Real Estate owners face declining property values

Rent growth has been decelerating while expenses have increased at a faster pace, resulting in downward pressure on property NOIs and valuations.

Central banks injected record amounts of liquidity into markets around the world after the Covid-19 pandemic began. Markets were buoyed by the influx of capital and interest rates being drastically cut. Activity in real estate markets picked up as buyers and sellers adjusted to the new normal. Valuations hit frothy levels as they were supported by record amounts of capital chasing yield, interest rates made acquisitions much more affordable, and consumers were flush with cash and could stomach huge rent increases. Cap rates were compressed significantly as property owners had large amounts of capital bidding on properties with growing NOIs due to record rent growth.

The momentum shifted the other way when the Federal Reserve realized its mistake of calling inflation transitory and began tightening monetary policy. The Fed believed by raising interest rates they would temper the labor market which was fueling consumer spending. Monetary tightening began in 2022, and slowly but surely, the labor market has cooled in conjunction with consumers burning through their stimulus checks and accrued savings. As a result, they have become less willing and able to stomach rent hikes seen from 2020-2021. In addition to consumers being strained due to heightened inflation, historic levels of new housing supply has begun to be delivered. This new supply is expected to be delivered through midway of 2025, which will suppress both occupancy and rent growth, posing a challenge for landlords.

As rent growth slowed down over the past year, operating expenses increased as a result of inflation. In the past year, operating expenses grew 7.1%, which is bad timing given that rent growth began slowing at this same time. This dynamic is a basic math problem, expenses have grown faster than revenue, which has led to operating margins and NOIs falling. This problem is the exact opposite of what occurred between 2020-2021.

For the 12-month period ending January 2024, multifamily expenses grew by 7.1% while rents only grew by 0.3%. Consider the following example that demonstrates the impact that expenses outpacing revenue growth has on property valuations. At the beginning of 2023, revenue was $1,000,000 and expenses were $450,000 resulting in NOI of $550,000 at a property. During 2023, rents grew by 0.3% while expenses grew by 7.1% resulting in a new NOI of $518,350. 

Estimates for average cap rates have ranged between 5-6% as buyers and sellers still are still in the discovery process of pricing, but we will use a cap rate of 5.5%. Year-end NOI for 2022 was $550,000 at a cap rate of 5.5% which would result in a valuation of 10m. However, the property’s valuation goes down by 5.8% to ~9.25m when taking 2023’s NOI due to increased operating expenses.

Operating expenses have outpaced rent growth over the past year, putting pressure on property owners as their NOIs and valuations are shrinking. Declining operational performance is happening as record amounts of debt is coming due and interest rates have remained higher than expected. Although the commercial real estate industry has not yet experienced high levels of distress, owners are facing immense pressure to refinance their maturing debt or remain current on mortgage payments until conditions projected to improve midway through 2025.

Climate change and what it means for real estate investors

Climate change has caused a massive uptick in the number of catastrophic weather events in the United States, inflicting more property damages than ever before. Insurance markets have been recalibrating following the elevated number of claims and average premium increases have consistently outpaced inflation for the past several years.

In 2023, there was $92.9 billion in property damage caused by severe weather in the United States. This total only includes the 28 disasters that caused $1 billion plus of damages. In 1980 there were on average 8.5 perilous events a year which caused $1 billion plus in damages. Since 2019, there has been an average of 20.4 perilous events a year, which is an increase of 140%. The massive increase in severe weather-related property damage has shaken up the insurance market over the past several years. 

Since real estate owners face more instances of severe weather on a yearly basis now, there are a multitude of ways in which they should be contemplating what this means for their current portfolio and future acquisitions.

1. Limited Carrier Options: In response to the high number of claims being paid out in states like California or Florida, some companies stopped issuing policies there altogether. They cited the ongoing risk of more catastrophic weather events which resulted in an increased risk profile for them. In turn, both existing owners and investors looking to acquire assets may find it more difficult to find coverage, and as insurers have left the market, premiums may have gone up as well.

2. Climate Related Risk Mitigation: As part of coming to terms with facing more severe weather on a yearly basis, owners may find it beneficial to conduct a climate analysis of their portfolio for any vulnerabilities. As part of that review, they might find climate related capital expenditures that might be required to secure parts of their portfolio.

3. Site Selection Impacted: Investors may need to take climate-based risk into their acquisition criteria. This includes due diligence on the potentially increased cost of insuring the asset, additional capital expenditure needs at the property, while also taking into account the likelihood of climate related damage the property might be exposed to.

4. Returns Impacted or Deals Cancelled: As seen in the graph below, insurance premiums have skyrocketed over since late 2020 and early 2021. Many real estate deals have been killed or had their returns materially altered due to  to the drastic increase of the insurance premium. Investors will need to be wary they do not face sticker shock at closing. 

5. Asset Management: Property owners will need to ensure they have ample policy protection to face the increased risk of weather-related damage. They will also need to be proactive in mitigating risk across their portfolio and implement strategies to minimize rate increases upon renewal or when setting up a new policy.

Where is the distress?

Investment firms  have been circling the commercial real estate market for several years now, waiting for the right time to acquire distressed assets. This strategy gained traction following the upheaval in the capital markets as the Federal Reserved began tightening monetary policy. Firms saw an opportunity to acquire commercial real estate assets at an attractive basis due to the wave of debt that was coming due in an higher interest rate environment than it was originally financed in. Despite the Fed keeping interest rates higher for longer, there have been few distressed sales thus far. Why has this proven to be the case?

Source: Preqin 

From 2022 to 2023, loan modifications increased by 150% across all commercial real estate property types. Lenders and property owners agreed to these loan modifications to extend the maturity date on the loans. This was done to provide more time for rates to come down, to improve operations, to wait for a more favorable exit environment, or all of the above. With the exception of office and particular types of retail, commercial real estate as a whole has a positive long-term outlook. Lenders are not currently under pressure to unload assets at a loss or to recover their debt basis. As such, for assets where it makes sense, investors and lenders will continue to work together to create workouts and loan modifications. As such, they will continue to hold assets until a more favorable exit environment and as a result will minimize the amount of distressed sales.

Source: CRED IQ

The darlings of real estate investors for the past decade, multifamily and industrial real estate, both currently have ample supply pipelines set to deliver in 2024 and through the end of 2025. These deliveries, which were in response to the strong performance previously experienced, are challenging occupancy and rent growth in the near-term. However, once the new supply comes online through the end of 2025, the supply pipeline for both asset classes will return much closer to their historical norms. Once the near-term headwinds pass by, operators will be in a much more favorable environment given the existing supply and demand fundamentals that made both multifamily and industrial real estate attractive investment opportunities. Investors and lenders alike are reluctant to let go of assets since there are strong long-term fundamentals and will hold onto them for as long as possible to ensure they can realize the upside they believe is possible.

Although record amounts of capital has been allocated to this strategy of acquiring distressed commercial real estate assets, few sales have occurred. This has happened despite a record amount of commercial real estate debt facing a much higher interest rate environment than it was financed in. Owners and lenders are unwilling to let go of any assets right now as they still believe in the long-term upside due to favorable supply and demand dynamics across commercial real estate. To date, they have been able to come to the table and create workouts to extend the maturity date until they can exit in a more favorable market. Until enough pain comes to bear that would force the hand of an owner or lender to give up long-term gain, distressed sales will continue to few and far between.

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