Hedge Cap Rates With Due Diligence

2022

Is the supply of capital driving growth more than the economic fundamentals that enhance the demand for commercial real estate?

Referenced Topics:

Lower rates have historically suggested higher commercial property values. If interest rates go up, will cap rates go up? Is the supply of capital driving sales and cap-rates more than the economic growth that demands the use of real estate? If either the supply of capital or the demand for the use of real estate was to contract, are there components of due diligence that can help hedge cap rates?
The fear of rising interest rates shouldn’t deter real estate investment because of the intrinsic value of the assets, as well as the long-term increased cash flow and inflationary insulation that real estate provides.
Capital being moved into non-core markets and non-core assets might have more robust spreads, but the need to properly mitigate risk can be enhanced through due diligence, as well as unitizing key metrics within the valuation of all assets (core and non-core).
Enhanced due diligence will foster risk assessment, as well as provide details for asset-level unitization and strengthen returns in any interest rate environment. That level of support in due diligence, parlayed with the acquisition and capital deployment strategies of today will build layers of protection from cap rate volatility regardless of economic fundamentals. jhme Real Estate Advisors is here to partner with you on that component of your capital allocation.

Trends:
There is a perceived rise in loan sizes by some institutional capital sources and many of these are being held and not syndicated. Overall lending parameters were becoming more flexible and the securitization market closed-out Private commercial property debt issuances totaled $161 billion in 2021, surpassing the amount issued in 2020 by $100 billion, according to the CRE Finance Council. But SASB and CLO deals accounted for $45 billion and $83 billion, respectively, while conduit and other CMBS issuances made up $31 billion.
Despite yield volatility and a slow summer in 2022, the CMBS market continues to grow year-over-year. Yet like all capitalization structures, CMBS, Agency, Institutional Capital, Conventional Lending and the like appear to poised for pause due to the rising cost of capital.

More volume and more loans yield immense opportunity, but will also have its inherent risk. Yet the new “state of the state” for current capital markets invokes a new question:

How do capital sources and real estate investors hedge that risk? How can we as an industry hedge cap rates? One supporting mechanism to do so is the detail of due diligence.

The Conundrum:
The global capital environment and global GDP have been forecasted to be cautiously optimistic with a very prudent and recently upward trending cost of capital in the market place. With inflation and slow global GDP, escalated rates (and higher than historically average construction costs/replacement costs) might be a conclusive assumption. If historically lower rates have yielded higher values, what does the real estate market do if rates spike?

Rate increases due to true economic growth are believed to increase rents and occupancy, so by proxy, values should be preserved. What if (however) noneconomic factors increased rates? GDP remains marginal and rates increase in the form of slowed QE.

How do we as an industry insulate value and spreads? Some experts suggest that such a rising rate environment with little economic growth will only have marginal negative impacts to cap rates and spreads. There is clearly a plethora of factors that influence spreads, but sound investments (from an equity acquisition, debt or preferred equity perspective) require sound due diligence. This is particularly evident if the cost of capital increases.

Historically speaking, cap rates have remained resistant to increases in interest rates and one might argue that the spread between cap rates and the risk-free rate provides cushion.

Additionally, many investors are moving away from core-assets within the most core markets due to possible increased values. Non-Core and opportunistic investments are gaining appetite with many platforms.
-This included "right-sized" and favorable capital stack with enticing equity and mezzanine opportunities.

The detail of tangible due diligence can provide finite and empirical findings that assist in supporting the assumptions that ensures that spreads remain favorable.
-Physical diligence that goes beyond the surface of the asset and truly fosters capital expenditure forecasts that are tailored to the asset in question will enhance the unitization of various metrics.
-Environmental diligence that identifies risk.
-Development and construction underwriting support that understands the physical nature of ground-up asset quality and risks associated with providing construction capital in today’s lending environment. This entails experts on the ground and opining on budgets, documents, agreements, specs, plans, etc.

The Root Question:
Risk is not a one-size fits all underwrite. Cap rates are difficult to hedge, so stringent underwriting is necessary. Lenders now unitize valuation metrics in per square foot form (Rent, Expenses, Capital Expenditures, Values and Loan Sizing). However, if rates spike due to economic inflation, real estate assets should also go up in value.

This may not be the case, however, when rates rise to hedge inflation (at least initially).

If risk is assessed asset by asset and exit strategies are timed, then finite due diligence on every level should mitigate the interest rate risk associated with the capital markets today. Rates should not conflict with value, thus sustaining returns. Yet cap rates have not risen as quickly as interest rates and the cap rate to cost of capital spread is tight. Parlayed with lagging yield-on-cost characteristics in the development space, investment allocation strategies may seem opaque.

This brings us back to the original question: Are interest rates and cap rates correlated; and what is driving volume today?
Summation:
With improving fundamentals in the broader economy and the threat of marginal inflation, real estate should look attractive. Cap rate hedging is difficult, but cash yields from real estate assets and the intrinsic underlying value offer more inflation protection than Treasury or Corporate Bonds.

Real estate cash flow can increase over time through rent escalations, expense pass-through and the fundamental positive economic growth that could force rates to increase. Providing sound due diligence behind your investment criteria mitigates risk regardless of the driving force in the market place or the movement of interest rates. But this must carefully dissected (more than ever) as investors and lenders alike assess attachment points and underwriting guidelines.

At jhme we have an eternal guiding focus on the fundamentals of the asset itself. Delineating capital expenditures, drilling into realistic construction capitalization details and the environmental risks that are based upon our client’s needs, assumptions and sensitivity models is our specialty. The opining and analysis that our engineers, architects and financial analysts provide, will extrapolate details from a diverse platform of synergized disciplines and deliver usable data that is developed with underwriting, reliance and sustainable returns in mind. We are in the business of helping our clients to mitigate risk and move quickly through their deal-flow.

One of those key service channels is the construction capitalization platform. As capital sources, investors and institutional players allocate into development and co-invested opportunities, jhme has been entrenched in the business of mitigating risk for all vested stakeholders of any asset or project.

The key difference, however, is that the details of due diligence are more intense and comprehensive today. We’re seeing debt and equity providers delve into sub-categories of capital expenditures that are much more enriched. Our expertise will enable your team to focus on execution while we focus on any associated risks to the physical and environmental concerns of your asset or investment.

As stewards of debt, equity, shareholder returns and partner cash-flow, it is incumbent upon each of us to engage counsel and due diligence entities that deliver laser-focused analysis of the assets and capital that are represented. Whether this is physical, environmental, new development, analytical or comprehensive; we’re here to partner with you in your 2014 capital allocation strategies.