The definition of simplicity is as follows: The state of being simple, uncomplicated, or uncompounded.
Here at RanchHarbor, we spend our days (and sometimes nights) managing the execution of business plans on our existing assets and diligently evaluating new real estate investment opportunities in the small-cap, value-add segment of the real estate market. In both our asset management and acquisition efforts, we are constantly assessing situations and trying to ‘simplify’ them to develop a sound business plan that executes our investment thesis or justifies acquiring a new deal. We strive to turn complexity into simplicity.
Today’s complex issue is simple – it is the CAPITAL MARKETS. Nothing is more complex or impactful in commercial real estate than the capital markets. However, as investors, we are firm believers that everything can be broken down into simple terms which in turn leads to better decision making.
In this summer edition of our investment outlook, we utilize a number of charts and datapoints to illustrate the ‘Simplicity’ of the primary issue in the current real estate capital market environment – the flow of capital to real estate on all levels has slowed dramatically.
Interest Rates go up, prices go down.
Fed narrative suggests that rates will remain elevated in 2023. When it comes to real estate valuation, higher interest rates take money from the borrower’s cash flow and put it in the lender’s pocket. Simply put: the price investors or buyers are willing to pay goes down due to lower cash flow resulting from higher interest expenses.
This decline in value is clearly illustrated below in the Commercial Property Price Index from Green Street. We include the specific sectors where we focus: multifamily, industrial and storage. The ‘Recent Peak’ is March 2022. The index value is the change in property prices (100 = 2007 peak).
At the expense of being ‘Captain Obvious’ (by now, we all know asset prices have declined), it is important to show the impact that higher rates have had across all real estate asset classes. No one is immune to this, although the industrial sector has been holding its own on a relative basis.
Attractive yields in money market funds and US T-Bills.
Flight of funds from bank deposits. Depositors are taking funds traditionally held on deposit with banks and investing idle capital into short-term money market funds and US Treasury Bills due to higher yields available in these short-term securities.
Given the yields shown above, it is no surprise investors have been seeking these safe havens. The chart below further illustrates the dramatic flight of capital from bank deposits to money market funds in particular.
The ‘knock-on’ effect of this phenomenon is far-reaching. Keeping it in simple terms, the ‘deposit flight’ naturally restricts the ability and willingness for banks to make new loans. And the attractive yields in short-term securities keep investors from deploying capital into real estate opportunities. Given the decline in property values and interest rate uncertainty, why wouldn’t an investor park capital in the short- term that can earn 5% (low-risk) until there is more clarity in the real estate markets?
Real Estate debt availability has declined.
Lenders aren’t lending aggressively. As a bank loses deposits, it needs to find alternative sources of funding to make loans which constrains credit availability. This circumstance is compounded by the impact higher interest rates are having on property valuations across all asset classes. Impending loan maturities over the next 18 – 24 months further compound the impact as many real estate investors will be having to refinance at much higher interest rates. There is a lot of complexity to the current lending environment, however, the simple conclusion is that credit flows have decreased substantially.
Real Estate fundraising and buying power is down.
Fundraising and Buying Power Decline. Real estate private equity investors are concerned about the current volatility in the capital markets; therefore, they are less inclined to invest in private real estate opportunities. They find it much safer to invest in short-term, low-risk treasuries or money market funds until economic volatility subsides. Investors are happy to take a risk-free 5% yield over a 5% illiquid real estate yield even with potential appreciation of an asset. The data and charts below illustrate the significant decline in real estate fundraising and corresponding buying power across real estate asset classes.
The relationship is simple: Private investors want yield, price stability and liquidity. It is evident that equity investors are taking a ‘risk-off’ position and waiting until there is more stability in interest rates, cap rates, and availability of debt. The net result: less equity flowing into commercial real estate.
Real Estate transaction volume has declined dramatically.
Deals aren’t getting done. In a rising interest rate environment, it is difficult to discern relative value. Determining the proper cap rate is one of the primary issues – at times, it feels impossible to establish conviction around exit cap rate assumptions. Furthermore, given the sharp decline in valuations, sellers and buyers maintain different views on value – the stalemate has ensued, and the flow of transactions has decreased. Here at RanchHarbor, we continue to underwrite new opportunities, but consistently find a 10-15% delta between our valuation and where a seller is willing to transact. As evidenced below, real estate transaction flow has slowed substantially.
The chart below drives home the point that no market is immune to what is happening in real estate transaction volume across the county.
Back to Simplicity
While the capital markets are incredibly complex, in this outlook we simplify current conditions and capital flows by focusing on the key influencing factors as summarized in ‘Simplicity Scorecard’ below.
Our simple and uncomplicated thoughts on the back half of 2023.
- Interest rates will remain elevated in 2023.
- Attractive short-term yields will continue to provide a safe haven and reduce capital flows to CRE.
- Debt availability will be exacerbated by upcoming loan maturities.
- Equity fundraising and buying power will remain challenging.
- Transaction activity will remain muted.
The obvious question is what will change these conditions and improve capital flows?
Our thoughts are simple:
- The Fed controls inflation and stops raising rates.
- Yields on commercial real estate need to offer a premium to safe haven short-term yields.
- Confidence in projecting exit cap rates.
While the market is currently in a state of flux, we believe opportunity is on the horizon and will arrive sooner than most people think.
At RanchHarbor, we will continue to focus on the asset classes that we believe are the ‘Real Estate Essentials’: Multifamily, Industrial and Storage. People always need shelter; companies need warehouse and distribution space, and we all need a place to store stuff … especially RVs and boats!
Have a great rest of the Summer!
The RanchHarbor Investment Team
RanchHarbor is a real estate investment firm based in Newport Beach, Calif., focused on investing in small-cap, value-add opportunities in the multifamily, industrial and storage sectors. RanchHarbor provides joint venture equity, general partner co-invest equity and invests directly in real estate. Target equity investments range between $2 million and $10 million in select U.S. markets. The firm also provides sophisticated asset management services to its institutional and private investors and operating partners. Since its founding in 2012, RanchHarbor (formerly Isles Ranch Partners) has closed on 50 investments, managing over $650 million of equity capital. In 2020, the firm shifted its focus to investing in value-add real estate. For more information, visit ranchharbor.com. Follow the company on LinkedIn.