Recent actions by the Federal Reserve Board appear to be on their way to having the intended effect – an economic slowdown, especially in the commercial real estate (CRE) market. The Fed’s Board of Governors has raised the federal funds policy rate by 225 basis points since the first of the year to 2.5% and that rate may reach 3.5% or higher by year end.
Let’s look at some of the national CRE implications of these rate increases before we zero in on what really matters – the Metro Denver market.
Slowdown in Commercial Construction and Transactions
Higher interest rates increase borrowing costs and, therefore, CRE construction project costs. These increases are coming on top of the higher costs already factored in over the past two years related to labor shortages, supply chain bottlenecks, and the cost of building supplies in general.
Developers and lenders seemed willing to accept those previous construction cost challenges given the strong post-pandemic economic rebound and the related strength of the CRE market as late as Q2 of this year (especially in the industrial sector). But the added burden of higher borrowing costs and the onset of a recession have tipped the scales, and commercial projects have quickly become less attractive for both developers and banks.
A Bisnow CRE survey in early August found that real estate industry leaders were taking a short-term “wait and see” approach to their commercial development projects. More than half of the respondents reported putting a project on hold “recently” due to cost increases and general market uncertainty.
Demand for CRE financing for construction projects and property purchases was still quite strong in Q2, due in part to the desire to act before rates increased even further. The situation shifted dramatically, though, beginning in July. As Fed Funds rates rose once more, and a recession seemed very likely, more and more loan applications were pulled back.
The trend may be short-lived though. According to the Mortgage Bankers Association®, while commercial borrowing is expected to drop by nearly $300 billion this year compared to 2021, activity will rebound in 2023, possibly surpassing 2021 levels.
An economic slowdown will be good for CRE buyers.
Increased borrowing costs plus greater uncertainty about future values will dampen CRE price increases that peaked in recent years.
As noted above, increased borrowing costs are one reason contracts are being canceled. Another reason for this, though, is the expectation that better prices and higher CRE investment yields are on the horizon.
Earlier this year we explored the concept of the cap rate spread (the difference between the cap rate of a CRE investment and a benchmark interest rate) and the implications of high and low cap rate spreads. We’re in a period now where those principles explain a lot regarding short term property valuations.
As interest rates increase, the cap rate spread decreases to the point where the risk-adjusted return from that CRE property isn’t likely to outperform a “risk-free” government bond rate by a very wide margin. Thus, investor demand falls and price pressures moderate … a buying opportunity for those taking the long view. And that’s the time horizon where CRE investors should be focusing.
The Denver Market Caveat
CRE markets are not the same across the country; they’re regional and reflect unique, local business conditions for better or worse. Metro Denver is well-positioned to perform better than most markets for a number of reasons, including the continued strength of high-tech industries, the diversified economic base and our skilled labor force.
Thus, a national recession or economic slowdown won’t have as dramatic an impact on the Denver CRE market as it will in other locations. And that means we need to temper all the national economic generalities described above. In other words:
- Local banks in the Front Range are expected to compete for asset-specific CRE business and, therefore, most transactions should reach the Closing table, albeit with a more expensive cost of funds.
- A relatively higher CRE cap rate spread translates to more opportunistic CRE investing by those investors with “dry powder.”
- Sinking your “dry powder” in the stock market instead of CRE investments will incur higher volatility and less cash flow so be prepared to strike even if national pundits are doomsayers.
That’s why we’re still generally bullish long-term on certain assets in the Metro Denver commercial real estate market. Yes, opportunities vary across the region, including between the central city and the suburban corridors. But the market is still conducive to making good deals if and when deals must be made.
Waiting one or two quarters for CRE markets to sort themselves out is a reasonable strategy for investors with patience since even a modest shift toward a buyer’s-market can improve the situation.
Our eyes are locked on Denver real estate market trends and we’re not easily distracted by worrisome national media accounts. If you’re contemplating the purchase or sale of one or more CRE investments, there are good opportunities and proven strategies to follow.
Please contact us and we’d be happy to identify the best opportunities that align with your overall investment strategy.