The Rising Cost of the Deal

Inflation may be falling closer within reach of Fed targets, but commercial real estate is still feeling the pain from both higher interest rates and higher operating costs.

“Obviously, the higher interest rates are affecting the bottom line and debt service coverage ratios,” says D’Etta Casto-DeLeon, CCIM, a Director at CBRE Loan Services in Houston and The CCIM Institute’s 2024 Global President. Operational costs also have been climbing across the board on a variety of different line item expenses. Insurance costs, in particular, have spiked over the past two years, while property taxes, payroll, and materials costs are all moving higher in many cases. “If you don’t have any rent growth, that will cut into your ability to offset some of those costs as well,” she adds. 

The most significant pain point for commercial real estate is the higher interest rate environment, which is clearly impacting underwriting on financing, new construction, and investment sales. At the end of the first quarter, the trailing 12-month volume of commercial real estate investment sales activity was down 45%, according to MSCI Real Assets. On the leasing side, higher CAM and tenant improvement costs are influencing landlord and tenant decisions, impacting how deals are structured and are limiting a building owner’s ability to push net rents higher.

One of the prevalent themes in deal-making in the current environment is that sponsors need to bring more equity to the table to get deals done. Often times, borrowers are having to put more equity into the deal and/or are having to reduce their expectations of what their sell price might be,” says Casto-DeLeon. Indeed, there are nuances depending on the location and property type. Office has more challenges, while industrial, multifamily, and retail are all still doing relatively well. “We are seeing these increased costs across the board, and that's going to affect the value of just about every product type on some level,” she says.

Rising costs are impacting debt service coverage ratios, which in some cases can trigger certain loan covenants, such as a lender implementing a tax and insurance escrow or some type of cash management agreement with a cash flow sweep. Higher costs are also having an impact on the value of a property. “That hinders a borrower’s decision on when they want to get out of a deal because not all borrowers have a hold mentality, meaning that they plan to sell the property at some point in time,” says Casto-DeLeon. If they can’t get their target sell price, they may end up holding the property longer, and that also may impact the return they are expecting to pay their investors, she adds.

Waiting for Rate Cuts

Market participants are still navigating the “higher for longer” interest rate environment. The silver lining is that further increases are likely over. “In essence, we are at a cyclical peak, and maybe we’ll begin to trend down,” said NAR Chief Economist Lawrence Yun in the “2024 Market Outlook for Commercial Real Estate”. In fact, the 10-year treasury has already shown improvement. After peaking at nearly 5% in October, the benchmark rate dropped back to 4.4% as of mid-May. 

The big question is when the Fed might move to lower rates. Although inflation has come down from very high levels, it does remain persistently above the Fed’s 2% target. As of April, the CPI remained at 3.4%. The consensus view of when the Fed will move to cut rates continues to push out further in the year. As of mid-May, the CME FedWatch showed forecasting was a higher probability for a rate cut in September at roughly 63% versus a 37% likelihood that rates would remain the same.

A more normalized environment with higher rates has implications on property cap rates. “From that standpoint, we will continue to watch how the market views those cap rates,” says Brian Bailey, CCIM, commercial real estate subject matter expert at the Federal Reserve Bank of Atlanta. “There's not a lot of transactions right now. So, finding an accurate cap rate and an associated accurate property value is much, much more challenging,” says Bailey, who focuses on the commercial real estate industry in the bank supervision department.

Stabilizing Construction Costs

On a positive note, rising costs of construction materials appear to be slowing. The cumulative change in the producer price index (PPI) for inputs and bid prices for nonresidential construction for March was up a modest 1.5% year-over-year. However, contractors are still feeling the cumulative effect of increases over the last few years with the PPI that is up 39% since February 2020. In addition, the average hourly earnings for construction workers were up 4.9% in March compared to the prior year. 

Some of the cost pressures that were created due to supply chain problems associated with COVID have been corrected, and commercial real estate costs are coming back down. 

A decline in construction starts could help to ease some of the pressure on material and labor costs simply due to supply and demand impacts on pricing. 

Yet construction cost increases will vary depending on the region. “We all joke about real estate being location, location, location, and that is really the case,” says Bailey. As an example, multifamily has seen very robust new supply across Sun Belt markets such as Nashville, Charlotte, and Austin, which is resulting in some near-term softening of vacancy and rental rates and slowing of new construction starts. 

“There are pockets in the United States that are benefiting from either the slowdown, in construction costs, or perhaps the reemergence of some of the labor that had gone to other sectors to get jobs that are returning,” says Bailey. “So, there are a couple of dynamics that are influencing construction costs, but I don't I don't see a sizable drop in construction costs because the economy continues to remain healthy.”

Insurance Costs Have Seismic Impact

Another pain point for commercial real estate has been surging insurance costs. “We have several factors that are playing a role in current insurance costs, and they're all having a say in the rate that’s being charged,” says Gary Sullivan, Senior Director of Emerging Risks at the American Property Casualty Insurance Association (APCIA). 

One key factor is a rise in exposure values, the amount being insured, which has been driven in part by inflation and higher rebuilding costs. Generally, exposure values in the U.S. have increased by more than 450% since 1990. In addition, there are more building occurring in disaster prone areas. Roughly 127 million people in the U.S. now live in coastal counties, which is about 35% of the U.S. population, according to the APCIA. 

Climate change is another significant factor with mounting insurance losses caused by the increased frequency and severity of extreme weather events. The estimated total economic costs of direct physical damage and net-loss business interruption from global natural perils in 2023 was $357 billion, with public insurance entities covering about one-third of those losses, according to “Gallagher Re’s 2023 Natural Catastrophe and Climate Report”. 

Anecdotally, brokers are reporting that the level of increases for commercial properties appears to be slowing down, and the reinsurance market is reflecting ample capacity, which is good for insurance carriers, notes Sullivan. “There are indications that 2024 may be the year of some positive adjustment,” he says. 

However, insurance is one of the few industries where rates are approved by regulators, meaning there is a lag in changes to rates. 

What that means is that recent losses and persistently high replacement costs will continue to factor into future rates.

Property owners are working more closely with insurance brokers and carriers to try to get better pricing. “One area that we’re promoting as an industry is to promote resiliency in buildings,” says Sullivan. Taken preventative measures to mitigate property damage from risks related to flooding, wind, seismic events, or extreme heat can result in more favorable insurance pricing. “I would encourage any commercial property owner to reach out to their agent broker insurer and tap into those resources to see what sort of risk reducing measures they can take to help lower the premiums or control their premiums in a better manner,” he adds.

Eye on Distress

Cost pressures are occurring at a time when many owners and commercial real estate sponsors are battling softening fundamentals and maturing debt. The market is keeping a close eye on potential distress emerging, especially considering the wave of loan maturities ahead that will need to refinance into a higher interest rate environment. There is an estimated $1.2 trillion in commercial real estate loans maturing in 2024 and 2025, according to CRED iQ and the Mortgage Bankers Association.

As the commercial real estate expert at the Atlanta Fed, Bailey is monitoring commercial real estate loan maturities and distressed debt every day. Bailey believes that the larger banks and regionals are staying on top of managing the risks within their commercial real estate portfolios. The Atlanta Fed has also been engaging with smaller banks to make sure they fully understand their geographic competency and concentration risk. Banks have been highly focused on analyzing risks within their commercial real estate loan portfolios over the past few years. First, commercial real estate portfolios were getting more attention from lenders due to the elongated growth cycle and fears of a potential recession, and then secondly due to stress that occurred during COVID. “From that standpoint, banks were going through some of the mental gymnastics and analysis of looking at their portfolios,” says Bailey. 

In addition, while operating and capital costs remain front and center in the current environment, it’s important to also look at costs in the context of the current environment. Higher costs are landing in a relatively good economy. Turn the clock back a year; there was a lot of uncertainty about a possible recession. Now, those fears of recession have faded more into the background. “We still see job growth at rates that are, in my opinion, in excess of what the economy needs to create to keep up with natural population growth,” says Bailey. The latest consumer sentiment numbers were not quite up to the level that was anticipated on Wall Street. However, the consumer has been and continues to spend. “So, I think we're in a fairly healthy economy on that front,” he said. The performance of retail, and to a lesser degree, the industrial sector benefit directly from consumer spending.

Looking at commercial real estate specifically, office has some obvious challenges related to remote working and more efficient use of space that is going to be a longer-term dynamic that plays out. Multifamily and industrial are slowing due to the high levels of new supply that have been added to the market, but both have good underlying demand drivers. Retail has also been surprisingly strong due in part to the lack of new construction, which has resulted in higher occupancy levels. “There are some areas of commercial real estate facing a bit more headwinds these days,” adds Bailey.

Current cost challenges highlight the need to work with experienced real estate professionals across all aspects of development, investment sales, leasing, and property or asset management on the operations side. CCIMs have an opportunity to provide valuable advice to their clients and fellow CCIMs who are trying to better understand current market dynamics. “It depends on who you’re talking to, but most of the time, you’re talking to owners who need experienced CCIMs who can get the leasing, the financing, and the property management done,” says Casto-DeLeon. “You need all of those individuals on your side to give you advice on where you can get the best deal and transact in this marketplace.” ■