Commercial real estate – buy, sell or hold?

By Chris Zarpas

The commercial real estate market was hit, destroyed and declared dead by COVID in 2020. It revived in 2021 with record-breaking sales of $809 billion, but like cops pulling up all night outside a rowdy sorority house, the arrival of rampant inflation and rising interest rates could signal the end of the party. That’s why many real estate investors ask themselves at a strategic crossroads: “Do I buy, sell or hold?”

Privately owned commercial real estate has historically offered strong protection against inflation. Owners of properties with short-term leases, such as condos, self-storage, and prefab communities, can quickly increase rents to adjust for inflation, as measured by the consumer price index. That’s a significant benefit given that CPI was above 8% in March and April and hit 8.6% in May, the highest rate since 1981. Then, as now, inflation was fueled by a dramatic rise in oil and gas prices and an unbridled flood of states fueled the economy with money. In 1980, the newly installed Federal Reserve Chairman, Paul Volcker, responded by restricting the flow of money so that mortgage rates hit 20% in December 1981. Inflation fell quickly, but at the cost of 10.8% unemployment, a 3% drop in GDP and not one but two recessions. While inflation is many landlords’ friends, the recession is not, and the commercial real estate business began a decade-long decline.

Every sharp rise in inflation over the past 75 years has been followed by a recession, and the current gravity-defying trend shows no sign of abating. The producer index – what manufacturers pay for commodities – rose 0.08% in May, doubling the rise from 0.04% in April to an annual rate of 10.8%. This cost is passed on to the consumer, driving the CPI even higher. Gas costs over five dollars, diesel flirts with six. With sudden spikes in energy costs preceding six of the last seven recessions and the Commerce Department reporting an unexpected drop in retail sales in May, another recession seems inevitable.

Investment property performance and GDP rise and fall together. A weak economy leads to a drop in business and consumer spending and limits landlords’ ability to raise rents. Pandemic-resistant “essential companies” like Dollar General and Walgreens were heavily favored by investors. However, with rents remaining flat for 10 to 15 years, landlords will lose money every year, as will owners of large retail and office buildings with long-term leases that are not indexed to the CPI. The Fed’s more aggressive monetary policy will lead to higher long-term interest rates, provoking a recession and tighter commercial lending requirements. Higher interest rates and equity requirements lead to lower returns, causing investors to pull away and real estate values ​​to fall. For investors with such assets, alarmed by a deteriorating economy and considering a sale, it may be best to hold and wait for the inevitable recovery.

The cycle of decline and recovery often spans a decade or more. Homeowners under the age of 50 can afford to wait for the next upleg if the market sees a significant correction. Commercial real estate has been consistently positive for decades, outperforming the S&P 500 Index for 25 years with average annualized returns of 10.3% and 9.6%, respectively. And unlike stocks, bonds, and cryptocurrencies, real estate has never been worth zero. For younger investors, this could be the right time to buy. “While interest rates are managed higher to deter inflation, they are still historically low. Buyers who can secure fixed income investment property debt at current rates of 5.5% to 5.6% will be winners as these rates are likely to be the lowest they will ever see,” said David Beatty, President of TowneBank Commercial mortgage. Named a 2022 Forbes Top Ten US Bank, TowneBank is a leading commercial real estate lender in Virginia and North Carolina.

What are the arguments for selling in the current market? Few doubt that commercial property values ​​have reached a cyclical peak after a 12-year bull run. Treasury Secretary Janet Yellen recently expressed her concern to the US Senate Banking Committee that banks and non-banks, such as insurance companies and hedge funds, could become over-leveraged in a time of rising interest rates. Knowing that cash is king, there is anecdotal evidence that portfolio owners are choosing to increase liquidity with strategic dispositions at prime prices. In what may be a record-breaking sale of just one such property, an Arizona company paid $363 million for Jamaica Bay, a residential development in Fort Myers, Florida.

Many investors are anticipating a wave of defaults if aggressively pre-COVID-priced acquisitions fail to cover debt service when their loans are soon rolled back at higher rates. When the real estate market collapsed in 1973, legendary investor Sam “Gravedancer” Zell, the father of the modern REIT, acquired dozens of high-end apartment buildings at a fraction of replacement cost. Zell used the massive cash flow from those assets to buy office buildings at 50 cents on the dollar when the housing market crashed again in the 1980s, and became a billionaire. Today, the post-COVID “hybrid working” trend is driving tenants from downtown office buildings to the more affordable suburbs. Remaining tenants are demanding aggressive rent concessions to stay.

Harbingers of an impending market correction are dozens of “distressed” real estate funds that have amassed billions of dollars. Global investment firm Angelo, Gordon & Co. LP has attracted $11 billion in investments in 36 months for its Distressed Debt and Special Situations platform. Investors are betting on a rise in home loan defaults as banks are forced to sell their debt at deep discounts to meet FDIC liquidity requirements.

What about the smaller investor or owner/user? If you are a doctor over 60 and looking to cash out the equity in your doctor’s office building for a more comfortable retirement, now may be the time to sell and lease back. The demand for these properties is unbroken due to their resilience in economic downturns. Montecito Medical is one of the nation’s largest private companies specializing in the acquisition of healthcare-related real estate and is a leader in sale and leaseback transactions. Since its inception in 2004, Montecito has completed over $5 billion in healthcare real estate transactions. “With the forecast that the population of Americans over 65 will more than double by 2040, fundamentals for physician offices are very secure. That makes the category recession-resistant and a haven for capital at a time when other commercial real estate sectors may be struggling. This was proven both in the Great Recession of 2008 and again during the COVID-19 pandemic,” said Chip Conk, Montecito’s chief executive officer. “We have built our entire business around medical practices and the market has repeatedly confirmed this strategy. We remain as bullish on this sector as ever.” Sale-leasebacks are becoming increasingly common in other asset classes such as commercial real estate, perhaps the hottest commercial real estate category around.

Owners with management-intensive assets like single-family homes, condominium communities, and small multi-family homes may want to relax, travel, and otherwise enjoy the results of decades of hard work. You can use IRS Code Section 1031 to trade in unmanaged “absolute net”, single tenant retail stores, enjoy historically low interest rates, avoid capital gains and bag tax-free money.

Being sensitive to economic cycles when buying, selling or holding is essential to commercial real estate success.

Chris Zarpas is a commercial real estate agent at SL Nusbaum Realty Co. in Norfolk VA, one of the largest fully integrated commercial real estate companies in the Southeast.

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