Fall 2022 - We Are Entering A New Era

Like furniture that was ordered 5 months ago from Pottery Barn, investment markets are moving, we just don’t know when they will arrive at their destination. They may be sitting in a shipping container at a port somewhere, they may be on a truck, the people who work at Pottery Barn cannot even tell me when the furniture will arrive, just that it will. It’s frustrating just like our Fed created inevitable recession that has been in the cards now for a few months now.

Inflation started to spike more than a year ago now, the Fed said it was transitory. Anyone who was working in real estate development could see it was anything but. Today like that furniture order from Pottery Barn, the markets expect a recession to arrive, we just don’t know when. Construction costs are through the roof, interest rates are up 300 basis points+, and capital markets are a mess. Inflation continues to burn hot with September Core CPI at 6.6%, the highest since 1982. Rents continue to climb in some markets, while having flattened in others across the U.S. Cap rates for commercial real estate and multifamily have been flat to rising, with expected rising cap rates over the next 6-24 months.

What does all this mean for investments opportunities? Where should you put your money? Well if you own investment real estate you should hold onto it. Rising rents will only continue to improve your cash flows, though your exit becomes less clear as cap rates rise. As recently as last year many real estate investment pro forma were underwriting annual cash on cash returns as low as 3% due to high costs, and high returns on an IRR basis due to low cap rates allowing large exit sales prices. Now rents are rising faster than conservative underwriting. Over the past few years for either multifamily or industrial we were underwriting rent increases of 2-3%. In some cases, such as in Tampa multifamily has grown by as much as 9% per year over the past 3 years.

While we do not expect 9% rent increases to continue, they will be higher than originally anticipated by many investors. Of course with higher rents and inflation comes higher operating costs, such as for property management staff, maintenance staff, electricity and other utility costs. But generally, from what we have seen, rent increases have outpaced operating expense increases to date.

Now if you were underwriting for a big exit you better find a buyer fast. Though if you are selling to institutions or using institutional debt, you might be too late. A recent conversation with a well known broker in the multifamily space yielded the comment that “institutions are no longer transacting and they are waiting for capital markets to settle. While high net worth families and private investors are still buying and selling.”

Conclusion - Hold onto any existing cash flowing real estate and enjoy the rent increases. If you have a property that can be sold at the right price sell it now. That might be easier said than done though.

Other investments to consider include a “molecules instead of bits” approach to hard assets instead of technology and software which has been the biggest beneficiary of low interest rates over the past 12 years. These alternative investments include - commodities such as oil and gas, pipeline and refining companies, and metals. Bonds are also beginning to be a good alternative to real estate, with a risk free return at 2 years returning 4.4% that starts to look pretty attractive when your annual cash on cash return is 3.5% on commercial property. Private debt is another good alternative now with some opportunities yielding upwards of 8-12% depending on your appetite for risk.

Pugh Management continues to look for dislocations in the real estate market for underpriced assets. They are out there today, just extremely limited. We expect 2023 to offer many more opportunities for either mortgage default purchases or from sellers with lower expectations. As interest rates rise over the next year owners with floating rate debt will look to refinance, sell, or default. These opportunities will come as we move forward and Pugh Management will be ready with dry powder.