Optimism? That’s in short supply today in the commercial real estate industry.
This isn’t surprising: Interest rates remain high, something that has throttled investment sales. Buyers and sellers can’t agree on the sales prices of industrial, multifamily and retail properties. And recent bank failures are bringing even more uncertainty to an industry that craves stability.
But in their Mergers & Acquisitions and Strategic Transactions Monitor report released in early April, JLL’s researchers found plenty of optimism in the commercial real estate market. As the report says, inflation might have peaked, the Fed has indicated it is nearing the end of its interest-rate hikes and institutional capital sources have amassed a war chest of more than $240 billion, money they are itching to spend.
Midwest Real Estate News recently spoke with Sheheryar Hafeez, managing director with JLL Capital Markets, about the company’s latest report and the state of the capital markets. His overall message? Yes, these are challenging times. But there are reasons to be optimistic, too.
Let’s start with the biggest news. How have the recent bank failures effected the commercial real estate industry?
Sheheryar Hafeez: It really is a week-by-week determination these days for where the market psyche happens to be. One week it feels like the sky is falling. The next, we are off to the races and on top of the world. After all the noise about the volatility of the market and the bank failures, we have basically been flat across pretty much every sector except maybe office.
It’s interesting: Despite the headlines about the bank failures and interest rates, the market has somewhat absorbed that information. I think the market saw that the Federal Reserve Board was constructive and moved aggressively to curtail any contagion effect from the bank failures we’ve seen. That was well-received. When I spoke with people I knew in the venture capital or tech world, they told me that the Friday night when Silicon Valley Bank failed was one of the most nerve-wracking nights since the 2008 recession. But the government moved fast to limit the damage. That eased some of those fears.
There are still concerns about future bank failures, though?
Hafeez: We don’t have a crystal ball. We don’t know when the next shoe will fall. The Fed seems to be constructive in dealing with this, though. And the damage seems to be specific to certain banks. The banks that operate in a more conservative environment since the last financial crisis seem to be safe.
I like to be careful when speaking about these matters because you never know what will happen. But we haven’t seen a chain of failures yet. And the important point is that if we are going to see more failures, it seems like the Federal Reserve is prepared to not let it become a major issue if it can reasonably curtail it.
How about interest rates and inflation? Is there good news on that front, too?
Hafeez: It seems that inflation might have peaked and it also appears that the Fed might be nearing the end of its interest rate hikes. The Fed raised its benchmark rate by a smaller 25 basis points last time partly because the data led it to say that the economy might be cooling off a bit. The Fed recognized that it might not have to be as aggressive with rate hikes now.
The aggressive interest rate increases were going to have some repercussions. The banks that were overleveraged and took more risks paid the brunt of it.
What commercial sectors today are attracting the most attention from investors?
Hafeez: The sectors that are performing well today are the same ones that were performing well before interest rates started to rise. Self-storage is very strong. Data centers are attracting a lot of attention. Net lease is flat for the year but is still a solid investment. The same sectors that were outperforming before the Fed started hiking its rate are still the ones that investors favor.
The net lease sector is interesting because it encompasses so many asset types. These assets usually feature longer-term leases, 10 years or more on average. They might not generate big profits, but they are steady-Eddie investments. They are safer investments.
But investors aren’t only focusing on the safest of investments. Some are investing in riskier assets.
What riskier asset types are investors targeting today?
Hafeez: The one asset class that jumps out is retail. You’d expect investors to target industrial and healthcare. Those are strong sectors. But retail has seen a lot of recovery since the early days of the pandemic. Retail was off the radar for investors but is now starting to come back. The retail sector went through a lot of volatility and restructuring. But retailers have come out of this period stronger. There are a lot of healthy retailers now. There are a lot of retail landlords with strong portfolios. They have produced compelling same-store return-on-investment growth and are getting rewarded for that. Because of that, retail assets are attracting the attention of REITs and other investors. That was a sector that I wouldn’t have thought investors were targeting so much before I looked at the data.
What about the office sector? Are you seeing any positive signs there?
Hafeez: Office is going through the same type of life cycle now that retail has already gone through. Over time, the office picture will become clearer. Office will remain an important commercial class. People won’t stop going to the office. It will remain an important part of the real estate sector. There is just so much uncertainty now. We don’t know where we are headed. It will take more time before the story clears up a bit.
REITs have owned some of the best office spaces over the years. They have acquired and developed some of the best and most competitive product in the office space. They might be getting hit now by the volatility of this sector. Hopefully, this is temporary.
The JLL report lists some reasons why investors should have optimism about the commercial real estate market. Can you talk about some of those?
Hafeez: For one thing, inflation might have peaked. Hopefully, that will start to go down. But another reason is that REITs have been effective at getting rents above the rate of inflation. They have become more sophisticated. They have better assets and are using better technology to work those assets. That shows up in the same-store net operating income growth. Investors can typically beat inflation with the growth in net operating income.
Then there is the liquidity out there. There is a lot of liquidity for asset allocations sitting on the sidelines. There will be a push to get that money out as the economy starts to settle down.
As humans, we often think that where we are today is where we are going to be forever. We all do that. In the middle of COVID, we all thought that no one would be going back to work in an office, that cities will be dead, that everyone will be moving to the suburbs and that we’ll be wearing masks forever. Now, two or three years later, we are in a very different place. We even had some record years when it comes to transaction activity. So a lot of us might think that we are always going to be dealing with today’s uncertainty and higher rates. But we won’t be. Things will stabilize and deals will get done again. The human psyche can change dramatically.