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Welcome to Altus Insights Podcast Series. This podcast brings together some of our leading brainiacs at Altus Group to discuss, debate, and on occasion complain about the evolving state of Canada's residential and commercial real estate. Join Ray Wong, Marlon Bray, and Avi Zelver for monthly podcasts covering the latest market and construction cost trends across major markets in Canada.
Welcome to Altus insights podcast series with Ray and Marlon hosted by me Avi. This podcast will cover monthly market updates and construction cost impacts across major markets in Canada. Welcome to the Altus podcast series with Marlon Bray and myself Ray Wong. Today we have Omar Eltorai, the director of research at Altus Group. With more than a decade of experience in the industry, in investment management and financing roles. Omar's focus at Altus is on macro capital and market trends affecting US CRE market. Welcome, Omar. Thank you. Happy to be here. Great great to have you. Today we are going to discuss Omar's recent webinar, the US State of the market, and discuss the differences and similarities with respect to the Canadian market. We will focus on the capital markets, then dive into the multifamily, housing, industrial and office sectors. OK so let's go with the first question. So, Omar, can you give us a brief overview of how has the capital markets performed in the US in 2022 and what you've seen so far in 2023? So discuss perhaps some of the concrete direction assets and regions. Absolutely so I think what we've seen over the last year and two months has been some pretty big shifts, especially in terms of narrative. So right now, we're in a period where the capital markets are searching for a new narrative. As we were closing out 2022, we there was a narrative in the marketplace that was widely accepted around a Fed pivot. However, this has really faded quite a bit, and I think especially in the first two months of this year, that has really been knocked out as the markets have really turned more of their attention towards higher expectations for higher rates and higher inflation for longer. The result of this was that there was significant softening at the tail end of last year and higher correlations across asset classes. I recently put a piece out in February just highlighting the correlations of how the assets that are usually used to diversify have been trending together and how the bond market and equity market have. Dramatically different views and interpretations of what lies ahead. Now, how all of this relates to commercial real estate? I would categorize 2022 as a year that really started off very strong and that was based on the momentum that we had seen in the banner year that 2021 was. So this was huge transaction volumes, but then it really started to decline and fizzle out through the end of the year. That was a combination of predominantly rising rates that we're chasing and trying to tame an inflationary in a high inflationary environment. And ultimately, by the end of the year, as I mentioned, the narratives that were a little bit more optimistic started to fade away. So, well, 2022 midyear might have been a rise in the sentiment as being cautiously optimistic by the end of the year. I think it was striking much more of a cautious tone. And this is very true for commercial real estate as well, speaking very broadly across the property types. This caution tone came in the form of and is still present with concerns around effective rent growth, not necessarily just rent growth, but active rent growth, expense management and overall financing concerns. Well, Omar, I know there was a slow down and based on all of the practices similar that were seen in the Canadian marketplace. But do you think investors. Do you think they're still motivated to buy or do you think they are? They're waiting for sort of price adjustments. So I would say I think we're at a point where we're going to start seeing different types of motivations come into the really into the market as a whole. And there are motivated, certainly more motivated buyers than motivated Sellers as well. However, where they agree on that, that where they believe that price point is, I think that's what's stalling or it really has been stalling the market transactions recently is because they just can't agree on where they think the right price should be. So they're off and therefore transactions won't take place. I do think that there are quite a few that there still is motivation, I guess both sides. But the higher not only just the higher cost of financing, but the pullback of a lot of traditional financing sources has made it difficult to get these deals done. Plus, on top of that, you have. With if you look at. I know this is true pretty much across the world, but if you think about Fed funds rate has passed. So if this is your risk free rate has actually passed where cap rates were in the last 12 to 18 months. And that gets really difficult to justify. And so I would say that there a repricing is needed. But on top of that repricing, you also need the financing to come back to the market to enable transactions to take place. So basically it's getting more expensive for deals to happen. And there is a risk element and perhaps some of the assets that are selling. There's a little bit of motivation with some of those transaction. Yes wouldn't there be opportunities in the market, though, right now? I mean, that's the thing we're seeing just anecdotally is a lot of people sort of circling around, waiting for those opportune deals to grab them while they can. Absolutely and if you look at the fund raising, so I know Preqin puts out the numbers, but if you look at buy strategy, write of what real estate fund strategies are actually raising money, it's optically opportunistic and distressed category is hands down the only one that is really. Able to fundraise at the moment. And they said that they started really saw that really take off over all of last year. And that money has not been able to just looking at the market as a whole. And this is where you have this breakdown of buyers and Sellers of where they think the price should be. And the entry point that would justify the overall return, whether that's for the investment or the vehicle, the investment vehicle as a whole, know, it's still there's a bit of a spread between there between their expectations. But to your point, Marilyn. Yes, I think I think the opportunistic buyers are present, but they haven't been able to be active yet. We just need to wait for the market to drop a little bit more, get a little bit worse, a little more blood in the water, and then they'll be able to smell a deal. Yes and I would say that if you look at how much money is there, it's I don't want to say it's comforting, but it is kind of a backstop to the pricing as a whole. Like there will be if enough money if enough opportunistic money is waiting for price drops. And they will be competing as prices drop that actually should support pricing. And before we get into those, mesoamerica, samarra, is there any sort of a regional differences? Because we've seen a lot of, I guess, a population shift to the sunbelt. Is there more is there some more sort of regions sort of at risk or are there sort of more opportunities and elsewhere just because of some of the shift we've seen in the last few years? Yeah, I, I do think that there is less on there less concerns around people reversing their migration and moving I guess if, if they were coming from the Northeast and moving to the Southwest or Southeast there, I think there's less concern that they're going to all choose to go back to the Northeast or go back North. However, I do think where there are certain risks is looking at the. Really looking at the. Supply that is. Is that coming or. If you look at supply pipelines, a number of the very hot Belt markets have very robust supply that is lined up to be delivered in the next 12 to 18 months. And pairing that with a broader macro environment that has higher recessionary concerns or recessionary risk could mean that the deals are not necessarily going to perform as they were once penciled in. So there's a good third way into the multifamily sector. So especially from a supply and demand side. So what is your overall take on the multi read side in here? You definitely get into some of the regions just based on what you just described with the overbuilding. So can you give us and again, it's still, I think, one of the most. The sort of most in-demand investment types on the multifamily side. Yeah and before I get into the negative or kind of the knee counter arguments, I would highlight that. There is a lot of strength with multi family and it really comes from the fact that the US has been undersupplied for housing as well as if you look back to you have to look back to the global financial crisis and the housing bubble that formed there. And since then we've had we really have had over a decade of under, under building happening in the housing space. And so we've had because we've had this deficit, the ability or I would say that deficit. Now actually is almost like a strength. Right so even if there are supply concerns in certain areas, it's actually not at the National level. It very much becomes market specific because going into the global financial crisis, the US, we really did overbuild, but that is not the same this time around. Right and I know those are dangerous words to say, right? This time it's different. What what I'm really watching for is not necessarily just the top line growth, but how expenses are going to continue to perform. Because if you start seeing expense ratios climbing up as even if they're able to keep maintain, like I would say solid to neutral kind of growth on the rental side if expenses start climbing and eroding noi, I actually think that that's a really bigger concern. So yeah, and we're sort of seeing the same thing, especially with the older, older projects and especially with buildings and owners trying to get down to net zero. And though ESG, so definitely with on the order buildings with capital improvements is going to increase some of the cost standpoint. But what we're seeing is that, again, marlin, we've seen those 20% to 30% sort of headlines as well. At the same time, though, in Toronto, there's rent control. So that, yes, the new leases are coming in at 20 or 30%, but other renewals are coming in at or 3% Right so it's sort of like the hype is 20, 30% based on our low vacancy rates across Canada for multifamily. But there's actually a good percentage of renewals that are coming in a lot lower than what those banners are showing. It also depends on how much those buildings are leveraged, as well as a portfolio, how much leverage, if they got where they had been in terms of the new financing world, in terms of the overall leverage they have in the portfolio, you have no finance and your expenses go up a little bit. It's not the end of the world. How many people have no finance in question or don't leverage those assets. But over investments? Yeah, two things I would add on multifamily. There is the first thing on the comment around that, the rent control we in the last 12 and the last 12 months, there have been a lot more actions in term and rent control really has come up in the US. But of course it's almost always a local issue. So we actually just did a piece on a bill that that's gone through and is going to put that into play across California. But then also I just read this morning around the like Boston as well. So yeah, I think rent control certainly is going to be, you know, maybe not so at the fore. If if rent growth starts coming down and you're not seeing these is huge print of what year over year growth is. But I do think affordability will be an issue that will continue to drive it, especially if we do enter a recession that will bring it to the fore again. But then another piece I would flag, especially in the multifamily and it's very us centric, is the agencies Fannie and Freddie, they didn't hit their caps last year, so that meant that they ultimately had more capacity that they could be lending. And similar to other periods of whether it's distress or market disruption, the agencies do tend to play a bigger role, especially in multifamily. And one change is their got their effect. Effectively, their scope of work has been really in the last I think it was January of this year. FHA came out and broaden their scope so they're able to actually play or lend, you know, in a much larger area, including, you know, smaller, smaller properties and less kind of traditional multifamily. So I do think that that's certainly a positive as well for the specifically for the US multifamily space, rent control generally achieves one thing, a reduction in supply if you start switches to supply. And often that's all it's ever achieved every time they've done it. So it's quite ridiculous in the Western world we. Still talking about rent control as a means to solving a problem when it's just increased supply, which you're seeing in the US right now. Increased supply is reducing rents. So decrease more cuts to say, yeah, it cuts two ways. Right like the intent is to for one thing. But it often kind of backfires. And so. That being said, it's not the just. Even if it's not the most effective, that doesn't mean that, you know, it's not used. Unfortunately, that's like, you know, that it's one of the tools that is there unintended consequences to things the government never thinks about. Yeah, that's a theme, Marilyn, that we should carry forward. Well, I think most of the problems in the world are unintended consequences of elected officials. But that could be a whole topic on its own. Before we leave this area, we talk about the traditional Lenders and we've seen a lot more sort of private Lenders into the marketplace. That's causing well, we're finding that there's a bit of a shift just because of some of the more stringent requirements to banks and the typical traditional Lenders have had compared to some of the private players, even though perhaps that the cost is a little bit more based on the percentages. But are you seeing that shift? Because that's definitely causing that slowdown in the best and not just in multifamily as well. Yeah, absolutely. The some of my favorite data is they Republic data is coming from the Fed and it's the senior loan officer opinion survey with the one acronym of solutions. And this really gives an indication of the expectations and kind of the intentions of these senior loan officers. And one of the questions that does come up is whether or not these bank loan officers are tightening or restricting effectively restricting credit. And in the last survey, I think it was 80% said that they were tightening for commercial real estate. Now, there were minor differences and they do report it on a net percentage. Right so it's know, it is. But you can back into well, OK, if this is the net percentage, how many were actually saying that they were tightening, it was right around 80% And then on top of that, if you look ahead over the last year, whether it's 12 months, nine months, the cost of borrowing has actually gone like just the interest rate has gone up by multiples. That together means finding financing. Very difficult. Very difficult. You're not going to have in this came up on the last state of the market where you're not going to have you don't have multiple Lenders competing for your business. Right you're going out to ask multiple Lenders and maybe getting one or two debate. But if you're going to be a borrower, you ultimately are going to be following their like, you know, it's they pretty much are going to be telling you, look, this is what we're doing. You don't fit. Sorry maybe come back later. So the I do think that is certainly a challenge, but it has also high rates plus of backing out of the traditional Lenders has created, especially in the us, an opportunity for whether it's private credit funds or these non let's just call them nontraditional Lenders or maybe they're traditional but they don't do it at size because they usually manage it or they're going for more niche credit exposure. Whether that's seen the return of mezz like mezz Lenders have really come back in a meaningful way, but also just Lenders that are more willing to take more risk. But that risk often comes at a price. And to sort of close off this area on pricing and cap rates, you know, what direction do you think it is going to go over it next? Based on everything you just said, with supply financing opportunities, investors in the marketplace. So two things. One, the Fed as well as the market's reaction and how the market's really pricing the tenure. It's the 10 year US Treasury. Right so the reason I first focus on the Fed is if you look historically. And they have looked historically at the relationship between the Fed funds rate and cap rates. And what you can see is usually as historically and the Fed funds rate has been hiked, cap rates can give to a certain point. So the spread can really compress quite a bit, but it ultimately can't keep you can't keep compressing a spread. And yeah, there becomes a logical point or like, you know, where a point when the spread does need to give, when you know, when effectively risk free money should not be worth or risk free money should not earn you a bigger return than money at risk. And so that is certainly watching that. But then also the 10 year Treasury is is, you know, another area just because it's practically where it is the most used for like benchmarking pricing, especially in real estate. And so with that, I would say and I have never been in the camp of fight the fed, I do think that the Fed is very much trying to they've added this kind of like forward expectations and their commentary as one of their tools to help guide the market. And set their expectations and. I don't think that they're speaking necessarily in code. They they've made it very clear that they are concerned about longer lasting or stickier inflation. And and a lot of that is being contributed by a incredibly tight labor market that has. Concerns over a wage price spiral and which is fueling the inflation rate. And so because they haven't necessarily broken that yet and tamed it. The expectations really are for them to keep hiking. And I think that this is the long answer to your question. I could have probably just answered it up. Yes but yeah, hopefully, hopefully your follow with the logic of all of this goes to the point of, you know what? I do think cap rates are going to continue to go up and not just from a theoretical standpoint, but I do think that another factor that's going to bring that on is if you look across the if you do look across banks and whether it's in at least in the us, whether it's in their filings, in their call reports and their call report data, or if it's with the publicly traded banks. And it's great to get some of their commentary on it, but they're building up their loan loss reserves, which means that they're anticipating credit issues right there. They're they're anticipating writing down and charging off some of their credit exposure in their loan book. And because of that, I think that is a sign that there will be some distress. And as and a bit, Lenders are in the business of lending. It's not in owning real estate. And when you and I And there's not a call for any sort of bubble, but if you take these kind of high level, the comments of markets have slowed down because cost of financing has gone up and a perceived level of uncertainty has been elevated. We're still in that environment, but there's now a concern around some credit that's out there. And if the Lenders do get the keys, they're going to be looking for sales and if they're likely will be discounted prices. And if those are discounted prices, that is also because these observations are going to lead to and support higher cap rates. That's that's all the time we have for today. And thanks, Omar, for your insightful comments. And as I see the contrast between some of the trends, some similarities and, well, some of the differences, US and Canada. But I guess what we have to do is continue on with another segment, again, with Omar to cover the office and the industrial sector. A bit of a review of 2022 and what we expect for 2023. So please stay tuned for that next sort of continuation of this discussion of the similarities and differences between the US and Canadian markets. Thanks Thanks so much. Thank you.