Google Font Addon

April 23, 2024

Forecasting Commercial Real Estate: What Investors Should Know

Kip Sowden was invited to be a guest contributor on NASDAQ, speaking on the current forecast of Commercial Real Estate, giving an in-depth look at what factors correlate to a successful project. 

We are currently in a time where the commercial real estate industry is heading into unchartered territory. However, when facing headwinds in commercial real estate, this shouldn’t mean that your company should come unprepared with a strategy. Your business should stick to your company’s priorities and focus on the four fundamentals: Location, Cost-Basis, Asset Class, and Sponsor Quality. These are the factors with the highest correlation to overall project success. Let’s break down each essential so you won’t be left out in the dust when it’s all said and done.

Location: This is probably the top consideration out of the four. Successful investors focus on growth states. Take a look at Texas as well as the Southeast region. This area continues to see positive net migration, according to the 2020-2021 Census, the South was the only region to see positive growth. Factors such as cost of living, low taxes, and business-friendly environment point to the trend continuing in the future.

Right now, we have a real housing shortage in the United States, so asset class is just as important because you want to focus on sectors where demand far exceeds supply. The winners will be those developing multifamily, single-family for rent, single-family lot developments in master-planned, highly amenitized communities.

Cost-Basis: The cost of living is another factor that is creating this unprecedented net migration. This demand gap is further exacerbated by the current difficulty in obtaining debt and equity for new projects, and the overall cost of that capital at a time when construction costs continue to increase.  These fundamentals will significantly slow the building process, which inhibits the ability to create the supply to meet the ever-growing demand. As a result, consumers will likely continue to pay a premium for quality housing as the imbalance between supply and demand continues to expand. 

Asset Class: The market is also currently bullish on other asset classes such as drive-to-leisure hospitality, extended stay hospitality and RV resort conversions and developments. Investors should realize the highest risk-adjusted returns in all things housing related in Texas and the Southeast. These sectors of real estate should continue to be a sound investment as the fundamentals remain resilient. Nobody anticipates that supply will catch up with the demand anytime in the foreseeable future elsewhere, but the economy in this region continues to grow. 

Sponsor Quality: Most seasoned developers and sponsors will continue to be able to source capital (debt and equity) for their projects, albeit at a higher cost. Banks are currently being extremely selective in their debt offers and underwriting has become much more stringent and conservative with lower loan-to-cost percentages and a much higher focus on the quality of the developer or sponsor.  As a result, top tier developers and sponsors with well-located projects have the ability to command the best terms. 

Private debt capital has also increased its market share of the debt markets to help fill the void being left by the traditional community and regional banks. These private debt options typically come with a much higher cost of capital, which could lead to potential stress on a development. It is critical for today’s investors to fully vet the sponsor in any real estate project and make certain the sponsor has a proven track record in the asset class in which they are contemplating investing and a well-thought-out business plan. It’s equally important to make sure all parties understand the debt and equity being sourced for a particular product. This of course, is more important than ever in a more challenging real estate environment, such as the one the industry is currently experiencing.

With all this in mind, the bottom line is transaction volume should be significantly down in 2023 as lenders pull back and underwrite much more conservatively.  With the rapid increase in interest rates, controlling cost of debt, and cap rates remaining below that cost of debt, thereby creating negative leverage, it is less likely buyers will be able to buy. If a seller is not forced to sell, they will likely hold the asset until the market comes back into equilibrium.   

Kip Sowden is the chairman and CEO of RREAF Holdings LLC (“RREAF”), privately held, vertically integrated commercial real estate company based in Dallas.