Facing High Inflation, Commercial Real Estate Investors Reevaluate Their Strategies

Chief Investment Goal Becomes Strong Income Through Occupancy Instead of Price Appreciation, Analysts Say

By Mark Heschmeyer CoStar News June 8, 2022 | 1:36 P.M.

Real estate investors appear to be changing what they’re buying in a market hit by the highest inflation in more than 40 years and the economic fallout from Russia’s invasion of Ukraine. Income through occupancy is in favor while risk is avoided, at least for now.

A clear reevaluation of investor strategies showed up in CoStar Group’s sales data for May. There are some distinct differences between what was bought last month and what was purchased back in February, before the war in Ukraine and the Federal Reserve’s increases to borrowing rates in an attempt to control inflation.

The occupancy of properties picked up in May were notably higher across every property type except for hospitality. And investment yields in the form of capitalization rates were noticeably lower in May, except for offices. Average sales prices per square foot, unit or room were substantially higher in May, again except for offices, which are suffering in tandem with hotels from reduced use by businesses.

The numbers indicate that investors were willing to pay more for performing properties with the potential for higher revenue in May than what was occurring before market dynamics changed in March, market analysts told CoStar News.

The distinction between the two months is important, according to Aaron Jodka, national director of capital markets research for Colliers. February deals were negotiated and agreed to at the beginning of the year, or even at the end of 2021, he said in an email to CoStar News. May, June and July transactions will be more representative of higher borrowing costs and any changed macroeconomic outlooks.

“The reevaluation is mostly a result of higher borrowing costs,” Jodka said. “At a macro level, the interest rates themselves are not a problem. They are similar to levels seen in 2018. The challenge has been the pace at which they have adjusted.”

Regarding the move to acquiring higher-occupancy properties, Jodka said that predictable cash flows are always attractive to certain investors and show that long-term leased deals are in high demand. However, when investors will realize returns on their latest purchases will come down to how much time is remaining on the lease terms of tenants in the newly purchased properties. Leases that expire soon mean a chance to boost rents.

“A property with a high occupancy level, but short-term lease expirations, particularly in industrial, offer substantial rent upside” for owners, he said. “Industrial rent growth has been so strong, so there is an opportunity to see massive rent adjustments. Those assets are being priced differently than a long-term leased asset where owners will not be able to get to the rent rolls for many years to come.” CoStar data shows that industrial properties acquired in May were 93.8% occupied versus 90.5% in February; capitalization rates were 4.5% in May versus 4.8% in February; and the average sale price per square foot was $157 in May versus $115 in February. Income Over AppreciationThe focus on income over higher property prices is a shift from what the capital markets were showing in 2021 and early this year, Lauro Ferroni, head of U.S. capital markets research at JLL, told CoStar News in an email. Then, two-thirds of value increases were driven by the abundant availability of money at record-low interest rates. However, volatility and risk have now become more elevated as investors grapple with the impact and scale of inflation and rising interest rates, which is making some companies shift their spending strategies.

When the interest rate on a mortgage rises to the point where landlords could make less money on the assets than the banks, despite carrying the higher risk, that's when negative leverage occurs. Rents can be boosted to counteract negative leverage, and landlords are doing just that, Ferroni said. “Rising borrowing costs have resulted in negative leverage for the lowest cap rate sectors in many instances — notably the industrial and multi-housing sectors,” Ferroni said. “As such, there is an increased focus on income growth.”

A strong labor force, with low unemployment and elevated wage growth, has combined with higher home prices to make homeownership less affordable. That is all contributing to a very strong rental market, Ferroni said.

“Lease trade-outs are as high as 15% to 30% across many markets, and investors continue to underwrite robust rent growth projections,” he said. “For value-add investments, the rent boosts tend to be the greatest, so this is an area where investors’ focus on income growth is manifesting itself.” According to CoStar data, multifamily properties acquired in May were 98.3% occupied versus 95% in February; cap rates were 3.9% in May versus 4.2% in February; and the average sale price per unit was $281,853 in May versus $232,023 in February. Office UncertaintyAbby Corbett, managing director and senior economist at CoStar Group, said the evolution of the investment landscape since February stems from the accumulation of uncertainties surrounding fundamentals and income prospects for each property type.

“In office, we see the most distinct shift in key capital markets statistics; investors are adjusting their targets largely as a result of the continued recognition that the widely expected and broad return to office has not fully transpired,” Corbett said. “We’re still dealing with a significant wall of available sublet space, which will need to be worked through to ultimately shore up fundamentals.”

Office purchase volumes were down in May, $4.5 billion versus $6.2 billion in February, according to CoStar data. Sales were taking longer to close, 14.6 months versus 10 months, in a look at the same comparative period. And pricing was down, $301 per square foot on average versus $333 in February. However, Corbett said, “We’re seeing investors gravitate toward higher-quality office targets.” That dynamic is reflected in the higher average sale price per building being bought, $39.2 million in May versus $34.6 million in February, and the higher occupancy rates at the time of sale, 89.4% versus 81.8%.

Boston Properties paid $730 million in May for the Madison Centre in Seattle, CoStar data shows. It was the largest office deal of the month, and the property’s occupancy of 93% at closing reflects a preference investors are exhibiting nationwide.

“The shifts in capital markets are occurring as investors sift through a combination of risks and given the comparative strength of the other sectors — industrial, multifamily and even certain segments of retail,” Corbett said. “The shifts in investment activity show that investors are remaining diligent in deploying capital to areas with relatively more medium- and long-term clarity.”

Office fundamentals are important to how investors view hotel properties, according to Jan Freitag, national director of hospitality analytics for CoStar Group. As offices remain closed or open only intermittently, business travel to those offices is still affected. “The lack of certainty of return-to-office has a direct influence on the value perception of hotels that cater to business travelers,” Freitag said.

Investor appetite for hotels in May favored higher-priced properties than in February. The average property sale price was $29.6 million in May versus $21.9 million in February. The average sale price per room was much higher, $244,741 in May, almost $100,000 more per room than in February. “There is a continued bifurcation of investor appetite for high-end resorts versus urban, full-service hotels. Continued strong leisure customer demand has supported very strong rate growth on the upper end and that has kept investors very interested,” Freitag said. “Interest is fueled by hotels being seen as an inflation hedge since rooms can be repriced nightly, allowing for quicker price growth in high-cost times.”

Whether the trends hold going forward depends on how quickly certainty returns to the market, analysts said. One thing that does seem likely, according to Colliers’ Jodka, is that last year’s record high property sales will become more challenging to beat as investors need to bring more money to the deal as interest rates rise. Despite that, and the fact that some investors have become more selective, capital is still readily available to complete deals.