By Nicole AdamsWhen interest, inflation, and cap rates are on the rise, the market creates challenges for commercial real estate operators and investors. As the cost of capital and perceived risk increase, lenders and investors become more cautious and selective.
What differentiates owners and operators that thrive from those who merely cope is a strategy to maintain and build NOI, occupancy, and valuations.
Let’s look at how market conditions impact CRE and what owners can do to force appreciation, obtain financing, and reallocate when the highest and best use of capital dictates.
1. Property owners can no longer ride the market to higher valuations
Due to unique economic conditions, economists aren’t yet calling recession. However, record-high inflation, consistent Funds rate hikes by the Fed, and capital market volatility are disrupting the long run of low borrowing costs, operating expenses, and cap rate compression.
CRE operators in recent years have enjoyed extremely low financing costs and growing valuations as cap rates fell. Now, rising rates, cost of capital, and rate caps are dampening the demand for acquisitions. Consequently, automatic appreciation is no longer working in owners’ favor.
Owners and investors holding adjustable rate loans are facing rising debt payments. Additionally, as materials, utilities, taxes, insurance, and labor costs rise, NOI is taking more work to maintain and build. For the first time since just before the Great Recession, there are signs of negative leverage — a condition that occurs when interest rates exceed rates of return.
Even though cap rates are rising, they’re still relatively low, and the prime rate is already pushing past cap rates, making it more difficult to cash flow and resulting in downward price pressure.
2. Forcing appreciation
The ability to actively influence value is one of the inherent benefits of investing in commercial real estate compared to other assets. Despite economic conditions, owners always have the potential to increase NOI and valuations. Real estate is among the few types of investments where you can take immediate action to drive value creation, whereas market securities restrict you to a passive role.
If you can grow cash flow and reduce risk, you’ll keep appreciation going and maintain a comfortable margin to cover rising debt service and expenses. Experienced real estate professionals, including investment brokers and appraisers, are most qualified to advise you in forced appreciation strategies.
What can you do to support NOI and demand for your properties?
Attract and keep tenants at market lease rates. As demand continues to fall, inventories will rise, and it’ll be harder to keep spaces occupied and new leases rolling in. You can establish a competitive advantage in the local leasing market by offering the best amenities, top condition, and an excellent experience for tenants.
To ensure you go in the right direction with improvements, listen to the needs and feedback of tenants to identify what is genuinely valuable and will drive demand. At heart, CRE is a service industry, and tenants are your customers — they’re always right!
Futhermore, lean on the insights of professionals with experience in your market and high and low market cycles to develop an improvement plan that yields the best ROI.
Technology is also an indispensable catalyst of value creation and efficiency in commercial real estate. Consider offering a tenant portal that creates user value by facilitating communication with property management staff, automating rent collections and maintenance requests, and encouraging social engagement between tenants and staff.
3. Optimizing operating costs
Operating expenses are a principal variable in the calculation of NOI; therefore, the most important thing you can do to force appreciation is run lean and increase your spread.
Property management (PM) expenses and efficiency are a good place to start. Owners often rely on frontline PM staff to oversee the operations of properties. And depending on the geographic makeup of your portfolios, one PM firm may be managing and influencing the performance of a group of your assets.
A decision that has cost implications is whether to manage properties with an in-house team or contract a third-party management company. It’s worthwhile to run a cost comparison between the two approaches and request the input of a trusted advisor with connections in your market.
If you’re leveraging on-site and cloud-based technology to its fullest (i.e., automated/AI-powered systems to manage and monitor energy/water consumption, rent collections, maintenance requests, security, etc.), the reduced personnel and utility costs may make self-management more cost-effective than hiring an outside company. Tech considerations are also apt criteria on which to evaluate a PM firm.
The next high-level consideration is sustainable design and operations. For new builds, it’s crucial to design with energy and water efficiency in mind. Fortunately, most planning jurisdictions already require that you build to a minimum efficiency level; however, going the extra mile in sustainable design per green building standards such as LEED ensures peak efficiency and savings.
For existing buildings, the investment in energy-efficient systems and sustainable materials when renovating has a payback period of 1-4 years (sometimes longer) and results in up to 90% operational savings over the asset’s lifecycle.
Building or renovating green also enhances the marketability and demand for your asset and is congruent with the prevalent ESG expectations of investors and tenants. Moreover, sustainable building materials are more durable, resulting in lower Capex throughout the life of the property.
The cumulative effect of savings across these factors is a minimized risk profile that enhances appeal to lenders and investors, as well as operational efficiency that attracts exposure- and spend-averse tenants.
4. Financing and reallocation strategies
As you consider long-term expense optimization, what becomes apparent is reworking your PM strategy, implementing tech, and renovating for efficiency all require capital. Given the cost of capital is increasing, you may face a funding dilemma if you don’t have the liquidity, i.e. cash flow or reserves, to bankroll these initiatives internally.
The choice here is between debt and equity financing. Either can be appropriate depending on the interest rate or rate of return offered/projected. With the Fed’s monetary policy tightening and interest rate caps increasing, equity may be favorable — if you can demonstrate to investors the logic and feasibility of optimization plans and how they’ll support NOI and occupancy.
A traditional refi, cash-out, and repositioning strategy can also work if you show that you won’t be negatively leveraged once the improvements and optimizations are complete.
After all considerations, cost/benefit analyses, and advisory input, the numbers may not make sense. This could be the case if asset demand is falling, population and income are declining, or other micro/macroeconomic factors restrict or reverse growth.
When this is the situation, selling or exchanging the asset and reallocating capital to assets and markets with greater potential upside could be the best strategic move for the long term. When appropriate for your investing strategy and the economy, and with the guidance of your broker, seek opportunities that offer plenty of equity and cash-flow margin to make improvements, service debt, weather recession, and position for optimal demand.
Engineering for efficiency and appeal
We could be in for a tough time as market conditions unfold post-pandemic. Yes, inflation is high, and rates are volatile. Still, owners and operators that re-engineer their portfolios for maximum appeal and efficiency will continue to produce increasing NOI and top valuations. Take the long view and stay the course. No matter what the economic environment, there are deals to be done and margins to be made — when the strategy is sound, and the numbers make sense.
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