JOHN BURPEE & ASSOCIATES

The current state of the Q1 2024 commercial Real Estate market reminds us of the Simon and Garfunkel song from 1970. The song’s lyrics echo the market conditions in many ways, “When you’re down and Out, when times get rough and pain is all around”, echo’s the chorus buyers and sellers are singing.

The investment sector of the market has stagnated with only desperation-stricken or unrealistically priced sellers wading into a pond filled with piranha like buyers. But, even when desperation is forcing a sale, the “Hopium Hangover effect” of practically pricing properties is not being reflected in current listings. Every seller we talk too is praying they find a desperate 1031 buyer willing to overpay for a multi million-dollar deal.

Sellers still believe the Fed is going to “Ease their mind” and build them “a bridge over troubled waters” by rapidly cutting interest rates. Unfortunately, we do not believe the federal reserve has any intention of reversing rates in the foreseeable future.

We believe higher rates are here to stay for at least the next 18 to 24 months unless the country encounters a national economic or geopolitical global setback. We believe the fed will need to see unemployment rise above 5% and several quarters of slowing economic data before changing course. We do believe there will be a “Show of political good intention” with one .25 basis point gesture in the late third quarter prior to the election. Past this, the Fed will need to see a consistent stream of negative economic data before changing sentiment.

We believe weakening economic data will begin to be reported in the fourth quarter of 2024 as the election season ends and sectors outside of commercial real estate begin to experience the same stagnation. Pinholes in the economic ballon are already leaking air with GM reporting first quarter cars sales falling by 1.5% and Tesla announcing a 10% workforce reduction. Additionally, Lending Tree reports that national credit card debt is at an all-time high of $1.129 Trillion dollars with the average household carrying $6,854 with only $3,215 of available credit. Gone are the days of $20,000 over sticker at new car dealers with special financing incentives and cash back offers currently the norm.

Below is a Bloomberg chart showing 52-years of average interest rates for real estate loans. As you will see, rates are currently at historical averages but cap rates and expected values are out of sync with historical trends.

One only needs to review the federal reserve’s meeting calendar to establish a forward looking path to rate cuts. The fed meets 8 times a year to determine policy changes, if they were to lower rates 25 basis points per meeting it would take 26 months to return to 2022 rates. It is possible that the fed could “Shock the system” and lower rates by more than 25 basis point at any given meeting but the data would need to be so negative it would send financial markets into a tailspin.

The current fed board of commissions seems to be very cautious with a “wait and see type of governorship”. We do not believe we will see any “shock and awe” type moves from this fed unless the nation is faced with another humanitarian crisis such as a second global pandemic or geopolitical military event such as China invading Taiwan.

The chart below is our example of the historical average of Cap rates to interest rates.

As you will see the anomaly of interest rate inversion started in 2022 and we feel will top out in mid-2025.

We are forecasting an additional 15 to 25% downside pricing pressure in commercial real estate based on the federal reserve normalizing interest rates through 2026. We believe the values will be forced back to the historical matrix of interest rates below cap rates by lower prices rather than lower interest rates over the next 24 months.

Using the historical data presented in these two charts you will see that current cap rates are 20% below average interest rates, presenting a negative spread. Historical pricing prior to 2022, has always allowed investors to arbitrage the spread between the cap rate and interest rate to profit from the 100 to 200 basis point spread. Hence, they borrow more to make more theory.

Currently, the market is priced at an inversion of cap rates below interest rates creating a negative mortgage to cap rate environment. This is forcing investors to inject far more capital than at any time in history as equity into a deal to meet the debt coverage service ratios and underwriting requirements.

The often-overlooked DCSR (Debt Coverage Service Ratio) has become a thorn in the side of investors and lenders alike. The industry underwriting standard for most lenders ranges from 1.2 to 1.3 DSCR. (We have used 1.25 for our analysis) This means your corrected NOI (Net Operating Income) must be 1.25 times greater than your total cost to service your mortgage debt.

DSCR = Net Operating Income Divided by Total Debt Service expense

The risk is compounded further for investors that chose an interest only bifurcated loan as their I/O period is close to ending and will most likely be caught in a catch 22 trap. If the investor was not able to increase rental income enough to offset the increased debt service and inflationary pressured operating costs, they will be caught in the equity trap described herein.

Borrowing from our 2022 white paper, we are recapping the following loan scenario for a $1.2 million NNN investment property purchase made @ 4% Cap Rate 36 months ago: We have used today’s average rates and underwriting to determine the refi shortfall. We have assumed a 10% rise in NOI for the last 24 months.

Initial Acquisition Underwriting 36 months ago

Cap Rate at time of Purchase: 4.5%

DSCR: 1.25

Purchase price of the Asset: $1,200,000

Net Operating Income (NOI) at time of purchase: $54,000

Total Required Down Payment to meet 1.25 DCSR: $450,000

$750,000 Mortgage @ 4% Interest Rate and 30 Yr. Amort 62.5% Loan to Value

Monthly payment $3,580.61 (Annual P&I Debt Service $42,967.38)

Underwriting at current 2024 interest rates

Current Cap rate of 6.5%

DSCR: 1.25

Initial Purchase price of the Asset: $1,200,000

Current value of new appraisal at 6.5% Cap $907,693 (Value Loss $292,307)

Net Operating Income with 10% Increase $59,500

Total Required Additional Capital to mortgage paydown $210,000.

$540,000 Mortgage 8% Interest Rate with a 30 Yr. Amort 47.5% Loan to Value

Monthly P&I payment $3,962.32 (Annual P&I Debt Service $47,547.94)

The doubling of interest rates has forced the investor to inject additional equity into the investment to buy down their debt and reduce the outstanding loan balance enough to meet the 1.25% DCSR.

Unfortunately, we believe the worst is yet to come for the investment side of the commercial real estate market. Investors will simply sit on the sidelines and wait for the bridge over troubled waters to collapse before entering the market. We feel the market will remain in a state of turmoil for at least the next 12 to 24 months or until cap rates over mortgage rates return to normal levels

We hope this paper helps you with your current and future investment strategies.

John Burpee
CEO
John Burpee & Associates
727-828-9498
[email protected]