July 06, 2023
In the ever-changing world of real estate investing, it is crucial for investors and advisors to stay informed on the latest trends, risks and opportunities. There are four key themes to be aware of in the current commercial real estate market: fundamentals, valuations and capitalization (cap) rates, the capital stack and considerations for investing in real estate.
Fundamentals
Overall, the state of the real estate market is similar in both Canada and the United States, characterized by a continued shortage of housing. There are, however, some notable differences between the two countries. In Canada, there is a more disciplined immigration system, which affects population growth and housing demand. On the other hand, in the U.S., domestic migration from northern to southern regions is prevalent, while international immigration is comparatively lower.
When considering property sectors, investors should focus on the current reality on the ground rather than news headlines. Markets in key regions are gaining strength, and there are many opportunities, particularly in the Sunbelt states. However, it is important to note that profitability and potential returns may not match previous cycles. The environment has shifted, and while there is an opportunity for healthy returns, they may not be at the same level as in previous years. This is the cycle of the market.
It is most important for real estate investors to look at specific sectors independently. Multi-family is currently the asset class that is performing the best overall. According to Moody’s Analytics, as of the end of 2022, multi-family vacancies were at 4.4%—a five-year low. In the changing environment, there may be cost increases, but multi-family owners and investors are able to adjust rents annually—sometimes even monthly—to account for market changes.
Office investments recently have seen rising cap rates, particularly in suburban and class-B properties due to lower demand. Investors should remain vigilant in assessing the risks associated with lease exposures and refinancing in the office market. Office spaces are experiencing increasingly high vacancy rates, which have made office-to-multi-family (OTM) conversions a popular topic, but the execution is still rare and not likely to impact either sector significantly. Over the past 20 years, OTM conversions have made up only 1% of multi-family deliveries, according to CBRE. There are many factors to conversions such as construction costs and residential construction regulations. Office spaces might see some conversions on smaller, older properties in markets with exceptionally high multi-family demand, but the impact on the overall market is projected to be minimal.
Slower Gross Domestic Product Growth (GDP) is projected as monetary policy continues to tighten and global economies adapt to inflation. Commercial real estate has a cyclical nature and prepared lenders, asset managers and investors will have an opportunity to grow their portfolios at a lower cost.
Valuations and Cap Rates
Investors’ concerns about the next several years are not unfounded. We have witnessed interest spreads widening and cap rates increasing in the real estate market across North America. Various factors contribute to this, such as increasing interest rate environments.
Real estate asset values naturally fall when interest rates rise, and tighter financial conditions hinder economic activity. Since bottoming in early 2022, cap rates are up by approximately 100 basis points (bps) across all property types, translating to a 10% to 15% decline in values.
It is important to note, however, that the pace of cap rate increases has slowed considerably. In the first quarter of 2023, according to CBRE, in Canada, the national average all-properties cap rate rose marginally by only 10 bps to 6.12%, a small change compared to the increases experienced in 2022.
Capital Stack
The lending environment has recently undergone significant changes as well, impacting developers and their ability to secure financing. Regional banks have pulled back and are demanding deposits due to having limited the availability of credit for real estate investors. As a result, developers now require more equity, face lower loan-to-value (LTV) ratios and contend with higher prime interest rates. Some developers are exploring options such as mezzanine financing or second liens, while alternative and private lenders are stepping in to fill the gap left by traditional lenders.
Investing in Real Estate in 2023 will Benefit Investors
Real estate continues to be an attractive investment option and a great diversification play for investors’ portfolios. Real estate pricing adjusted considerably in some markets in 2022 and this repricing is likely to continue into early 2023. The good news is that there is still a significant amount of capital sitting on the sidelines and, as with any period of adjustment, investment opportunities continue to arise.
Throughout 2023, it is likely that the volatility of debt costs will ease, the current phase of price discovery will pass, and more certainty will enter the market as underwriting becomes clearer.
For investment advisors, focusing on residential properties in high-growth markets may be a valuable strategy. Trez Capital continues to identify and invest in high-quality opportunities, especially in residential in high-growth cities, with recent focus, particularly in the Sunbelt states such as Texas, Arizona, and Florida. We have boots-on-the-ground and strong relationships with first-class borrowers and developers. Our expertise in the key market locations we invest in ensures that we can provide unique insights and opportunities to our investors.
Optimism and Opportunity
At Trez Capital, we acknowledge the challenges posed by the current lending environment. With the decrease in LTV ratios and higher prime interest rates, especially with equity projects, developers are facing hurdles. Trez Capital, however, views this market shift as positive, as it allows us to identify unique opportunities and provide creative financing solutions to developers and property owners. With our debt funds, we see positive indicators with higher interest rates, as seen with our continued distribution rate increases to our investors. We continue to home in on opportunities for our investors, raise and deploy capital and evaluate lending and development opportunities all while remaining mindful of liquidity concerns.
Trez Capital maintains a conservative yet optimistic outlook on commercial real estate investing. With our extensive experience, deep market knowledge and strong relationships, we have navigated market cycles over the last 25 years successfully. While risks exist, opportunities exist. It will always be important to maintain real estate exposure in portfolios, particularly in regions with high job and population increases, for diversification and to protect against inflation.
Information presented in this material is information purposes only and does not constitute an offer to buy or sell in any jurisdiction. This information must not be relied upon in making any investment decision. Trez Capital cannot be held responsible for any type of loss incurred by applying any of the information presented. Past performance is not indicative of future performance and cannot be solely relied upon. Trez Capital does not assume responsibility to update any of the information. Trez Capital cannot guarantee the completeness and accuracy of third party information it may use. This material cannot be distributed, altered or communicated without the prior written consent of Trez Capital.