The Impact of the Coronavirus on Commercial Real Estate
Rise Realty wants to address the uncertainty in the market and advise on how we believe this will impact commercial real estate holdings. To make a long story short, while the stock market is forecasting disaster ahead, certain sectors of private real estate may actually win as a result of some of the economic forces in motion.
Protecting and preserving generational wealth is Rise Realty’s primary goal. We are considered to be managers of risk and practice this in every strategy we implement in both company and propoerty acquistions. We understand that real estate is not immune to the cyclicality of the market and our decisions for our funds have been designed to withstand such economic shocks. We focus on high growth cities like Miami and Fort Lauderdale that produce ample cash flow.
In the past week equity markets have lost more than 10% of value, realizing the largest weekly point drop in United States history. Coronavirus COVID-19 Virus and its impact to global supply chains are real. The virus has now spread to every continent but Antartica. Today world’s products all tie to China. Investment sectors such as lodging, gaming, and the airline industry have been hit harder than others as companies and individuals reconsider travel. Last week Goldman Sachs revised their growth forecast for S&P 500 earnings to zero for the entire year. The public markets volatility is expected to continue until there is full clarity on the full impact of the Coronavirus on the economy.
Rise Realty does not have the ability to see the future or what impact will be. The ten year bull market of nonstop economic growth had to come to an end at some point. With the forces in motion, mainly the global decline of interest rates which may benefit the long term outlook for commercial real estate, but also must consider impact of a global economic slowdown to property level operational performance. These two forces combine to influence borrowing costs, net operating income and capitalization rates. These variables have the greatest impact on commercial real estate asset values as we explore these relationships in todays market.
Cost of Debt
Cheap debt is positive for near and long term outlook of real estate. Leverage is part of real estate investing and lower interest rates mean lower cost of debt. A property will produce only as much cash flow and with lower borrowing costs mean less money to the bank and more money to investors. Properties that utilize variable rate debt are in very favorable positions as are those in position to refinance or newly acquired. The ten-year treasury is at historic lows and borrowing costs will follow as we’ve already witnessed. Rise Realty has seen debt quotes as low as 3.1% on new acquisions, roughly a full percentage point lower than it was eighteen months ago. On a $10 million deal leveraged at 65%, the annual interest savings amounts to $65,000. Consistent cash flow is one of the main reasons to own commercial real estate making up a large percentage of long-term returns and these savings potentially increase cash flow to investors by more than 50%.
Net Operating Income
Real estate investment performance is highly correlated to population and job growth. A slowdown in the economically could impact the operational performance of commercial real estate properties if the Coronavirus leases to company layoffs. Alternatively multifamily housing should perform better than most other sectors as people need a place to live.
By example of a decline in net operating income impacts the value of an investment. The $10 million project valued at a 4.5% capitalization rate in today’s market would produce approximately $45,000 of net operating income. If the net operating income declined by 5%, the properties value would decrease to $9,500,000 assuming capitalization rate remains the same. In this example, equity will lose approximately 15% of its value. We are still winning with 85% of our equity position intact and property still producing nearly double the cash flow needed to service the 3.1% interest on the debt. Cash flow to investors remain uninterrupted.
Global supply chain disruption will impact construction projects and will be something to continue to keep watch on. The combination of forces in motion can take months to realize. If it does impact new construction this will limit the amount of supply for new product which will bode well for existing supply.
Cap rates will continue to decline. The great indicator of this relevance is the ten year to cap rate treasury spread. The spread determines if investors are getting paid premiums to take risk. The spread was zero in 2007 telling of what was to come. Historically the spread is between 175 and 250 basis points. South Florida multifamily cap rates are roughly 4.5% and treasury yields at or below 1.2%, the spread between the two is 330 basis points. If we assumed a normalized treasury rate of 1.7%, the spreads still 280 basis points still above historical averages. Therefore investors are being adequately compensated for risk of investing in commercial real estate.
Over the next twelve months cap rates will trend downward to 4% range which is still a healthy 230 basis point spread from a normalized treasury rate of 1.7%. If cap rates decline to 4% and occupational performance is not affected, a $10 million property will increase to $11,200,000 which would be a 34% gain on equity. If net income declines by 5%, the property would be worth $10,068,000 and if the net operating income declines by 10% the property is still worth slightly more than $10 million. Rise Realty intends to take advantage of historically low rate environment as we acquire new properties.
Potential for higher cash flow and lower cap rates more than offset the risk of lower operational income. While interest rates stay low as the economy rebounds we might have an opportunity where we have higher operational cash flow and a low interest environment in the future as we had between 2013 and 2016.
The market will higher no matter what in the next five to ten years and we encourage our investors to invest as such. The near future might be gloom but we will overcome just like every crisis of the past.
Feel free to respond if you have questions. Thank you.
Keith Darby, CCIM President