The “Doom Loop” That Could Crash Commercial Real Estate

Dave:
Hey, everyone. Welcome to On The Market.
James Dainard, what’s going on man? Good to have you here.

James:
I’m happy to be here. Just landed on a Red Eye in Naples, Florida. So I’m in a random hotel room right now.

Dave:
Why are you in Naples, Florida?

James:
It’s for a sales retreat. We’re having a bunch of guys meet at one of our partner’s houses, so it is pretty cool. But I literally landed, got in the Uber and pulled over to a random hotel to hop in for the podcast.

Dave:
Oh, my god. So that’s not even where you’re staying.

James:
No, this is halfway mark.

Dave:
You just rented a room to record the podcast.

James:
Got to get that good wifi.

Dave:
Wow. Oh, my god. Wow. You stay at nicer hotels than me. My wifi is always terrible there. But that is dedication, we greatly appreciate that. Well, today we have a great show. Let me ask you, have you heard the term “doom loop” recently?

James:
It is on repeat. It is the term of the month, at least. I know that much.

Dave:
Well, if you haven’t heard it, to our audience, doom loop is the scenario that a lot of journalists and analysts are talking about where commercial real estate defaults start, banks stop lending, credit tightens, which puts more downward pressure on prices, more people default, and it becomes this negative downward spiral. And this has happened in the past. This is not fiction or theory. This has happened and a lot of analysts are thinking that it could happen in the U.S. with commercial real estate.
So today we have brought on an incredible guest. It is Richard Barkham, who is the Global Chief Economist and Head of Global Research for CBRA, which if you’re not familiar, one of the very biggest commercial real estate firms in the entire country. He maintains a massive team of analysts and economists, and we have an incredible conversation with him about the doom loop, about what’s going on in the international property market, and how it could impact the U.S. And so I think we’re going to hear some really fascinating stuff in this conversation.
James, do you have any questions you’re particularly interested in asking Richard?

James:
Yeah, where are the deals going to be? We haven’t seen the huge deals yet.

Dave:
Give me those deals.

James:
Where are they going? Let’s go find them.

Dave:
Yeah. All these economists, they talk a lot about theory. They’re wonderful guests and they’re super helpful, but I don’t think they’re going to be showing you any properties that are going to be big deals for you.

James:
They drop you those little gold nugget hints that you should start looking.

Dave:
Yeah, they inform your strategy.

James:
Yeah, take notes and go dig on all the sectors he’s going to talk about.

Dave:
Before we get into our conversation with Richard, I just wanted to call out that you’re going to hear two different terms that you may not know. One is cap rates. We do talk about that a decent amount on the show. But cap rates are one way that commercial real estate is often valued. And it’s basically just a measurement of market sentiment and how much investors are willing to pay for a particular stream of income, or a particular asset class. The higher the cap rate, the less expensive the building is. So buyers usually like high cap rates. The lower the cap rate, the more expensive the building is. So sellers typically like that. So just keep that in mind as we go through this interview.
The other thing we are going to talk about is IRR. If you’ve never heard of it stands for Internal Rate of Return, and it’s basically just a metric that real estate investors really of all types use, but it’s used particularly often in commercial real estate, and it is a preferred metric for commercial investors because it is a very sophisticated one. I’ve written about it in my book, but I can’t even tell you the formula off the top of my head.
Basically what IRR does, in the most simplistic sense, is allows you to factor in all the different streams of income that you get from a property. So a lot of people look at cashflow and cash-on-cash return ,or they look at their equity growth and look at equity multiple. What IRR does is it looks at the different cashflow that you’re getting, the different equity that you’re building, the timing of that income, and gives you one solid number to understand your overall return. And it is a great thing to learn if you’re a real estate investor. We talk about it in Real Estate by the Numbers. Just know that Richard and James and I are going to talk about IRR and that’s what it means.
All right, James, with no further ado, let’s bring on Richard Barkham, the Global Chief Economist for CBRE.

Dave:
Richard Barkham, welcome to On The Market. Thank you for joining us.

Richard:
Very glad to be here.

Dave:
Let’s start by having you tell our audience a little bit about yourself and your position at CBRE.

Richard:
So I’m Global Chief Economist at CBRE, and CBRE is the world’s biggest property services company. I’ve occupied this role for eight years. Prior to that I was with a very well-known English company called Grosvenor, and prior to that, for my sins, I was a university professor.

Dave:
Excellent. And can you tell us a little bit about what you, and I presume your team as well, work on at CBRE in terms of economic forecasting and analysis?

Richard:
Yeah. So my team is 600 people around the world, and we are primarily engaged in collecting and managing data about real estate markets. Now just keeping connected with global real estate markets is what we do, and we like to be first in the market with commentary on recent trends in real estate, and we like to have the best big ideas about the forces that are driving real estate.

Dave:
Oh, good. Well, we want to hear about your big ideas. Let’s start though with just a general outlook. Everyone has a different opinion these days about where the U.S. economy is heading. What’s yours?

Richard:
The U.S. economy has been surprisingly resilient, but we still expect a recession to come. We’ve got it penciled in for Q4 of 2023 and Q1 of 2024. But given the resilience in the economy we can’t be exactly certain with that. I could see us pushing that out a little bit, but the sharpest rise in interest rates in 40 years eventually will bear down on the economy. It’s already bearing down on certain sectors, real estate’s one of them. Global conditions are worsening as well, which points us more in the direction of a recession.

Dave:
And what are some of those global conditions that you’re referencing that you think will have the biggest impact on the U.S. economy?

Richard:
Well, I think first and foremost, we’d expected China when it bust out of Ziglar, that covid lockdown, to take off into really rapid growth. And it did for a quarter. But in Q2 the Chinese economy has slowed up quite a lot, and it’s partly because people spent all of their money in Q1 and have restrained themselves a little bit in Q2. But I think there are more fundamental issues in China to do with the weakness of the housing market, particularly in tier two, tier three cities. And also the Chinese economy is running into its normal channel of growth is exports, but western markets are very sluggish.
So I think the Chinese economy has got problems. Now why does that affect the U.S.? It’s because behind the scenes over the last 20 years or so, China’s been an increasingly important driver of global demand. And although the United States is a fairly isolated and resilient economy it can’t completely get away with weakening global demand. And that’s the big thing about China. But I also noticed Europe has weakened as well. Germany, France, Italy, all had negative GDP growth in Q2. So the bigger developed economies are beginning to feel a pinch as well.

James:
Glad you brought that up because I’ve actually been reading up on the Chinese economy quite a bit and how much it’s been cooling down and possibly heading towards stagflation. That’s a huge deal because it’s a massive economy that’s been emerging. What is that going to do to our possible recession locally? A concern of mine is that could actually send the world into somewhat of a spin which could keep rates a little bit higher. Do you think that that’s going to affect rates going forward for the next 12 months with the impact of any kind of global slowdown as well?

Richard:
No, I think it’s the reverse in the case of China. I think China’s going to send a deflationary impulse, a slowdown in China, because China’s a very heavy user of resources and commodities in the world economy. If the Chinese economy slows up then that puts downward pressure on commodities and that helps to reduce inflation in the developed world. And I also think China drives a lot of the emerging markets. China and the emerging markets together may be 35% of the global economy. U.S. companies export to those markets. So I think through that there’s a slow down impulse sent to the United States economy and the other developed markets. But I don’t think it’s inflation, I think it’s deflation.

Dave:
So one question I keep asking some of our guests is, for those who believe a recession is in the future, what is going to change between now, which you described as resilient, to one that actually dips into a recession? What do you think some of the drivers are going to be that tip the scales?

Richard:
I think at some point corporates will want to reduce their headcount. If demand slows up corporates will want to let labor go, and I think what we’ll start to see is unemployment ticking up. We’ve got incredibly low unemployment. It’s been at 3.5. The last number was 3.8, but I think over the course of a recession that could easily get up to 4, 4.5. And indeed, it was much higher than that in the great financial crisis. So fewer jobs, harder to get a job, longer between jobs, and that feeds through into consumer sentiment. And I think then that triggers households being much more cautious about what they spend. And we’re beginning to see some element of that, because at the moment the U.S. economy is continuing to add jobs, the new jobs that is offsetting the slowdown in spending from people who are already employed.

James:
So Richard, when do you think… The jobs report is starting to turn. I think this last month was indicating that it’s starting to cool. It’s definitely starting to cool down, and as far as what I understand is a lot of the interest rates that are being hiked up is high, it’s to (a) battle inflation, but also to cool down the labor market. Do you think, until we see more unemployment, do you believe that the Fed is going to continue to keep raising rates to try to battle the labor market? Or is it something that they can make it more of a soft landing to where we’re not going to have to see a ton of unemployment to get rates under control? Because right now cost of money is excessively high. I know I’m paying it in all my daily activities in real estate. I think we’re all waiting for them to come back down, and we’re seeing inflation starting to tick down. The job market’s starting to slow down, but do we really need to see a break in the labor market for that to start changing the other way?

Richard:
I think the Fed would love to slow the economy up without actually impacting the labor market. So I don’t think the Fed is attacking the labor market, but at the moment today’s data shows that the employment cost index was revised up. So the cost of labor is still higher than is ideal. And one simple way of expressing that is the rate of growth of hourly wages in the U.S. economy right now is 4.4%. The Fed would like to see that at about 3.5% because, and this is a technical economics answer, 3.5% wage growth plus 1.5% productivity growth gives you 2% growth in unit labor costs, and that’s the rate that is consistent with 2% inflation. So 4.4% is above the rate that’s consistent with 2% inflation, and indeed, actually productivity is flat lining, so that impulse from the labor market.
Now there’s two ways that that can ease. One, we can get more workers back into the labor force. So labor force participation can rise, and that has been happening. But the other way that it can happen is through taking demand out of the labor market. And demand for jobs, jobs created is going down, but I think there are still something like 8 million vacancies in the U.S. economy. So for all that it’s slowing up it’s still a robust labor market, and I don’t think the Fed wants to cause unemployment, but it’s going to keep interest rates high until that wage growth eases back substantially, and that may then trigger a rise in unemployment.

James:
Yeah, I’m hoping it cools down. We’re still trying to hire right now and it is impossible to get people, like at the Pacific Northwest, it is just terrible. Every time we put a job ad up it takes us three to four months to fill it, rather than 30 days, like it used to be.

Richard:
Well, I think you’re not the only business feeling that really. And there was a sense I think that manufacturing industry was slowing up. But if you look at surveys of manufacturing industry, the biggest issue is not cost of financing manufacturing, it’s access to skilled labor. It’s a real thing. One of the drivers of that, of course, is demographic. You’ve got a lot of boomers leaving the labor market. On top of all of the cyclical stimulus and all of the macroeconomic cycle, you’ve got demographics overlaying that, and you’ve got boomers leaving the labor market. And some forecasts actually say the U.S. labor market is going to shrink over the next five years. So that needs to be replenished, I think, with I would say, legal migration of skilled people. And that is picking up, but it is, as you suggest, labor market conditions have cooled but they are still tight.
Getting back to the original question, that is of concern to the Fed. Absolutely it is.

Dave:
All right, Richard. Well, we’ve peppered you a lot about macroeconomics, but we would love to hear, given your experience at CBRE, your take on the commercial real estate market. It seems every single day we read a headline about some doom and gloom scenario, and would love to hear if you feel the same way? Or what is your thought on the commercial market?

Richard:
Okay. Well, let me just put that in context for folks, just big picture, just before I start. Commercial real estate in the United States is worth about 10 trillion. It’s a little bit more than that. Single family homes, or residential real estate, is worth 45 trillion. So the residential real estate market is much, much bigger, and that is in good health actually. Prices are going up and even construction is looking up, and that’s really odd given that we’ve got mortgage rates at 7.5%. I think what accounts for that is post great financial crisis. We’ve just failed to build enough homes in the United States. There’s a deficit of three to 4 million homes, so the demand and supply balance in the residential market is reasonably healthy.
Now we can come on to how that affects the apartment market. People talk about doom and gloom. Let’s just get commercial real estate in context. And the real recessionary sector in commercial real estate is the office sector. And of that 10 trillion, offices may be 25% of that. So again, it’s a big sector, it’s very visible, it’s in our face. And vacancy in the office sector is 19%, up from 12% a couple of years ago, which is a rate of vacancy we haven’t seen since the savings and loan crisis in the early 1980s. Companies are really cutting back on the amount of space that they’re going to use because of remote working.
And also, we’ve got a delivery of new real estate into the market from the previous construction wave. So fundamentals in office, very weak right now. This is a nuance, I’m going to talk about real estate stuff.

James:
Please.

Richard:
It’s not true that the market in offices is completely dead. I’d looked at the number of transactions that CBRE is doing in 2023, and it is only 5% down on the number of transactions that we did in 2019. But when companies are taking space which is 30% less than they took in 2019, so the market is active, just companies are taking lesser amounts of space, and they’re also preferring the newer build. The real flight to quality and experience, I think. Market not dead, but the unoccupied stock has increased from 12% to 18%.
Looking across the rest of real estate, by which I mean apartments, by which I mean the retail sector, by which I mean industrial, and increasingly alternatives such as data centers, medical office, life sciences, I would say the fundamentals there are actually reasonably robust. It’s really surprising when you look across it. Vacancy rates are notching up, demand is not quite what it was, but I would say fundamentals in all of those sectors are reasonably okay. By which I mean to say that people are active in the market, taking space, and there’s not a big surge in vacancy rates and unoccupied space.

James:
Richard, have you seen much price compression? We’ve seen it across some of the residential space, but now we’ve seen the median home price creep back up. Have you seen much compression with interest rates rising and the demand? Like you were just saying, tenants are occupying less space. Have you seen much compression in all those segments, like industrial, office, retail and pricing? What adjustments have you seen? Because I have seen pricing start to tick down in those sectors, not as many transactions going on, but what kind of price adjustments have we seen year over year, based on the demand being smaller?

Richard:
Yeah. I mean, that’s a complex story, so this’ll be a bit of a long answer, but let’s kick off with apartments. If you’re a user of apartments the price you pay is the rent, obviously. In that period 2020 to 2022 when people really bust out of Covid, we saw apartment rents going up at 24%, on average across the States. It’s terrible. I would say apartment rental growth has dropped to about 2%. So prices are still creeping up but it’s below inflation. And there are certain markets I think where there’s quite a lot of new apartments being built where you’ve actually seen some price declines. But on average, I think prices across America in apartments are still creeping up slowly.
In the case of retail, that’s another strange story. We haven’t built any retail space for 15 years or so. And the retail sector has gone through Covid. It’s cleaned up its balance sheets, it’s reinvented itself as a omnichannel operator, very snick omnichannel and I think part of the fact the consumer exuberance has sent people into retail centers. So actually in the retail sector our brokers tell us there’s not enough Grade A space. Companies are being held back from expanding because there’s not enough good space. We haven’t built enough. So rent’s still creeping up in retail, actually. That’s not to say there isn’t a problem with Grade B and Grade C malls. I think everybody would see that in their daily lives, but even some of those are reinventing themselves as community hubs and antique mall destinations. And they’re finding other uses, even flex offices are going into some B and C malls.
So that’s apartment, that’s retail. Industrial, that’s got the tailwind of the digital economy, of e-commerce, still well and truly behind it, and we are going to see leasing in industrial down 30% this year from a billion square feet last year to maybe 750 million square feet, but it’s still going to be the third-strongest year on record. So rents are moving up and more than a little in industrial, maybe around somewhere between 9 and 12%. So that’s a very hot market. And of course, other things like data centers. There are folks here in Dallas, where I’m based, leasing space six years out. There’s really huge demand for data centers around Cloud computing, artificial intelligence, it’s an incredibly hot sector.
So I’ll pause there. There are other sectors I could talk about, but I think the fundamentals in real estate, apart from offices, are surprisingly strong, which is not to say that investors are active. If you make a distinction to people who use the real estate for what it’s built for and they pay rent, and the people who own real estate, which are pension funds, life insurance companies, university trusts and other private capital, it’s very quiet on the investment front right now. And prices are dropping. The actual price that you would pay for real estate as an asset will be down anywhere between 15 and 20% on where it was two years ago.

Dave:
So just in summary. Yeah, so demand among tenants, whether they’re apartment tenant, retail tenant, seems to be holding up relatively well, but demand among investors is slipping. That is what we’ve been seeing, and the data I’ve been looking at shows that cap rates are moving up. Is that what you’re seeing? And if so, outside of office, I think we all understand office as being the biggest hit, but our audience is particularly interested in multifamily apartment type of audience so I’m just curious how cap rates are performing in that specific sector of commercial real estate.

Richard:
Well, I think it’s like all of the other sectors. Cap rates would be out approximately 125 basis points to 150 basis points, depending on the type of asset and the location, from somewhere around 3.5% out to 4 or 5%, depending on the location. And maybe higher than that, depends what the starting point is. There are a range of cap rates reflecting the different gradings and the different locations. I would say, as a general, prices are out 150 basis points, and that is the equivalent of approximately a 20% drop in prices.

Dave:
And do you think that’s going to continue?

Richard:
Yes, I do, actually. I see… Not forever.

Dave:
No, I just love someone who gives a direct answer. So usually when we ask something like that they, hey, well. Because it is complex, don’t get me wrong, there are many caveats, but I do always appreciate a very clear answer like that.

Richard:
Yeah. I think there could be further loss of value, and it won’t reverse itself until investors begin to see a clear glide path for interest rates. We began to see, I think maybe two months ago, just a little bit of a sense where people were… Looking at what I saw, which was actually offices, that’s got a problem, but fundamentals in real estate actually not too bad, we seem to be getting on top of inflation. And those forward rates of return, take a 5% cap rate, add 2% rental growth and we’ve got notionally a 7% forward IRR, and that equates to debt costs somewhere between 6.5 and 7.5%. People began to think maybe we’ll start looking at deals again.
But I think the spike in the 10-year Treasury, when it went from 4.2 to 4.4 in the last two weeks, again brought that uncertainty about the glide path for interest rates front of mind. So people just put their pens down again and thought, well we’re just going to wait and see what happens. We’re in this world, I think, that good news is bad news, whereas between 2009 and 2020, for real estate bad news was good news because it kept interest rates down. Now we’re in the opposite world, it’s the same world but it’s opposite. But good news is bad news because it increases the people’s worries about interest rates higher for longer.

James:
So Richard, you’re saying we could see some more buys over the next 12 months. I feel like the multifamily market has dropped a little bit, but the sellers are still hanging in there and there’s not a lot of transactions going on because the cap rates, they’re not attractive enough for us to look at them. Because I’ve seen the same thing, we were seeing cap rates like 3.5, maybe low 4s, and now they’re up to 5.5. It is not very attractive with the debt out there right now.

Richard:
No, no. I mean, I think if people had more confidence you wouldn’t just look at, to get technical, you wouldn’t just look at the cap rate. You’d have to look at the IRR, which takes into account the rental appreciation that you would get.

James:
Right.

Richard:
And I think the IRRs, even if you assume 2% rental growth, 2.5%, it gives you an IRR that is getting in the ballpark. But I think when confidence evaporates people are not IRR investors. IRR investors involve making assumptions about rent in the future, and people don’t want to do that. And just, as you say, there’s no positive leverage right now and people are unwilling to accept negative leverage in the marketplace.
But it won’t take much to tip that equation, I don’t think. We’d like to just get a bit more obvious direction on where inflation is going, a bit more obvious guidance that we’ve reached the peak of the Fed funds cycle, the Fed have been very equivocal about that, then I think things will tip. Because on the leasing side, leasing disappeared in Q2 of 2022, just when interest rates started going up people dropped out of the market. Well, leasing is back. Q2 of this year leasing came back. And we’ve got quite a high level of new construction, maybe 90,000 units per quarter, but the market is absorbing 60 to 70,000 units per quarter, at least based on Q2 evidence and Q3 trajectory.
So demand has come back up. Vacancy is probably increasing slightly. But with demand coming back it won’t take too much, in terms of that expectations for people to say there are some bargains to be had here. I would say, just on your point about sellers holding out, if the Fed hadn’t intervened and provided liquidity to the banking sector, which has allowed the banking sector to be able to transit through a period of loans. They might still be paying the interest but they’re below water in terms of value. We might have had a different situation. The Fed has been very active in providing liquidity to the banking sector. And of course, I think that’s kept pressure off the owners, and therefore you’ve got this standoff between buyers and sellers, or owners and potential buyers.

Dave:
Richard, I do want to follow up on the banking sector and what’s going on there. Just yesterday I was reading an article in the Wall Street Journal where they were positing about a “doom loop” in commercial real estate. The basic premise is that their valuations are already down. It’s put some properties under water and now people are starting to default on those loans. Bank credit is tightening up, which means people can’t refinance or they can’t purchase, which puts further downward pressure on valuations, and it creates the spiral that creates sustained downward pressure on prices in the commercial real estate space. I’m curious if you think there is a risk of this doom loop, or whatever you want to call it, if there’s more risk in bank failures and the lack of liquidity impacting the commercial market?

Richard:
I mean, what I’m going to tell you is rather a complex argument, which is somewhere in between, there’s no problem and there’s a doom loop.

Dave:
Okay.

Richard:
I think, with great respect, the journalistic maxim is to simplify and exaggerate.

Dave:
Right.

Richard:
And I think, to a certain extent, with real estate that’s what’s going on. And I’m not saying that there isn’t an issue with loan impairment, but I think what we are hearing and what we’re seeing is banks have got ample access to liquidity, and because of that they’re not suffering deposit flight. So where they are making losses or they have to write down loans, they’re able to bring that to their P&L account on a relatively orderly basis. There is no doubt that the cost and availability of credit for new financing is much tighter. It’s incredibly tight. But I don’t think the banks want to end up with real estate on their books. I mean, they’ve been through this before. They don’t want to put people into default and then they’ve got the real estate that they’ve either got to manage or they’ve got to sell it at some discount to somebody who holds it for two years and then makes a profit two years down the line. They’ve been through that before and they don’t want to go through that again.
So I think what we’re seeing is that, where possible, banks are extending. I’d go as far as to say extending and pretending, but there are lots of creative ways in which banks can work with borrowers in order to get through the period of acute stress. And I’m not saying there aren’t going to be losses. Our own research tells us probably 60 billion of loans are likely to default. There’s 4.5 billion of loans to commercial real estate. That 60 billion, maybe it’s 1.5% of total bank assets. So it’s going to be painful, but it is not going to bring down the banking sector. Therefore, the doom loop, it’s not good, and making losses is never good, but I don’t think it’s quite as an aggressive doom loop as we have seen in previous real estate crises. We’ve seen doom loops do exist in reality. They did in the savings loans crisis, they did in the great financial crisis, but at the moment, for a variety of reasons, I don’t think we’re there yet.

James:
There’s definitely a lot of articles with that word doom loop going on. It’s the new in-term I’m seeing on every article, where it’s doom loop, doom loop, that’s all I’m hearing.

Dave:
Just wait, James, the episode is now going to be called doom loop, and we’re going to probably have our best performing episode of all time if we call it the doom loop.

Richard:
Can’t we talk about virtuous circles rather than doom loop?

Dave:
Yeah, no one wants to hear about virtuous circles, they want to hear about doom loops, unfortunately. I would love virtuous circles.

James:
But if there is a doom loop coming, Richard, because it sounds like you feel confident in some commercial sectors going forward, what sectors do you feel are the most investors should be wary of right now? If you’re looking at buying that next deal in the next 12 months, what sectors are you like, hey, I would cool down on that or be wary of?

Richard:
Well, it’s very tempting to say offices, because offices, as I say, we’ve got that jump in vacancy from 12% to 19%. We’ve got no certainty about the return to work in U.S. office. We think the return to work will gather pace, but just over a longer period, but there is no certainty about that right now. On the other hand, as a professional in real estate of 40 years or so, you get the best bargains in the most bombed out markets. So amidst all of that repricing there are going to be some very good opportunities in the office sector. And if you really want to be contrarian you run in the opposite direction. All those people running one way saying doom loop, doom loop, you work out where they’re coming from and move in the opposite direction.
I think also retail has got quite a lot going for it right now. We were seeing quite a lot of private capital. And it’s not like office, the asset sizes can be smaller. It is possible for smaller investors to get involved in retail, and we are seeing a shortage of space, and we’re seeing some very, very interesting trends in retail. The sexy sectors, if I want to put it in those terms, or the sectors that we are most confident on, I think, because of the tailwinds are the industrial sector and the multifamily sector if you want to invest in longer term rental growth. But once the market starts moving that’s where the prices will rise quickest. So if you want to invest in that long-term story then you need to move quickly, I would say.
Don’t get me wrong, there are certain parts of multifamily and apartment that I think will run into some problems. There was quite a lot of very cheap bridge financing in the multi-sector where people were, in the boom years of 24% rental growth, people were buying Grade C assets with very low debt, and they were looking to refurbish and reposition those as B or B plus or A Grade space. Given the general weakness and the level of interest rates, I think some of those could end up defaulting. So if you’re a student of these matters there might be assets to be picked up or recapitalized in that segment of the market.

Dave:
James is going to start salivating now.

Richard:
Oh, I was. I was getting worked up.

Dave:
That’s his wheelhouse.

James:
I was getting itchy fingers all of a sudden. I’m like, yes, here we go. And I think Richard nailed it. It’s like everyone was buying these deals on very tight performers and then they’re debt adjusted on them in midstream, and your construction costs are higher, your permit times are longer, and then all of a sudden your cost of money’s gone up and it’s definitely got some trouble in that sector. It’s like the stuff that’s stabilized is still moving as well, but the stuff that’s in mid-stabilization that’s where we are seeing opportunities. And that’s definitely where we’re looking.

Richard:
That’s right. And again, over a long career, people who’ve made very good buying decisions have bought from troubled developers or troubled construction companies. We’ve seen this one before.

Dave:
Well, I hope no one loses their shirt. I’m not rooting for that at all. But I think it is helpful to recognize that this is happening and that there are likely going to be distressed assets that need to be repositioned by someone else other than the current owner.

Richard:
Yeah. I mean, the banking sector at the moment is writing off a lot of debt that’s below water so there is an economic cost to this, but it’s just not got out of control at the moment. And thankfully it hasn’t quite hit the consumer sector, the housing market yet, because that then impacts ordinary people, and that’s not very pleasant at all.

Dave:
Well, Richard, thank you so much for joining us. This has been incredibly insightful. I do want to share with our audience that you and your team have authored an incredible economic report, called The Midyear Global Real Estate Market Outlook for 2023. It’s a fascinating read and there’s a great video that goes along with it as well.
Richard, can you just tell us briefly about this, and where our audience can find it if they want to learn more?

Richard:
Yes, it’ll be on the CBRE website, cbre.com. Go to Research and Insights, and click through on that. It might take two or three clicks, but it is there. I have my research experts from around the world and we try to be neutral and balanced and data driven. We just give a broad overview of real estate markets in the United States and around the world. Actually, I participated in it and I learned from it as well, actually.

Dave:
That’s the best kind of research project, right?

Richard:
Yeah, absolutely.

Dave:
All right. Well, Richard, thanks again for joining us.

Richard:
It’s my absolute pleasure.

Dave:
So James, Richard has told us that he thinks asset values are going down, which obviously is not great for anyone who holds real estate, but also, that there might be some opportunities, which I know you are particularly interested in taking advantage of. So how does this type of forecast or prediction make you feel about your business?

James:
Well, I like he gave me verification that you should be buying when other people don’t want to buy, essentially. There were so many key little things when he was talking about how industrial the rents are going up, but the pricing’s going down. So there is some opportunity in those sectors of going through and just looking for those opportunities right now, because you hear it all the time that people are like, “Ah, you can’t buy anything. You can’t buy anything.” But that stat alone that he was talking about, industrial, rents are going up but the pricing’s going down, that is where you want to go look at. So I am getting more and more excited for the next 12 months, and it’s going to be a matter of being patient and finding the right opportunity.

Dave:
You mentioned on the show that cap rates where they are now, you said Seattle, what are they 5.5?

James:
Yeah, I would say 5.25 to 5.5, in there, somewhere there.

Dave:
But given where interest rates are, that’s negative leverage, that’s not something that’s typically attractive to investors given where debt costs are. At what point would cap rates have to rise for you to feel really excited about the potential of the deals you could buy?

James:
Well, you can always get a good cap rate if you buy value add. That’s where you can increase it. But I mean, in theory, I don’t really like to buy below cap rate. I would want to be in that 6.5. If it’s stabilized with little upside, I want to be around a 6.5 right now.

Dave:
And just so everyone understands, cap rates are a measure of market sentiment. And as James is indicating, it ebbs and flows based on cost of debt, how much demand, perceived risk. And generally speaking, cap rates are lower for stabilized assets. And when cap rates are lower that means that they trade at a higher cost. When cap rates are higher, they’re cheaper. And usually you can get a higher cap rate as a buyer if you’re buying, as James is saying, a fixer up or something that needs value add.
But sorry, James, go ahead.

James:
Yeah, I think that’s what we’re seeing right now. A lot of the transactions we’re seeing in this last six months it’s a lot of 1031 movement of money, but not a lot of new buyers walking in for that general 5.5 cap. If they have a purpose to go buy, they will. Other than that, everyone’s chasing that value add where you got to roll up your sleeves, get to work. But there is some really good buys right now. I know our IRRs have increased quite a bit over the last nine months to where we’re now hitting 17, 18%, and so those are all good things.

Dave:
That’s a very good thing. Well, we’ll just have to keep an eye on things and see how it goes, but I generally agree with Richard’s assessment. Cap rates are up, and I do think they’re going to continue to climb while my guess is that rents, at least in multifamily, which is the sector I understand the best, are probably going to slow down. They might keep above zero and grow, but I think these insane rent growth rates that we saw in multifamily are over for the time being. And so that combined with cap rates increasing we’ll bring down multifamily values even further past where they’re today, which might present some interesting opportunities. So we’ll have to keep an eye on this one.
James, thanks so much for being here. We always appreciate it. And for everyone listening it, we appreciate you. If you like this episode please don’t forget to leave us a review on either Spotify, or Apple, or on YouTube if you’re watching it there. Thanks again, and we’ll see you for the next episode of On The Market.
On The Market is created by me, Dave Meyer, and Kailyn Bennett. Produced by Kailyn Bennett, editing by Joel Esparza and Onyx Media, research by Pooja Jindal, copywriting by Nate Weintraub. And a very special thanks to the entire BiggerPockets team. The content on the show On The Market are opinions only. All listeners should independently verify data points, opinions and investment strategies.