By Nick Totah, First VP, investments, The Totah Group at Marcus & Millichap
Interest rates have created a lot of noise in the market recently. In a rising interest-rate environment, concerns arise about the potential impact on real estate. As the Fed continues to curb growth via monetary policy, interest rates are moving in a significant way compared to prior rate hikes, with further increases anticipated. In some instances, rates hikes will drive rent growth, as the affordability of housing continues to decrease. Further rent growth will continue to support strong asset values, specifically for multifamily.
Across the board, all product types will likely see or are already experiencing cap rates moving in an upward trajectory. The market has only so much elasticity before cap rates must move upwards to compensate. If interest rates are rising due to a stronger economy, it tends to be associated with a strong real estate market.
There are several value drivers in Southern California that will continue to allow brokers and investors to be successful in any market environment. Values are up and yields are low, this can make for an easy conversation with owners, creating tremendous opportunities for both owners and brokers alike. However, as the environment changes those residual expectations have remained. In my opinion, this has contributed to the decrease in sales velocity that we are currently experiencing year over year.
Moving forward, I believe sticking to the underlying fundamentals applies to both brokers and investors: add value. However, regardless of their successes throughout the past several years, many of the newer brokers will end up leaving CRE and moving to a more secure employment position. Without many years invested in creating a strong business foundation and track record, it can be hard for most to sustain post recovery, but not all.
As a broker and investor, I am optimistic about the changing environment. During our latest bull run, the market had become flooded with newer brokers and unmotivated sellers. The high levels of activity from established and especially from newer hungry agents resulted in owners overestimating the value of their assets. This led to an environment of overpriced assets and owners with little to no motivation outside of price.
My advice to investors is to cautiously underwrite rent-growth speculation (beyond the current environment) and focus on location driven assets and stable cash-flow. Moderating leverage over seven-to-10-year periods of fixed financing can really help hedge against potential downside. Owners can also begin having conversations with their tenants regarding lease expirations in the near term. Negotiating longer-term leases in today’s environment could prove to be advantageous, as opposed to two to four years from now. I think it is important to have an ongoing and open dialogue with your broker in regard to any existing vulnerabilities within your portfolio.
There are many reasons why investors should continue to seek properties in Southern California instead of looking to other markets where the yield might be higher and the deals easier to win. In my opinion, yield-driven investors are misled. To be clear, investors who are willing to venture into secondary markets vs. major markets should exercise a higher degree of caution. Although yields are attractive in contrasts to major markets, asset values with attractive yields can still be considered heavily inflated. Having the insight to reassess and understand the attraction relative to other markets vs. relative to an appropriate value for that specific market is key. Historically, core market appreciation has far out-performed secondary markets. With that said, opportunities exist in the large majority of all U.S. markets and environments.
I would like to reiterate that the commercial real estate environment is changing, and investors should adjust accordingly. My team and the rest of the community we interact with in-large are optimistic about the future. San Diego is performing beautifully over all. It is an incredible time in an incredible city that has progressed and expanded profoundly during the last five to seven years.
Although we are experiencing slower transaction volume, core assets continue to command high price tags in San Diego. In addition, leasing fundamentals are great, and record-high office and retail rents continue, with vacancies hovering around 13.4 percent and 4 percent, respectively. Strong employment represented by a record low unemployment rate of 3.4 percent is driving net absorption. As you can see, the future looks bright.