Capital Markets: Investing in a Rising Interest Rate Environment

Capital Markets: Investing in a Rising Interest Rate Environment

Midway into a panel discussion at CRE.Converge, a quip about the Federal Reserve behaving like a novice teenaged driver – “way too much gas, way too much brake, way too much gas” – drew laughter from many attending the jampacked session. But palpable nervousness tinged those chuckles at the metaphor by moderator Bart Johnson, president and CRE market head, Wintrust Bank.

Questions over the duration and extent of rising interest rates have slowed overall market activity. And no one on the panel predicted relief from the ongoing suspense any time soon.

In fact, the first perspective offered by Peter Schultz, a 39-year industry veteran who is executive vice president – East region, First Industrial Realty Trust, Inc., was that “rates are going to rise, there’s going to be more pressure for sure. I don’t think that’s going to change any time soon.”

That’s not to say that the year has been a complete dud. In the office sector, for example, prior market momentum resulted in a stronger first eight months than during the same period in 2021, which was a strong year, noted Al Pontius, senior vice president, national director, office and industrial divisions, Marcus & Millichap.

However, Pontius acknowledged, “The transaction that happened yesterday is no longer the relevant benchmark, because that transaction was conceived two, three, four months ago.” He also noted a “big divergence” in the investor profile currently.

“The institutional market is way more discerning, has narrowed the fairway for equity investment substantially,” Pontius said. “And the private investor has also done that but is generally much more active overall today than the institutional investor.”

Johnson asked Shahin Yazdi, principal/managing director, George Smith Partners, Inc., if cap rates would continue to go up as interest rates rise.

Focusing his answer on the multifamily market, Yazdi predicted cap rates “will continue to go up until [interest] rates stabilize, and people get a sense the government and the Fed is done raising rates. Even then, it’s going to take three or four months from then for people really to get comfortable with it.”

George Smith Partners tallied $4 billion last year in debt and equity placement across various asset types. However, the capital advisory firm has seen transactions fall through amid the market’s volatility, said Yazdi. He noted some recent deals in which buyers have sought to renegotiate terms, adding, “We’ve actually had a few borrowers willing to walk away from a transaction because It just didn’t pencil for them anymore.”

Many sectors, including the commercial mortgage-backed securities (CMBS) market, are in wait-and-see mode, panelists said, with a prevailing reluctance to commit to financing’s long-term implications until stability sets in. When that might happen – and in what range – is, of course, the multibillion-dollar question.

As Pontius noted, “institutional capital today is highly selective and is basically saying we want to watch this play out. I don’t want to lock into a – let me just arbitrarily say a six cap – and find out it should’ve been a seven [cap] in another two or three months. So, you have a pretty quiet audience.”

The private sector, meantime, is “equally educated on all these concerns, so it’s not about sophisticated or unsophisticated. It has nothing to do with that. The private sector includes billionaire families,” Pontius continued. “The difference is in the private sector, there are other motivating factors,” such as minimizing taxation via a 1031 like-kind exchange.

Yazdi provided a forecast for more institutional equity investor activity in the first quarter of 2023: “They do have a lot of money, that money is burning a hole in their pocket. They have a fund life [and] they need to get that capital out.”

Panelists covered ground on an array of other sectors, with Schultz returning to the topic of the office market, which he described as having “pretty good” demand.

“Rents continue to grow at a blistering pace. When would anyone in this room have thought that 150% of holdover rent would actually result in a below-market rent in certain markets?” Schultz added. “As tough as the cap markets are at the moment, we continue to see leasing holding up and we’ll see how long that goes.”

As always, the unemployment rate is an enormously influential factor, with Yazdi noting that he sees it as “the only thing that I think can derail the economy.”

“If companies start to falter, that’s going to affect every sector,” Yazdi said. “But right now, all the demand is still there, and companies are doing incredibly well if you look at the financials.”

For all of the “if this, then that” clauses littered throughout the discussion, Schultz perhaps best captured the hope that permeated the crowd attending the panel.

“Whatever the Fed does … let’s get to that point sooner than later,” said Schultz, “because I think that will start to make it a little bit easier for everyone to start making rational decisions again.” “If this is drawn out a long time, I think it creates more risk across the macro-environment.”

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