The commercial real estate transaction market, like many others, operates on a foundation of balance. At its simplest, it’s a meeting ground for sellers and buyers, both of whom aim to get the best deal. But when these two entities can’t find common ground, the bid-ask spread widens and real estate transaction activity slows down.
Stepping back, the bid price is what a buyer is willing to pay for a property, while the ask price is what a seller is willing to sell it for. The difference between these two prices is the bid-ask spread. In a balanced market, the bid-ask spread is minimal. However, in today’s dynamic commercial real estate market, the spread has widened, resulting in fewer transactions getting done. Why is this happening? Several factors are in play, each altering the perceptions and financial calculations of both buyers and sellers.
To start, let’s look at bond yields, which significantly influence commercial real estate valuations.
For many institutional investors, bonds are a benchmark. If bond yields rise, real estate’s attractiveness as an investment option declines since it often offers lower relative returns (smaller spread between bond yields and real estate yields). This means that buyers would then require a higher yield (or cap rate) for real estate, resulting in lower bids. On the other side, sellers may see this reduction in bids and choose not to sell their property, viewing it as a less than optimal time to sell. This is particularly pronounced if the move in interest rates happens rather quickly, as happened in 2022-2023. Eventually, if interest rates continue to stay elevated, sellers adjust their expectations and ask prices come down. However, this process can take months or even years to play out.
CRE Spreads and Required Returns
To dig in a bit further, the spread between the risk-free rate (i.e. the yield on a 10-year government bond) and the yield on a real estate deal compensates investors for the risk they take when investing in real estate versus a government-backed risk-free asset.
In addition to the fluctuation in bond yields, this spread can fluctuate too. If the 10-year bond yield is 3% and a commercial property is valued at a 5% cap rate, that implies a 2% spread. Now, if the 10-year rate moves up to 4%, then the cap rate would have to move to 6% in order to maintain the same 2% spread.
However, this spread can also fluctuate and is impacted by future expected growth in real estate cash flows. If buyers expect growth to shift modestly higher due to a prolonged inflationary environment, they may be more willing to accept a lower spread over the risk free rate, since the growth in cash flows will add to the expected return. Suppose buyers shift their growth expectations higher by 0.5%, then the spread would move down to 1.5%, from 2%, and the cap rate would be 5.5% vs. 6%. While interest rates and cap rates are certainly correlated, they don’t always move in lock step because of simultaneous fluctuations in CRE spreads.
Where do we go from Here?
As the market adjusts to the implications of a “higher for longer” interest rate environment, below are several factors that will impact how things play out.
Expectations of Interest Rates – market participants and specifically sellers’ expectations of interest rates will impact their willingness to accept higher cap rates and lower prices. To the extent that sellers still believe that higher rates are a somewhat temporary phenomenon, they may be more reluctant to sell. However, if sellers determine that higher interest rates are here to stay, they may be more willing to accept the new market environment and transact at higher cap rates.
Recession – if an economic recession emerges that reduces the outlook for rent growth, then sellers may be more willing to transact. This would reduce the attractiveness of the alternative to selling, or continuing to hold assets. With a less attractive alternative, selling at a higher cap rate would look marginally better.
Debt Maturities – in the absence of any external pressure to sell, property owners can sit on properties and continue to collect cash flow. However, one big external pressure is a debt maturity on a property. When this happens, owners need to pay off the debt via a refinance or a sale. If neither are possible, then a third outcome is foreclosure and ultimate sale by the lender. Two out of these three of these outcomes result in a transaction of the property and more pricing transparency for the market.
Seller Capitulation – when the real estate market turns down, usually at the end of a cycle, it takes time for the market to adjust to the new environment. With the passage of time, eventually sellers adjust their expectations and come to terms with the new market reality. Once sellers believe the odds of achieving “yesterday’s prices” are unlikely, they may capitulate and stop holding out on selling an asset.
Comparable Transactions – comps beget comps, leading to more transactions. No buyer wants to overpay for an asset and no seller wants to underprice an asset, so the availability of comps reduces this uncertainty and leads to more transactions. It is a virtuous cycle that leads to more market activity over time.
Government Policies and Regulations – Government policies can wield significant influence over the real estate landscape. Changes in tax laws, zoning regulations, and incentives for sustainable development can dramatically impact the attractiveness of certain property types or locations. For example, incentives for green building practices might make environmentally-friendly properties more appealing to both buyers and sellers. Or, incentives for office-to-apartment conversions may make purchasing distressed office buildings more palatable to potential developers.
While we can’t predict how exactly things will play out in the real estate transaction market, these are some key factors that we’ll be monitoring to assess the real estate pricing environment going forward.
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