Why office sales volumes are increasing & PSF is declining

Multifamily cap rates, which have been steadily falling during the pandemic, are being squeezed by the rising cost of capital.

This will ultimately put pressure on the sector’s property values, according to new research from Moody’s Analytics. “Without continued unprecedented rent growth, the darling multifamily asset class likely carries the most risk of value decline while the benchmark US Treasury rate is on the rise.”, analysts warn.

Cap rates have remained static even if Q3 has now started to show a little increase for industrial, office, and retail. According to Kevin Fagan and Xiaodi Li of Moody’s, ” For multifamily, cap rates have continued to decline, which, along with tremendous rent growth, has propped up multifamily values compared to equities and other investments.” However, the multifamily sector will ultimately see fewer buyer offers and higher property yields due to the rising cost of capital and growing worries regarding ex-ante exit cap rates. Therefore, pressure on multifamily property values will come from the Fed raising rates and the banks doing the same with loan interest rates.

Moody’s economists point out that rising 10-year treasury rates have driven CMBS loan interest rates significantly higher than in prior months, and both are expected to keep growing. But while the cap rate for industrial properties began to rise in Q3 2022, multifamily rates kept falling. Fagan and Li state that “cap rates with tight spreads are highly likely to increase under the upward pressure of rising interest rates.” They add that this raises the question of how much rent growth is required to stop a decline in value. As of Q3, spreads between cap rates and loan interest rates for the sector were clocked at 0.76%.

If a CRE investor wishes to leave in five years and the cap rate increases from 5% to 6.5%, they claim that the average annual rent growth must be higher than 5.4%. The exit value would be less than the current value in that case. Even while multifamily growth rates from Q3 2021 to Q3 2022 were 8.2% annually, a sustained average growth rate of 5.4% is significantly higher than any previous record.

In the end, the pair claims that narrow cap rate spreads and rising interest rates are “warning indicators.”

Fagan and Li assure, “We will keep a close eye on those numbers.”

Why not diversify your assets while holding on to your profits by deferring taxes on the sale of your property?

This is but one potential advantage of UpREITs and DownREITs, largely underutilized instruments that can offer an additional means of deferring the capital gains taxes incurred from an asset transfer. In that regard, they are similar to 1031 exchanges, but given the aim that the current government has set for like-kind exchanges, investors should be aware of Up and DownREITs. Let’s examine each in greater detail. 
A partnership that is still the owner of the real estate is below the REIT in an UpREIT (the “up” stands for Umbrella Partnership). As a result, the REIT does not really have title to the properties; rather, it only owns a stake in the underlying partnership. In contrast, a DownREIT will buy some properties outright and have a stake in a lower-tier partnership that controls the assets directly. 

For the purposes of this discussion, let’s concentrate on UpREITs, even if most of what we’ll discuss also applies to DownREITs. Such a transfer of assets is not regarded as a taxable event under existing tax laws. Naturally, this changes if and when the partner transforms their portion of the assets they brought to the table into REIT equity shares. The gain must then be acknowledged. This implies that the investor has the option of timing in addition to the tax deferment. Naturally, this assumes that the REIT in question is a publicly traded REIT.

However, both have significantly greater transaction charges, and the closing is more difficult. Also, keep in mind that REIT equities are simply that—stocks—and not necessarily real estate. Remember that they closely track the S&P 500 as equities rather than more traditional real estate performance indicators such as interest rates.

But let’s get back to the advantages, one of which is asset diversification. For instance, all of your risk is present if you own just one piece of real estate. You effectively diversify that risk over all the properties in the portfolio, including yours, by donating that property to the REIT and getting operating partnership (OP) units in the REIT. This is, unsurprisingly, a significant draw for new participants.

Liquidity is another factor to take into account when choosing UpREITs over 1031s or conventional deals. A standard transaction may take up to 90 days to monetize, if you’re lucky. In contrast, it may just take a few days or weeks to convert OP units and sell the resulting shares.

Three other benefits must also be taken into account. Freedom from managerial obligations comes first. The success of the REIT is predicated in large part on the staff’s ability to effectively and efficiently manage an asset. REITs come with staff to handle those tasks.

Predictability and simplification come next . The owner of an OP unit can count on routinely occurring cash distributions in sums comparable to the cash flow from a single property. They are merely getting a check in exchange for their donation. Additionally, take into account the basic reporting obligations for REITs. No other sector, it can be said with confidence, does as good a job of informing its investors as the REIT sector does.

In light of the risks to the viability of 1031s and the current state of the economy, investors seeking a relatively safe haven vehicle should pay more attention to the benefits of Up and Down REITs.

The topic of whether conversions could succeed frequently arises in any discussion about housing shortages in a CRE context. Take a look at all the office supplies that are waiting for someone to return to work. How about solving two issues at once: the demand for housing and the desire to make existing office stock profitable? Let’s convert buildings, turn them into flats, and rent them out.

Anthony Orlando, an assistant professor at CalPoly Pomona, and Chris Cunningham, a research economist at the Federal Reserve Bank of Atlanta, have examined the possibility of office conversions meeting housing demand for the bank.

In spite of the Fed, there are still concerns. Many office buildings won’t ever be suitable for uncomplicated housing conversions. It can be challenging to make them physically functional if they are not rectangular with corridors leading to rooms on either side or if there are columns everywhere. Who would desire a windowless flat in the heart of a structure? There are also some localities that oppose conversions because they earn more tax money from corporate use and need the money desperately.

Leaving that aside, they both brought up some interesting issues. For instance, “SupplyTrack revealed that an average of 2,300 multifamily units were built monthly out of previously used office, warehouse, or industrial space between 2007 and 2019.” Existing structures make up 3% of total housing units in buildings with five units or more, or historically, 10% of newly supplied multifamily housing, existing structures make up 3% of total housing units.

For conversions to significantly alter the housing supply, they would need to soar into the air.

A different argument, though, was even more convincing. A significant portion of the work-from-home market, which is influencing the office market, is hybrid work. According to the researchers, “Hybrid work may boost productivity or increase the surplus for employees, but it may not actually free up much conventional office space.” This is because if people are still coming in, especially if significant numbers of them do so on particular days, businesses will still need places to put them. The two wrote that “[t]he hybrid approach appears to be delaying the wholesale conversion of offices to rental.” In any event, it doesn’t seem realistic that office conversions will soon slow rental growth.

The movement for multifamily rent regulation has gained momentum nationwide over the past few years, and the pandemic has increased political and popular support for tenant safety. The negative effects that these policies will have on multifamily property owners and their capacity to upkeep and create housing has been vocally expressed.

According to a report by the National Multifamily Housing Council from earlier this year, owners are actively avoiding markets with rent limits or seriously considering leaving markets that enact these rules.

However, according to industry experts who spoke with Bisnow, California’s state and local rent control and limit regulations haven’t had a significant influence on multifamily financing. However, some projects, like value-add deals, have become more challenging to complete as a result of these and other laws affecting multifamily developments, particularly the still-in-effect eviction ban in Los Angeles.

Across the country, rent control is becoming more prevalent. In 2021, St. Paul, Minnesota, approved a 3% rent cap. According to a recent article in The Wall Street Journal, legislation that might establish rent restrictions has been proposed in at least a dozen states. The legislation would prevent rent increases by landlords of more than 2% to 10%. According to the WSJ, rents have increased nationwide by an average of 18% since the start of the pandemic. According to Insider, the states with cities that are considering similar restrictions are diverse in terms of geography, demographics, and ideologies. They include Arizona, Florida, Illinois, Kentucky, New Jersey, New York, Washington, and Massachusetts.

In 2019, Gov. Gavin Newsom signed AB 1482, which places a 10-year cap on how much landlords can raise rent in a sizable number of buildings throughout the state. California has had rent regulations in various forms for decades. Rent increases of more than 5% plus inflation per year are prohibited for multifamily landlords, as well as for owners of condominiums and single-family houses who are 16 years and older. According to the statute, landlords are also required to give “just cause” for evictions.

According to Doug Perry, senior vice president of sales at Archwest Capital, the law didn’t have the significant effect that many in the CRE industry had hoped.

The landscape didn’t shift overnight, according to Perry, whose company is a direct commercial lender with a nationwide concentration on multifamily and mixed-use properties. Rent control rules haven’t affected the way we underwrite loans, but they have made some situations a little more difficult.

For instance, it could be more challenging to complete a value-add project that entails purchasing a property with a lot of unfinished maintenance, upgrading it, and then boosting the rent.

Perry adds, “Those projects don’t get done as much because they can’t be done from a compliance standpoint with the rent control laws.”

There are workarounds that can be useful, such as “cash for keys,” in which a renter is given a lump sum in exchange for leaving a rental property. Most of the time, the rent for the apartment can be changed to reflect market rates. However, it can cost a lot of money to evict residents, and that money isn’t going toward the main goal of these projects, which is to improve the building so that the apartments can draw higher-paying renters.

According to Perry, “there are occasions when the expense of doing it increases the cost of the entire project to the point where it’s just not a profitable endeavor, and it doesn’t make sense.”

According to Perry, the impact of municipal rent control laws, as opposed to state-level ones, may be greater for smaller investors and individual owners who have investments in areas with such laws, but this is only a problem for specific projects and not a general problem.

Value-add deals may take longer to complete if there are eviction moratoria, like the one that is still in place in Los Angeles.

Shahin Yazdi, partner and managing director of George Smith Partners, which arranges loans for CRE borrowers nationwide, said that it is “simply not as realistic” for the borrower to expect to be able to turn around an entire building when there is an eviction moratorium and you can’t perform no-cause evictions.

Instead, it is necessary to diminish expectations, either that it will take longer to empty the building or that it won’t be empty enough. This means that the transactions must make financial sense even if only a portion of the building—say, half or a third—is made accessible to new, wealthier tenants. But in other situations, the resilience of multifamily during the epidemic has made this conceivable.

Regarding Los Angeles and its current eviction moratorium, Yazdi noted, “Multifamily continues to be a great performing asset, even with people not paying.” The rate of foreclosures did not soar. It’s a wonderful asset class for lenders since landlords, who may have made some postponed payments, nonetheless make their mortgage payments.

Despite the optimistic response from the lender side, a study released in January 2022 by the National Multifamily Housing Council revealed that efforts to enact rent control are having an impact across the country, not just in California.

The study asked 78 CEOs and senior executives at national “apartment-related enterprises” if the growing number of areas that had implemented, strengthened, or were considering rent control or rent ceilings had an impact on development and investment decisions. 32 percent of respondents claimed to already steer clear of rent-controlled areas, and 26 percent claimed to have reduced their investment in these areas due to local rent-control strategies.

However, almost the same number of respondents (23%) stated that despite rent restrictions, they have no plans to alter their investments or developments in these locations.

California appears to stand out from the pack of rent control initiatives despite their rising popularity across the nation. The NMHC survey asked participants to indicate the markets they actively avoid because of current rent control laws or the potential implementation of new regulations. According to NMHC, out of the 31 respondents who responded to this question, 55% mentioned certain markets in California or the state as a whole.

According to Jim Lapides, vice president of strategic communications for the National Multifamily Housing Council, “California is a uniquely challenging environment to operate” because of the state’s rent control laws as well as the laws that local governments have either approved or are preparing to pass. It adds up for every city that enacts new rent control legislation and every moratorium that is still in place.

Despite these obstacles, investing there is still profitable, according to Lapides, and investors will continue to do so. According to a year-end analysis by CBRE, which used data from Real Capital Analytics, the greater Los Angeles region attracted $58.8B in investment expenditures in 2021, making it the biggest beneficiary of those funds. With nearly $35 billion in tourism, the Bay Area placed fourth. The statistics showed that apartments were the asset class that attracted the greatest investment in the East Bay and greater Los Angeles. (Offices in San Francisco received the most investment.)

According to Lapides, “California is always going to be an appealing market because there are tens of millions of residents, there are huge marketplaces, and it’s vital for the industry.” However, the course they have been on will seriously harm them.

In contrast, Perry observes a pattern of adaptation to the challenges that California has so far generated.

The reality is that rent control is in place throughout the state and has been for some time. We have learned to live with it, adjust to it, and make it work from both a lending and a borrowing position, Perry said.

There’s no way we should raise any taxes that make it more expensive to live or work in the Los Angeles area, given that inflation today is above 8% and at a 40-year high. Measures like ULA and SP are specifically designed to accomplish this. Voters in the City of Los Angeles will decide on Measures ULA and SP on the ballot in November. On these ballot initiatives, we advise anyone to choose NO.

These two initiatives together result in a $1.1 billion property tax hike, the greatest tax increase in city history, which will raise prices across the board. If they are approved, small businesses and apartment rents will both increase by 6%. In the end, consumers will bear the burden of these two measures through higher prices on goods and services of all kinds. Owners of commercial buildings and multifamily housing will be “hit” the most by the passage of these measures, and as a result, prices for consumer goods and all types of services will increase to pay for these new taxes.

Measures like ULA and SP dismantle decades-old Prop 13 safeguards for tenants, homeowners, and small businesses.

Information on Measure ULA
On property sales of $5 million or more, Measure ULA, the so-called “United to House L.A.” proposal, would impose a new “documentary transfer tax.” A tax of 4% of the sale price would be applied to any property selling for between $5 million and $10 million, while a tax of 5.5% would be applied to houses selling for more than $10 million. That’s a substantial new tax of $800 million for the transfer of documents.

The new Measure ULA tax’s stated goal is to combat homelessness. Some of the funds would be used to build 26,000 additional housing units over a ten-year period. The remaining funds would be used to avoid homelessness, provide temporary rent relief, help disabled renters make ends meet, and provide free legal services to tenants who are being threatened with eviction. The failures of Measure HHH, which include the slow disbursement of funding and the soaring costs of building under the measure (with one-bedroom homes costing upwards of $800,000 each), have all already been witnessed.

While the bill claims to be directly at the wealthy. There will need to be a way to pay for more taxes, and that way is by raising the cost of all goods and services. In the end, these extra taxes and expenses will be borne by regular customers. 
Measure ULA would create a new “L.A. Tenant Councils and Citizens Oversight Committees” that could add up to $70 million in extra administrative and overhead expenses annually for taxpayers.

Information on Measure SP
The measure’s proponents claim that it is merely an extension of Proposition K.  Measure SP is a 908% increase above Proposition K and doesn’t expire until 2026.

Renters, homeowners, and small companies in Los Angeles will pay more in property taxes under Measure SP, which will raise the cost of all consumer products and services.

If approved, the typical family of four would have to pay hundreds extra in property taxes every year.

A “special tax” of around eight cents per square foot could be imposed by the City of Los Angeles under Measure SP in order to help pay for parks and other leisure-related initiatives.

Despite the fact that two other tax measures already in place allow Angelenos to pay for additional parks, Measure SP is still being introduced.

Before Angeleno residents are required to pay yet another tax increase, the City of Los Angeles should use the $150 million in unallocated park funds that are already available.

We advise anyone living in LA to vote no on these increases.

In an effort to shift to a more restrictive policy stance, US central bankers have increased their benchmark lending rate by 75 basis points at each of their most recent three meetings. As some economic sectors, like the housing market, have slowed due to the substantial increase in borrowing prices, total consumption seems to be holding up well while inflation remains above the central bank’s 2% objective.

“I anticipate additional rate hikes into early next year, and I will be watching the data carefully to decide the appropriate pace of tightening,” he said.

In his remarks, Waller explained how the rent component in inflation measures contributes to inflation remaining high, a tendency that is unlikely to reverse itself anytime soon.

According to Waller, “Shelter inflation is a particularly persistent component of inflation.” Unfortunately, the message is that the cost of housing will probably continue to rise for a while.

While the demand for rental housing is still robust, Waller claimed that increased borrowing rates were slowing down the housing industry. He stated that in order to reduce overall inflation, the cost of commodities and other services would need to moderate.

According to Waller, we are beginning to see some adjustment to excess demand in interest-sensitive sectors like housing, and the monetary policy stance is modestly restrictive. However, more work needs to be done if inflation is to be reduced significantly and continuously.

The September payroll report will be presented to policymakers on Friday. According to a Bloomberg study, unemployment is predicted to remain at 3.7%. Because of this, Waller called accomplishing the twin mandate “a one-sided war.”

He stated, “Monetary policy can and must be employed aggressively to drive down inflation because we now do not confront a tradeoff between our employment target and our inflation objective.”