Historic data shows commercial real estate (CRE) is still a viable investment asset class, but in today’s ambiguous market, investors may need to adjust their strategies.

The following guest article comes from Drew Reynolds, who is the chief investment officer of Realized, a real estate wealthtech firm providing investment property wealth management for investors. We have published articles from this US-based business before (see here). The editors are glad to share these insights; the usual editorial disclaimers apply. To jump into the debate, email tom.burroughes@wealthbriefing.com

Warren Buffet once remarked, “Interest rates are to asset prices like gravity is to the apple.” There is some truth in this, hence why many commercial real estate (CRE) investors are nervous as the US Federal Reserve continues to raise rates. But it’s important to remember that the long run we’ve had with low-interest rates (and cheap financing) isn’t the norm.

Interest rates are rising, yes, but they’re also returning to pre-pandemic levels. In fact, current interest rates are not that extravagant compared to their historic counterparts. Investors who study fundamentals to manage risk and reward, rather than relying on low-cost capital, can continue to find ample gains over the long-term when investing in CRE. 

History speaks for itself
For reassurance that the current market is likely normalizing and not crashing, one need only look to history. In the fourth quarter of 2022, 10-year Treasury rates shot up to over 4.0 per cent for the first time since 2010. However, for 44 consecutive years, from 1963 to 2007, the 10-year T-bill rate averaged over 4.0 per cent every year.

Investors can reference residential mortgage rates for another comparison. Though 30-year mortgage rates recently climbed to over 7.0 per cent, the long-term average interest rate since 1971 was 7.75 per cent. In 2006 and 2007, when the housing market was particularly robust, mortgage rates were around 6.5 per cent. And in the 1990s, during a relatively steady investment and real estate market, mortgage rates danced around 8.0 per cent.

According to Green Street’s Commercial Price Index, private real estate values have experienced a lot of spikes and valleys in recent years. But March 2023 values are comparable overall to those in May 2019 and May 2021. While on-paper real estate values have slipped, investors who haven’t over-leveraged themselves or who are not facing maturing debt should still find themselves in a solid spot for long-term gains. Rising interest rates alone aren’t going to make or break the real estate market.

Understanding the new market
The lack of both lending and purchasing transactions in recent months has reduced prevailing market data, which is contributing to the current uncertainty. That, in turn, makes it difficult for investors to plan or even extend an offer on a property. And variables like continued Fed-induced interest rate hikes that are impacting lenders’ ability to quote rates doesn’t help either.

The market is in the midst of reversing a 40-year downward trend in cost of capital. So, in general, for the last four decades, investors have been exiting investments at a lower interest rate than when they acquired the assets. This resulted in subsequent real estate or equity buyers utilizing a lower cost of capital than the previous buyer, in turn driving up pricing via lower capitalization rates and higher equity multiples. In this kind of investment environment, a marginally performing or even underperforming property could still yield a positive return simply because the new buyer could afford to pay more due to a lower cost of capital.

For example, if an investor purchased stock earning $100 at a 10x multiple for $1,000 and assumes those earnings will increase to $120 over the course of five years, they can anticipate selling that same stock for $1,200. However, if those earnings only increase to $110, an investor has theoretically overpaid because the stock’s performance didn’t match expectations. Of course, if the price-to-earning (P/E) ratio increased to 11 x because of lower capital costs, the investor could sell at $1,210, resulting in overperformance relative to projections, even though the investor missed the mark on earnings projections.

In short, investors have settled into a comfort zone of “financial buying,” or purchasing investments partially based on inexpensive capital, but now the market is reverting back to one where fundamentals are everything. This will require investors to adjust their strategies, especially with the current market uncertainty.

Investing in the current market
With the costs of capital ticking upward and returning to historic norms, it will be key for investors to get back to the basics of investing. That means investors need to keep in mind that cap rates are far more correlated to the availability of capital rather than the cost of capital. A study by Peter Linneman, PhD, and Matt Larriva found the key determinant of cap rates is the supply of funds. While a lender may want to extend funds, they won’t do so if market conditions seem volatile. That means capital is only available if a lender is confident about a subject property’s underlying fundamentals.

For a greater promise of long-term returns, CRE investors need to go back to the foundational practices of sound investing:

-- Conducting detailed initial analysis and due diligence. When analyzing a potential property investment, an investor can review the leases to determine if cash flow projections match the contractual terms; 
-- Developing a solid plan for risk assessment and management. Investors can identify potential risks pertaining to a deal and develop a plan to manage those issues should they arise; 
-- Looking at the supply-and-demand balance. If a CRE asset class currently has substantial market supply, it may be more lucrative to invest elsewhere; 
-- Evaluating Sponsors thoroughly. Ensuring the Sponsor of any CRE investment opportunity is one who has plenty of experience and success with past investments is critical; 
-- Appraising the staying power of the asset. Buyers need to analyze investments to ensure they’ll hold value for the long term; and 
-- Establishing strong operations to potentially achieve target earnings or net operating income. Conducting thorough, upfront due diligence can help an investor develop successful systems, procedures, and budgets.

Assessing and managing risk is complex. That’s why it’s important for CRE investors to work with experienced advisers who can help them evaluate deals and capitalization rates to determine a CRE investment opportunity’s true profitability. But ascertaining a real estate investment’s potential return can vary by product. For example, residential housing in the US has more demand than supply right now, but if buyers can’t afford to purchase, they opt for a multifamily rental option, which raises rents and increases earnings.

In the retail and industrial realm, consumer spending remains strong, sustaining steady online purchases. That helps maintain profitability for distribution facilities. But it won’t keep going like this forever, so there’s a risk of overpaying. Lodging facilities, on the other hand, can handle an inflationary environment because they can adjust their prices daily. However, if labor costs continue to rise, that could also cause issues in this sector.

No investment is fool proof, hence the criticality of evaluating a property for strong underlying fundamentals. As inflationary pressures subside in the next year or two, CRE will likely enjoy a broadly supportive macroeconomic environment. It’s also important to keep in mind that real estate has historically remained one of the strongest alternative investments available, regardless of the economic climate.

Investors can rest assured that lenders will eventually re-enter the market. Then things will begin to trade on a more normalized level, further defining this new market. In fact, many economists expect we will experience a significant uptick in transaction activity during the latter part of 2023.  

Interest rates in and of themselves are not the biggest determining factor in investment success. As Buffett also said, “Successful investing takes time, discipline, and patience.” Investors are now experiencing a market that requires ample planning, research, and equanimity. Gone are the days of historically low-interest rates that once offered safety nets for inexperienced investors. In today’s investing environment, due diligence and experience are paramount.

Full disclosure. The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.

About the author

Drew Reynolds is chief investment officer and head of research at Realized, a real estate wealthtech firm that provides Investment Property Wealth Management® for investors.