Cost of Capital Continues to Pressure CRE Values

The high cost of capital continued to pressure commercial real estate (CRE) values in the second quarter of 2023, with office properties seeing the sharpest decline, according to SitusAMC’s latest Current Valuation Insights analysis. SitusAMC anticipates continued deterioration in property values as the quarter plays out, with the retail sector showing the greatest value stability. 

Current Valuation Insights leverages the boots-on-the-ground perspective of SitusAMC’s appraisal and valuation management teams, offering investors real-time market and property-type insights ahead of many traditional CRE data sources.  

A notable trend is that the public CRE markets are implying cap rates significantly higher than those in the private market. Short-term divergence between the public and private markets is common in uncertain environments as REITs are more sensitive to stock-market dynamics. SitusAMC expects a convergence of public and private valuations over the course of 2023.  

Office Valuations Hinge on Stabilized Occupancy 

Overall, the office segment is surprisingly less negative than last quarter, but values are still down considerably, with the market anticipating further declines. Stabilized occupancy has become the true differentiator of office values; about 25% of the value decline is specifically due to stabilized occupancy change. We are seeing large declines in CBD gateway markets and to a lesser extent, suburban Sunbelt markets. 

There has also been a de-risking of cash flows, rate expansion and continued upward pressure on tenant improvement (TI) costs and leasing commissions. Negative adjustments to market rents are occurring in second quarter, particularly in San Francisco, New York and some other gateway markets. Many of these markets have reached the maximum amount of free rent and TIs, so base rent is coming down. West Coast gateway markets are also experiencing extended absorption periods on the existing vacancy.  

Landlords are experiencing extended downtime between office tenants. The pre-Covid-19 downtime of about six to nine months is now nine to 12 months and sometimes as long as 15 months. Renewal probabilities continue to weaken to about 65% currently, compared to 70% to 75% pre-pandemic. Tenants in the sublease market facing lease expirations in the next few years continue to see increases in free rent. 

Stabilized occupancy assumptions need to be challenged in the current office environment and brought closer to what was historically achieved or what can reasonably be achieved into the future. Exceptional-quality properties that have been historically well-leased may continue to have +/-95% stabilized occupancy, but the bulk of the segment will likely need downward adjustments, with a concomitant hit to valuations. 

There is additional scrutiny on weighted average lease terms (WALTs) at properties, with essentially no market for assets under three years. While many sales reflect stress, not all are distressed. The quality of the asset is key; some of the headline distressed sales in San Francisco were almost entirely vacant. It's important to keep this in mind within the context of suggested value/price declines.  

Investors have also made a conscious decision to stop putting additional capital into properties in a challenged office market and are increasingly willing to walk away from properties with debt. Office properties with debt coming due will potentially have material value correction and provide some discovery on an otherwise opaque market. 

However, it is difficult to paint a broad brush across the sector. For long-term leased properties to credit tenants, sellers might be able to get a 6% cap rate on in-place NOI. Some transaction activity has occurred over the past two quarters, but certainly nowhere near the level of sales pre-pandemic. Cap rates on these transactions have come in a little above 7%. Given the uncertainty of growth opportunities in the cash flow and reversion rates, it is unlikely that aggregate cap rates will fall below 6%. 

Industrial Rents Solid in Most Markets and Valuations Flat to Down 

Second-quarter industrial values have been generally flat to slightly down. Demand is strong for assets that have a mark-to-market opportunity in the near term – up to three years. Rental growth has been solid in many markets across the country, especially infill locations, helping offset some material cap-rate expansion. The South Florida Markets, Miami in particular, continue to be red hot, as they have for the last two to three years. Strong rent growth continues from Southern New Jersey to Washington, D.C., especially in the Baltimore area.   

Supply has been a bigger issue this quarter, but given inflationary pressures, especially the cost of materials and labor, future supply is expected to be tight. Strength in the overall sector will likely support high occupancies and continued rent growth. 

The industrial sector will likely see continued write-downs, in spite of the strong and wide growth, because of the variance between contract and market. Given that the first quarter NCREIF NPI-ODCE index showed an implied industrial cap rate of about a 3.2%, it would take years of double-digit rent growth without any value correction to reach a 5% cap rate. In the current interest-rate environment, even the best deals, with consideration to the cost of debt, are pricing toward a 5% cap.  

The tremendous run-up in rent growth over the last two years has made pricing on long WALT industrial deals more ambiguous, but some deals are occurring at a mid-4% cap rate. In general, appraisers are assuming that there will be a mark-to-market opportunity at some point in the future and are adjusting the discount rate accordingly. From a transaction perspective, coupling a longer WALT with a relatively below-market deal creates a tricky dynamic.  

Expansion of Rates Drives Apartment Valuations 

Similar to the industrial sector, apartment values in the second quarter have been flat to slightly down for most assets. Many that have seen larger value declines this quarter may not have been written down as much in previous quarters; assets that have already taken large hits over the past few quarters are more likely to see flat values. Most values are down about 8% to 12% from their peak in 2Q 2022. 

We are seeing rent deceleration. Quarter-over-quarter (QoQ) and year-over-year (YoY) trade-outs are positive but rent growth has slowed. Most markets are now at inflationary rent growth, except those in supply-constrained markets. Even in the few markets enjoying exceptional rent growth, performance is property specific. Market-to-contract spreads are tightening, but not at the same rate as in the first quarter. Second-quarter spreads are being examined more on an asset-by-asset basis based on property performance. Interestingly, assets with parking garages are seeing hefty YoY increases to monthly premiums, especially for urban assets. Few expense changes occurred from the first quarter. Insurance costs continue to be monitored, but there have been generally no industry-wide changes in premiums. 

Phoenix rents have continued to struggle due to oncoming market supply. San Francisco, Portland and Seattle have relatively flat YoY trade-outs and values are down about 14% to 20% from the peak. Dallas trades remain strong and pricing aggressive. Overall pricing in Boston is among the most aggressive in the country, with some trades in the mid-4% range. Deal flow is starting to pick up in many of Boston’s suburban areas. 

From a capital markets perspective, expansion of rates is driving value changes. However, increases to rates are more market- and asset-specific, with appraisers accounting for how much expansion has already occurred. Most of the assets that have seen increases to rates this quarter are those that saw the greatest compression throughout Covid-19.  

There is still some degree of negative leverage. However, many investors are waiting to see if the run-up in rates will revert back to a more normalized level. This is especially true for assets in struggling markets due to an overabundance of supply and/or those located in heavy tech-presence markets that continue to see large numbers of layoffs. 

As buyers and sellers are starting to come together, there has been an uptick in transactions, particularly in aggressively priced markets. Buyers are underwriting smaller spreads between going-in and terminal rates. 

Retail Chugs Along 

Because retail took most of its valuation hits earlier in the pandemic, it is seeing less of a boomerang than other segments; however, second-quarter valuations have been flat to down. Occupancy and leasing activity have been solid with decent market rent growth and positive lease trade-outs. We anticipate some further rate movements, with implied cap rates moving slightly upward.  

Working from home has been good for the neighborhood shopping center. The last few years saw record-breaking retail sales, especially for luxury tenants. While retail sales remain strong, we are starting to see growth trail off, as well as some closures and bankruptcies, including Bed Bath and Beyond, Tuesday Morning and Party City.  

The capital markets are at play in retail. Top-quality mall and grocery-anchored retail are securing financing in the mid-5% range. This is beginning to serve as a floor for where retail valuations need to peg. Recent sales point to a 5.5% to 6.0% cap rate range for quality grocery-anchored centers and a 7% cap rate range for power centers. Lower-quality malls are likely in the 8.5% to 9.0% range.  

Like office, investors are choosing to walk away from deals where debt is coming due because they are unwilling to put more capital into the property. This is true of even large, quality retail properties.