Evaluating Real Estate Investments – Planning for 2023

Recently, I listened to my son learn a violin concerto that features a wickedly high note three octaves above the violin's open A string. It’s unusual for violin music to go the top of the range—even advanced violin music tends not to go more than two octaves above the A string.

The high A in the concerto is at the end of an arpeggio that spans the violin’s more than four-octave pitch range. In contrast, beginning violinists play in first position, which provides them with just over a two-octave pitch range. Violin music that features first and third positions (third position usually is taught before second position) often is considered intermediate and covers a 2-1/2 octave pitch range.

When a violinist learns fifth position, they are considered advanced and have just over a three-octave range. The high A in my son’s concerto is in 12th  position. I had to calculate the position for this article because once the music goes above 6th or 7th position, most violinists don't think about what position they are playing – they just play the notes.

The Strad, a publication for string players, recently recapped "6 ways to improve shifting for string players." One quote from Simon Fischer in 2006 resonates with me: “The best approach to shifting is a musical one, where you simply decide there is no such thing as a shift.”  

Fischer’s point is that a violinist should focus on the goal – the music – instead of the mechanics of playing the notes. That doesn’t mean the violinist doesn’t need the skill to accurately shift and play all notes, including high notes, just that the focus should remain on the endgame—the music.

The real estate industry – and much of our economy – is at a point where we must shift. With the pace of inflation and interest rate increases, some of those shifts will be large. And those large shifts may challenge the skills of even the advanced players in the real estate industry.

Yet, although the challenges real estate is facing, the fundamentals and the endgame have stayed the same. Real estate investment operates on a cycle primarily driven by supply and demand. Interest rates also affect the real estate cycle and, in some instances, as we are seeing now, can be disruptive.

This article briefly discusses how real estate investments got where they are today and why it's best to focus on fundamentals and the endgame--despite current disruptions in the real estate cycle.

Real Estate Investments -- 1970-2020

Some say that the commercial real estate market came into its own during the inflation of the 1970s. More people sought real estate as an investment – rather than as housing or for business uses. And real estate investment became easier as real estate syndication became popular.

Whether this turn toward real estate investment was triggered by the belief that real estate is "inflation-proof" is debatable. Regardless of the cause, investors created an increased demand for real estate, which raised prices and eventually triggered more development.

Changes to the depreciation rules under federal tax law also may have contributed to increased interest in real estate investment. For example, with the "accelerated cost recovery system," investors could shelter more of their real estate income from real estate taxes at the beginning of their investment. These tax changes likely spurred real estate investment while incentivizing shorter hold periods (since the bulk of the depreciation was taken early in the hold period).

Another development that facilitated current real estate syndication funds is the limited liability company (LLC). First authorized by Wyoming in 1977, many view LLCs as a hybrid between a corporation and a partnership.

Before LLCs, most real estate investment funds were structured as limited partnerships (LP), with a sponsor serving as general partner and having management control and personal liability and the investors being limited partners. LLCs provide an ownership and management structure of a partnership which gives general partners (called managers in an LLC) the liability protection provided by a corporation.

However, given the hybrid nature of LLCs, there was a concern that they might be subject to "double taxation" like corporations. So, it wasn't until the Internal Revenue Service (IRS) determined in 1988 that LLCs are by default taxed as partnerships that LLCs became popular in real estate investment.

Leverage is another reason real estate investments have been attractive. With mortgage financing, for decades, investors could invest only 20% of the capital required to buy real estate while receiving 100% of the growth (after payment of the mortgage loan) on the asset value. With the real estate market driven by the belief that values could only increase over time, many investors added mezzanine debt on top of mortgage loans, resulting in total leverage of 90% or more.

Real estate investments took a hit with the 2008 recession. Mortgage fraud in the residential sector and lower values triggered foreclosures. And investors learned that real estate values could decline as well as increase. After losses from the 2008 recession, mortgage lenders tightened their underwriting. In addition to more conservative forecasts, 80% mortgage loan leverage went by the wayside in commercial real estate, but investors still can benefit from 60% or 70% leverage.

Real Estate Investments Since March 2020

In 2020-2021, the COVID-19 pandemic abruptly accelerated the real estate cycle, causing a downturn in many asset classes. As office buildings sat empty, tenants either didn’t renew their leases or sought to renegotiate them for lower rent. Hospitality assets struggled with the decline in travel and tourism.

Closures – some temporary due to government restrictions and others permanent due to financial losses – turned thriving retail centers into ghost towns. Multifamily assets in major metropolitan areas saw increasing vacancy rates as telecommuting tenants fled for less crowded (and less expensive) parts of the country. As a result, many commercial real estate assets declined in value as their vacancy rates increased and revenues decreased.

As things got back to normal, the country experienced inflation. In 2022, interest rates have increased, which translates to higher interest rates on mortgage loans for real estate buyers.

Higher interest rates drive CAP rates for commercial real estate investments higher. But paradoxically, higher CAP rates trigger reduced prices for commercial real estate – unless revenues also increase.

Multifamily real estate is strong in most markets – after all, people need a place to live, and during the pandemic, government programs helped many people pay their rent. According to the National Association of Realtors (NAR) October 2022 Commercial Market Insights Report (NAR Report), year-over-year multifamily rents increased by 9.4% during the first quarter, 11.3% during the second quarter, and 5.7% during the third quarter 2022. The absorption rate also remains high in multifamily.

According to the NAR Report, the retail sector also shows signs of recovery, with several successive quarters of positive net absorption. Due to inflation, retail sales have increased, and tenants are paying increased rent. The industrial sector also is strong, with warehouse space in increased demand.

However, other asset types haven’t been able to increase rents, or increases haven't made up for the increased CAP rates. According to the NAR Report, multifamily and industrial assets generally have been strong. But many office assets are struggling as companies continue remote work. And there is a net loss in businesses in major metropolitan areas, such as New York, Chicago, San Francisco, and Washington, DC. And the NAR Report notes that hotel/hospitality occupancy remains below pre-pandemic levels despite increased occupancy during the summer.

According to a November 4, 2022 New York Times article, home prices will decline due to higher interest rates. Although losses might not outstrip recent gains, lower inventory will likely cause investments in single-family homes to cool.

Strategy for Early 2023

Playing high notes on the violin and navigating a real estate investment in a changing economy are challenging. Real estate sponsors and investors facing new challenges can learn from violinists shifting to new positions.

Once a violinist starts a challenging shift, they don’t stop to think about every position they pass along the way; the violinist continues on their path, hyper-focused on the high note they are targeting. With market uncertainty, investors shouldn't expect short-term income or return on their investments in 2023. Instead of trying to tediously dissect current market conditions to produce short-term income, real estate investors should focus on short-term capital preservation and long-term growth.

Since interest rate uncertainty is likely to continue well into 2023, owners should, where possible, continue on their current course without making significant changes. Unless they must sell, recapitalize, or refinance due to a maturing mortgage loan or significant financial challenges, owners should focus on fundamentals – occupancy and rent growth. Although it may be tempting to defer maintenance when facing increasing floating rate mortgage loans, while inflation persists, owners should focus on increasing revenue to cover increased interest rate expense.

Owners whose mortgages are maturing or expect unsupportable increases in their loan payments may need to sell. Occupancy, rent growth, and asset preservation should remain central focuses. Those fundamentals will maintain maximum asset value and yield higher sale prices (and better mortgage loan terms for prospective buyers).

For owners with long-term, assumable mortgages with below-market fixed interest rates who held their assets for several years, 2023 may be the time to sell to recoup their capital. Although cap rates have increased, the opportunity to benefit from assigning the arbitrage on their long-term mortgages may more than offset any reduction in underlying asset value – provided the asset value remains strong enough to support the current mortgage loan amount required for an assignment.

For at least the first two quarters, 2023 will provide investment opportunities for investors with cash resources. Those investors may purchase properties and assume below-market, long-term mortgage loans with below-market interest rates. Plus, as current owners facing balloon mortgage payments sell rather than refinance at higher interest rates. Although current mortgage loan rates will be higher than they have been in recent history, lower cap rates should offer attractive purchase prices, with the asset's value likely to increase within one to two years as interest rates stabilize.

© 2022 by Elizabeth A. Whitman

Any references to clients and their legal situations have been modified to protect client confidentiality.

DISCLAIMER: The content of this blog is for informational purposes only and does not provide legal advice. No one should take any action regarding the information in this blog without first seeking the advice of an attorney. Neither reading this blog nor communication with Whitman Legal Solutions, LLC or Elizabeth A. Whitman creates an attorney-client relationship. No attorney-client relationship will exist with Whitman Legal Solutions, LLC or any attorney affiliated with it unless a written contract is entered into.