Can real estate investors sustain growth in the current market and looking ahead?

This Q&A was published as part of PitchBook's H1 2022 Global Real Estate Report sponsored by Baker Tilly.

The biggest question at the moment is where the market and economy are going. While we anticipate where we are headed, there is a different outlook for every area of real estate. Our real estate professionals analyze the current state of the market and forecast each service need now and moving forward.

What are your thoughts on the current real estate market, and where do you see things heading in 2022?

While the cost of capital is increasing, a large supply of capital is also chasing opportunities, looking for yield. Where this capital gets deployed depends on where interest rates go, whether we enter a recession, and, if so, whether it will be a V or U-shaped recession. The outlook is different for every type of real estate.

The office market, for example, has not been resolved. People are largely working from home versus going back to an office. Many investors are pursuing necessity-based retail opportunities, but if we fall into a recession, how will that impact an industry that depends on disposable income?

Clients investing in lodging are seeing some softening in the market but not a sharp downturn.

With industrial real estate, downside predictions include stagnating market rent growth or plateauing—or at least slowing—value growth.

Even though the immediate multifamily outlook is favorable, if there is a deep and drawn out recession, household formation will likely decrease as will the number of households. Historical trends say people will double up on housing or move back with their parents. Rising interest rates, however, may help multifamily because rising rates make home ownership prohibitive for many people, forcing them to rent instead of buy in the near term.

Another change related to multifamily is location. Pre-pandemic, the suburbs were not as desirable, except for those with easy access to downtown via mass transit. Now, things have shifted. The suburbs are in demand as people are hesitant to go downtown. In some cities, we will likely see the office space repositioned as residential units or other alternate uses as a result of companies not needing the same space they did three years ago.

What questions or concerns are your clients raising at the moment? How are you advising them?

Deal flow is top of mind as well as opportunities to deploy committed capital. Many clients who were focused in a particular geography or property type are refocusing, for example, from urban office space to industrial or exploring new geographies. Everyone is trying to anticipate where the market and the economy are going.

Also, a lender’s idea of value right now is far different from equity holders’, so matching that up is tricky. When an equity investor is selling a piece of real estate, they have a buyer, but when the buyer goes for a loan, the pricing may not match because lenders don’t always agree with the valuation. Deals will always get done, but it’s getting harder because yields don’t always match up. Valuation is more important and challenging than ever with variables moving in different directions at different paces.

Do you believe inflation or looming interest rate increases are starting to show up in investment levels?

Simply put, if interest rates go up, pricing for real estate assets goes down. If pricing pulls back, the only way to make the math work is to increase the operating performance of a real estate asset and lower return expectations. Recently, we’ve seen deals fall apart or be delayed because the cost of debt increased to the point where it didn’t meet return expectations or couldn’t get through bank underwriting. This is especially true in the office sector, where underwriting is more speculative and not as transparent.

How high can rents go? How low can operating costs go? If debt costs 6%, but we’re paying a 4% cap rate for a multifamily asset, the math doesn’t work unless you can increase operating performance, or if cap rates compress, neither of which is the case. Conversely, some large private equity (PE) funds can hold real estate assets for the long term. There’s a lot of money chasing US real estate, so some funds are willing to make those deals knowing they can hold property through a down cycle.

Also, because interest rates are high, we will likely see property owners get creative to improve performance and generate more income, such as adding experiential retail rather than just increasing rents. Another challenge is the poor performance of equity markets, which has driven up bond yields, pushing investors toward safer investments, such as bonds. Because equities decreased, investors may find themselves over-allocated into real estate, potentially forcing them to divest real estate positions at prices lower than they would like to get their balance back in order.

How have project life cycles changed over the past few years?

Developers are still having issues with underwriting deals, as projects take longer to complete largely because of supply chain and labor challenges. So a project they thought would be done six months ago may be extended several months. With increasing interest rates and construction costs, a project that looked good on paper 12 months ago may not in today’s environment.

Many investor decisions will be based on where they are in the debt life cycle. Someone looking to refinance tomorrow or in six months will experience much different pricing than they would have a year ago. Certain buyers with capital will have interesting opportunities because investors for whom refinance options are not attractive or obtainable will have to sell. If someone has long-term, fixed-rate debt maturing in 10 years, these uncertain times are just a small hiccup.

Have you seen increased focus on environmental, social, and governance (ESG) initiatives from your clients?

Yes. Our clients want to be good stewards of each of those initiatives. The environmental piece is most relevant to our business and ability to assist clients in achieving their goals. When it comes to target properties, clients are interested in equipment and whether they are adding solar or highly efficient HVAC units, lighting, windows, doors, etc. This doesn’t necessarily affect the underwriting on every investment we’re seeing, but more sophisticated investors are adding environmental concerns to their underwriting as a differentiator. If we do enter a recession, firms will look for efficiency advantages, and many of these environmental initiatives will help the bottom line after their initial capital cost.

That said, not only are real estate organizations incorporating ESG into their businesses, but investors are as well. So, an investor that incorporates ESG elements into their business will be attracted to a real estate owner or developer that does the same.

For commercial properties, has the recovery from peak pandemic vacancies progressed as expected?

At the beginning of the pandemic, investors were trying to determine what was expected. The vacancy impact in the retail and industrial sectors was accelerated from a trend that started pre-pandemic, while the impact on office and lodging was unexpected at the very beginning of the pandemic. Lodging has experienced a recovery of sorts but has work to do. Investors are taking a hard look at lodging. Multifamily will continue to see vacancies that are below the historical average given the national housing shortage—unless we experience a deep recession. Office vacancies are difficult to assess given the work-from-home shift and employees’ reluctance to return to the office. A recession could move the pendulum to employers, however, so we may see employees return to the office.

Which service areas are seeing the most traction recently? In which areas do you expect to see a rise in activity in the next few years?

Our valuation team has been busy assisting investors and owners with underwriting transactions and evaluating portfolio value for various reasons. Many situations are driven by tax changes circulating Congress; others are driven by the markets and difficulty in determining today’s value.

For more information on this topic, or learn how Baker Tilly specialists can help, contact our team.