something at a 3% or 4% cap rate,” Harvard Graduate School of Design lecturer Raymond Torto said. “Investors’ expectations in what kind of returns they want are varying, because people from other parts of the world are buying real estate. [But investors] accustomed to 6% and 7% returns look at a 4% cap rate and say that's too expensive.”
Traditionally, investors turned to real estate over the stock market or assets like oil and gas for its safety. By placing money in stable and fully occupied trophy assets in core markets, buyers were all but guaranteed fixed returns. That is no longer the case.
“Prices are high and returns are low, so some people are saying, 'I’m not going to buy at that price,' because they’re not getting a return that's attractive,” Torto said.
Investors in search of real assets today are increasingly turning to secondary and tertiary markets for better returns. Though properties in these markets are deemed more risky, these assets can be quickly flipped and sold to turn a profit, Torto said. Others are looking beyond stable assets to projects under construction for returns.
“A lot of institutional investors look at the costs of buying in New York City, Portland and Seattle, and are saying, I can build cheaper,” Torto said. "So they are taking on development risk by building apartments, hotels and offices. Then if they build it and lease it up, they can turn around and sell."
What Happened To The Risk Premium?
Typically, when investors bet on risky assets, they cushion the deal with a risk premium. By doing so, investors bake into the underwriting of the property roughly 250 to 350 basis points worth of risk on top of the 10-Year Treasury rate, Kern said. This acts as insurance so buyers are guaranteed strong yields no matter what occurs.
“It’s the difference between what you get and what you were expecting to get,” Kern said. “How much more can you make over the Treasury rate? How much risk are you willing to accept or underwrite to do that?"
Today, rising interest rates and compressed cap rates are eating into that risk premium in what Kern calls the “elephant in the room” that no one is discussing at industry events.
“The logical conclusion to me would be if you can't get a risk premium, you would withdraw capital until such time it made sense to get back into the market," he said. "Instead, these funds are under such pressure to put capital out and accept deals, they are accepting a much greater risk [and] trying to compensate by buying more things with limited leverage."
To compensate for this loss, Kern said investors are competing for trophy assets in gateway markets or buying more risky assets in secondary markets.
“Investors will say they're trying to compensate for the loss of it by operating better properties [and] staying in hot gateway markets,” Kern said. “But the reality is people are afraid that they just can't get it ... that the risk premium which provides some cover over a change of income they can't get.”