Current Valuation Report Reveals Where CRE Values Declined in 3Q 2022
Some commercial real estate (CRE) portfolios began to show declining and negative returns in 3Q 2022 after two years of extremely strong value appreciation, according to SitusAMC Insights’ Current Valuation Insights quarterly analysis. This report leverages the boots-on-the-ground perspective of SitusAMC’s appraisal and valuation management teams, offering investors real-time market and property-type insights ahead of many traditional CRE data sources.
Returns are heavily dependent on allocations, specifically to industrial, as well as location and property characteristics. From a diversified-portfolio perspective, values have been flat to negative in the third quarter, with allocations to office often weighing on returns.
Older, Functionally Obsolete CBD Office Values Suffer
Office, in general, is not dead, though functionally obsolete office is challenged. Investors are showing interest in the right type of office: new, state-of-the-art, and supportive of environmental, social and governance (ESG) goals. In general, tenants are not necessarily downsizing but instead looking for more amenities to attract employees back to the office.
However, SitusAMC is witnessing meaningful declines in office values, particularly from a capital markets perspective, for the first time since the pre-pandemic era. Most CBD properties throughout the country are exhibiting at least a 25 to 50 bps increase in investment rates, with higher rates primarily associated with higher vacancy. For the most part, CBD values declined, except for assets of exceptional quality. Since the onset of COVID-19, office investment rates have been relatively stable; life science, medical office, credit tenant office and trophy assets have seen rate compression, as well as rent stability and/or growth.
However, SitusAMC generally saw rate adjustments in the third quarter as a result of rising interest rates, thinning buyer pools and capital market adjustments. Investors that are over-allocated to office, or otherwise motivated to sell, are taking office assets to market. But the bidding pools are very shallow and there is no price reconciliation today because of the large bid-ask spreads. Efforts to offer short-term seller financing have been met with mixed results. Sellers are often pulling assets out of the market to hold, in anticipation of a market rebound.
Third-quarter rate adjustments have been primarily in the discount rate, with some terminal rate expansion and some assets with adjustments to both. However, it has not been a broad-brush adjustment for all assets. Appraisers are scrutinizing property attributes – location, macro- and microeconomics, the class type – trophy A versus B and C – occupancy and tenancy. The quarter saw few assumption changes, except for increases to tenant improvements and some market-specific rent adjustments. Office fundamentals remain weak; therefore, the segment’s flat rents and lower market rent growth are having an outsized negative value impact this quarter. The assets that are seeing adjustments are mostly non-trophy buildings that are not stabilized. Trophy class A, stabilized assets in certain markets may be insulated.
Markets in the Sunbelt such as Florida, San Diego, Georgia and North Carolina are faring the best at this point, with valuations flat to slightly down. By contrast, gateway markets, specifically the Northeast (New York and Boston), New Jersey, the Mid-Atlantic, Chicago, the San Francisco Bay Area and the Pacific Northwest, have been hardest hit. Even the darling of office, life science, is not immune to the rate changes. However, strong fundamentals are fueling value increases in the segment. Leasing is active and market rents are increasing, but value growth is slowing relative to recent quarters. As venture capital has withered, the market has also taken note of the lack of overall funding needed to drive sector demand.
Market and Property Nuances Drive Apartment Valuations
Apartment fundamentals are very strong. SitusAMC is still seeing dynamic rent growth – as much as 20% positive lease trade-outs for quality assets in strong submarkets. Robust employment is also a critical factor in how properties are performing. Because of the positive fundamentals and strong starting market rents for most assets, value are generally holding steady, even with the expansion of rates or a pullback in rent growth.
A general theme for the third quarter is de-risking of the cash flow. Most of the rate expansion is in the discount rate this quarter, which is tied to risk and yield. Only a handful of assets are expanding terminal rates. About one-third of apartment assets saw some pullback on future rent-growth expectations. The result of all the changes is a slight uptick in implied rates. SitusAMC performed sensitivity analyses on different blends of discount rate and future rent growth expectations, but the result is generally flat to moderately higher valuations.
The issue this quarter is debt and the avoidance of negative leverage. Many buyers have been walking away from deals because they do not want to put capital at risk, and it is all tied to the availability of financing; highly leveraged buyers are moving to the sidelines. Generally speaking, buyers are sensitive to negative leverage in their cash flows. While it may be acceptable to have negative leverage for up to three years, investors are very focused on achieving positive leverage beyond that.
Grocery-Anchored Retail Endures, While Malls See Weakness
Overall, investment rate movement was minimal across the retail sector. However, retail remains bifurcated with strip center/grocery-anchored retail performing well, and lifestyle/mall segment facing challenges. Grocery-anchored space has performed well in the last few quarters, with rate compression in some instances and the spike in COVID-era sales continuing, coupled with the inflated pricing of goods. Third-quarter valuations in these centers held very steady, especially if well-occupied. On the other hand, appraisers have expanded rates on non-grocery-anchored strip centers or those struggling with leasing. All things considered, the sector remains an attractive option from a risk-adjusted return perspective.
With virtually no transactions for top-quality malls, mall valuations are difficult to assess at this point. One Class A (not A+ or A++) mall sale recently closed at a capitalization rate of approximately 5.8%. Soft-goods retailers are not need-based and are being hit by high inflation, posing additional risk to this segment of the sector. With less disposable income for the consumer going forward, appraisers are considering investment-rate adjustments, particularly in the discount rate. In several instances this has been partially offset by NOI growth. Some leasing has been strong over the last year as mall retailers have come off COVID-era leases. Robust tenant sales, especially luxury sales, have driven up percentage rents, garnered higher fixed-rent renewals, and reduced overall occupancy costs.
On the other side, there are plenty of lower-quality mall sales occurring where there have been defaults or some sort of redevelopment play. Non-dominant malls in the trade area might see trouble as many retailers consolidate to the best mall in the area.
Industrial Valuations Depend on Tenancy
The industrial segment has enjoyed 12 to 18 months of incredible growth, and fundamentals still seem to be quite strong, particularly in coastal markets like Southern California, Northern New Jersey and Miami. SitusAMC is still witnessing high water marks in terms of rent. Demand is moderating for mid-tier or mid-size space, but strong tenants that occupy large space are still willing to pay for Class A, well-located assets.
Fundamentals in super-tight markets are propping up increases to yield. Southern California, Florida and New Jersey are still experiencing big leaps in market rent. Where product is more abundant, such as Dallas or Chicago, SitusAMC is seeing scaled back rent growth (and future rent growth) assumptions, which is hurting values.
Industrial capital markets started to materially shift at the end of the second quarter and flowing into the third quarter. Many of the buyers represented now are strictly cash buyers, life insurance companies or closed-end funds. The leveraged buyer is not active, resulting in thinning buyer pools and much larger bid-ask spreads. With exceptional rent growth over the last year, large institutional owners of real estate are willing to rely on the steady source of income, particularly for assets that have signed recently at historical highs for term rent bumps. On the other hand, buyers are trying to take advantage of the lower pricing and expanded cap rates. As a result, activity has stagnated.
Without much in the way of comparables, the market is challenging in terms of pegging cap and discount rates. The consensus from the appraisal community, SitusAMC and its client base is that rates are expanding, but the extent of that rate expansion varies. Long-term leased assets with below market, in-place tenancy are most vulnerable to rate expansion. This produces thin yields that investors are no longer willing to accept. These “bondable” type deals require significant adjustment to meet investor expectations, and to ward off long-term negative leverage.
Value ranges are wide, but average flat to negative. The vast majority of values exhibited rate expansion to the degree of 25 to 100 bps on the discount rate, depending on five-year average implied cap rates and weighted-average lease terms. Compared to the valuation zenith late last year, cap rates might be up 100 bps, but it is hard to apply this across a whole portfolio because the fundamentals differ considerably on a case-by-case basis. Rates may be higher for poorly located assets without the ability to mark-to-market, or they may be lower for assets in top markets still seeing fundamental growth, with the ability to turn leases to capture growth. For example, investors have been willing to take a low yield for a long time in Southern California, given high replacement costs, and further stabilization as tenants stick with long-term leases that are significantly below market.