How much warehouse you can buy today versus last year... sellers, take note.
The year was 2022 and it had been a relatively steady 40 years of declining interest rates from the peaks of 1981 where the Bank of Canada rate reached a whopping 21.46%. Many (most) of the current workforce had only ever seen downward trending interest rates, with the youngest generation of adults viewing rates at historical lows as the “norm”. However, the time came to pay the piper for years of unsustainably cheap money when the global economy careened into increasing and relentless inflationary levels. This prompted fiscal measures (aka rate hikes) in an attempt to control the effects of years of unwavering fiscal stimulus and heedless spending.
While the transitions through business cycles can affect consumer confidence and create uncertainty in the financial markets, it’s important to realize we are still a long way off from 20% interest rates, and remain, at present, in historical low territory. Having said this, it’s obvious that a 3.25% increase in the BOC benchmark rate over just a 6-month period will have some tangible consequences. I am going to outline the facts behind affordability in the commercial real estate sphere compared to 12 months ago, and outline how this is affecting our owner/user clients (those who would occupy their own building) and our investor clients (who are looking for tenanted assets with a return on their money). Spoiler alert… property values are (gradually) eroding.
Current State of Affairs:
I like flow charts, so I’ve provided a simplistic analysis through flow to outline some of the big picture elements affecting the commercial real estate market in Alberta, and more broadly across borders.
The above factors are affecting both owner/user businesses as well as investors who have been extremely active in recent years through the acquisition and sale of commercial real estate assets across the province. Each purchaser is analyzing the current market fundamentals uniquely to their goals of ownership. I’ll outline below the effect current market conditions are having on each group.
Owner/User Perspective:
The year was 2021 and and business had been good! You (business owner) were willing and able to put down 20% equity on the purchase of a commercial real estate asset for your operation. You had been quoted a monthly payment of $40,000 for a $10,000,000 facility, but for reasons out of your control, could not close on that specific property. Fast forward twelve months - what could you buy today for the same payment?
Generally speaking, spreads on 5 year debt are about 200 bps over the 5 year GOC Bond (up from 180 bps last year). This correlates to an estimated 2% increase in interest rates in the past 12 months which seems minimal, but as you see from the image, can correlate to massive differences in affordability for a business owner. Unfortunately, many industrial businesses in Alberta, particularly in the manufacturing sector, have been battling debilitating federal energy policies for the past 7 years preventing them from taking advantage of the low interest rates due to other market factors (even though most major markets in North America were on a 15 year tear). While the above comparison is simple in nature, it highlights why so many deals have died over the past 6 months as purchasers on the cusp of affordability have had to transition back to the leasing market. It also highlights why there is heightened competition for smaller, lower valued facilities. Higher priced buildings will be competing over a much smaller pool of qualified buyers as the interest rates continue to increase.
Investor Perspective:
Investors have been purchasing income producing assets for record setting low capitalization rates in recent years because the low debt costs allowed for return requirements to still be achieved. It wasn’t uncommon for Class A multifamily assets to trade in the low 4% cap rate range, and commercial assets to trade low 5% cap range, on average. We’re currently sitting in a transition period where the mortgage interest rates have increased over 2% in the past 12 months, however seller cap rate expectations have lagged, overvaluing assets. In fact, according to Brandon Kot, Managing Partner at Canada ICI:
“If you indexed cap rates in Q3/Q4 2021 against interest rates during that period, values in multifamily assets would need to correct north of 20% and commercial assets north of 15% today in order to maintain the same levered returns. This doesn't even take into consideration that yield expectations on the cost of equity have drastically changed in the last 12 months which would make a correction in asset values that much more acute. (The assumption on the level of value erosion is magnified in multifamily assets because of the prevalence of longer amortization periods (40 years +).”
Looking at the following simple case study, I’ve compared an asset achieving an NOI of $525,000 in 2021 to today. In order for this asset to maintain the same DSCR and cash on cash return variables, the current value would reflect these downward pressures.
Ultimately, the market will dictate the price corrections that will take hold in the coming months, but it is important for building owners considering a sale of their properties to realize that these are the metrics purchasers are dealing with when determining today’s values. The silver lining for some building owners is that if they have rollover or vacancy, they may see improvements in their NOI due to increased market activity and competition for space. This improvement in rents and income could potentially increase in line with the upward adjustment of cap rates.
E.g. $525,000 NOI becomes $600,000 NOI on a 65,000 SF building. This $75,000 increase correlates to a $1.15 PSF increase (from $8.08 to $9.23 PSF), which is realistic in Alberta’s current industrial market. If cap rates were 5.25% with $525,000 NOI, a $10 Million valuation would be achieved. If cap rates increased to 6.0% with $600,000 NOI, a $10 Million valuation could still be achieved.
For those not experiencing these improvements in NOI, firstly, call me. And secondly, these assets do present a high probability of devaluation.