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.