In a recent live event, CrowdStreet CIO, Ian Formigle, and Senior Managing Director of Investments, Anna-Marie Allander Lieb, provided an analysis of the current landscape of commercial real estate (CRE), focusing on the relative scarcity in the market and its general implications. This article summarizes some of the key points discussed, providing insights into current CRE transaction volumes, pricing dynamics, and CrowdStreet’s approach to the CRE market today.
Where are the deals?
In today's commercial real estate market, transaction activity remains subdued, though there are signs of potential recovery on the horizon. Here’s a closer look at the transaction volumes, pricing trends, and macroeconomic factors shaping the landscape.
Transaction Volumes and Pricing
- Transaction Volumes: While CRE investment volumes are still declining from their 2022 peak, the pace of this decline has slowed. In Q1 2024, the year-over-year decline in transaction volume was 19%, a marked improvement from the 40% year-over-year drop recorded in Q4 2023.1
- Sector-Specific Volumes: Multifamily, industrial, and retail observed the highest transaction volumes in Q1, with retail experiencing the lowest year-over-year drop in volume at -15%.1
- Pricing Trends: Pricing in the CRE market is beginning to stabilize. As of June 2024, the Green Street Commercial Property Price Index (CPPI) is down 21% from its March 2022 peak. However, there has been a slight rebound, with the CPPI up 1% year-to-date, suggesting we might be at a turning point.2
Macro Factors We See Affecting Transactions
- Impact of the 10-Year Treasury and Federal Funds Rate: One indicator we believe may signal greater demand for real estate assets is the 10-year treasury. The 10-year treasury rate has historically served as a benchmark above which cap rates for each CRE asset class tend to oscillate in ranges.3 Based on our observations, we believe that rates of 4% or below may act as a catalyst for increased demand, and while we are currently in the 4.25% range and moving closer to that benchmark, we are not there yet. We anticipate that possible future rate cuts may have the potential to help lower these measures and potentially activate greater capital inflows into the CRE market.
CrowdStreet Deal Flow: Lighter pipeline with more selectivity
The scarcity of the overall CRE market has also translated over to CrowdStreet’s deal flow. With a reduced number of deals being reviewed by our team and an increasingly selective approval process, CrowdStreet is navigating a landscape characterized by both challenges and potential opportunities.
Reduced Deal Flow
The number of deals we’re reviewing at CrowdStreet has seen a significant decrease as of June 2024. Compared to 2022, the number of deals we’re reviewing at the top of our funnel in 2024 has dropped by approximately 70%. This reduction is consistent with the overall decline in transaction volumes across the CRE market.
Higher Selectivity
Given the general market turbulence, the CrowdStreet Investments team has adopted a more selective approach to deal approvals. The focus is on ensuring that only deals that make sense to us in today’s environment make it to the Marketplace. As of June 2024, the deal approval rate at CrowdStreet has also dropped by approximately 70% from 2022. We believe this decline reflects the reduced quality of deals currently available in the market.
Three Reasons Why We Typically Decline Deals
- Outdated Assumptions: Some deals are based on assumptions that we believe were valid in a previous market environment but are no longer applicable today. This includes factors like rent growth, exit caps, and net demand.
- Capital Stack Issues: With senior debt generally becoming more expensive and proceeds dropping to about 50% of total cost for some projects,4 sponsors may seek solutions such as mezzanine debt or preferred equity to fill gaps in the capital stack. These types of capital generally add significant costs to the deal, potentially undermining profitability and increasing equity risk.
- Bases Not Reset: We see this scenario most prominent with recapitalizations that rely on legacy pricing and are not marked to current market conditions. If a project's pricing is closer to 2022 levels rather than where we believe it should be in 2024, the deal is likely to be declined.
Sector Case Study: Ground-Up Multifamily
The multifamily sector faces several challenges due to increased financing expenses, higher construction costs, and expanded cap rates, in many cases contributing to decreased valuations upon exit. These factors can often make it difficult to find a multifamily development deal that pencils.
General challenges we’re seeing with these types of projects include:
- Below 6% untrended yield-on-cost
- Borrowing costs up (Secured Overnight Financing Rate (SOFR) from 0% to 5.35% from 2022 to 2024) 5
- Cap rates up approximately 170 bps from Q1 2022 to Q4 2023 6
- Flat rent growth, 0.4% increase year-over-year in Q1 2024 7
- Construction costs have increased 20% to 35% over the past 5 years 8
When Would We Consider Multifamily Development for the CrowdStreet Marketplace?
While the market is generally challenged by the macroeconomic environment, there are situations where a ground-up multifamily project could be considered for the CrowdStreet Marketplace. Generally, we would be looking for the following:
- Healthy Market Fundamentals: Markets where units are still being absorbed and new supply is diminishing, signaling strong potential demand once the project is completed.
- Untrended Yield-on-Cost of 6% or More: This may be achievable due to reduced land bases, stripped legacy carrying costs, or lower general contractor bids.
- Relatively Prudent Capital Stack: Looking for debt service coverage ratios of 1.2 or better at stabilization, indicating relatively affordable debt.
- Unit Mix: Generally aligned with perceived demand in the geographic area
What Else Generally Makes Sense for the Crowdstreet Marketplace Today?
Given the current market where pricing has declined and assets are trading at a discount to replacement cost,9 we believe, generally speaking, acquisitions are currently more feasible than development. Specific sectors of interest to us include:
- Multifamily acquisitions: Actively pursuing projects we think are priced in 2024 terms with capital stacks and underlying assumptions that make sense to us.
- Industrial acquisitions and shallow bay development: Smaller industrial properties are particularly interesting due to consistent demand we’re observing 10
- Certain fund strategies: Targeting sponsorships that we believe have the potential to leverage dry capital to seize potential early-cycle opportunities
- Hotel acquisitions: Observing stable to moderately growing markets with increased cap rates 11
- Retail acquisitions: Generally interested in grocery-anchored neighborhood centers
- Opportunistic office, certain niche deals/special situations: Unique opportunities that we believe fit the current market conditions
Conclusion
So, where are the deals? While they remain scarce, we may be witnessing the beginnings of stabilization. This deep dive by CrowdStreet provides numerous insights into the scarcity-driven dynamics of the current CRE market. The commercial real estate sector has faced significant challenges, leading to reduced transaction volumes and generally volatile pricing. As we continue to navigate this environment, deals that meet our Marketplace criteria have become increasingly rare. However, we are beginning to see early signs of CRE market improvement, with the rate of transaction decline slowing and prices showing their first uptick since 2022. Although there is still progress to be made before what many would consider a full recovery, many are looking towards an anticipated first rate cut in September 2024 as a potential catalyst for increased velocity in CRE transactions.
This article was written by an employee of CrowdStreet, Inc. (“CrowdStreet”) and has been prepared solely for informational purposes. The information contained herein or presented herewith is not a recommendation of, or solicitation for, the subscription, purchase or sale of any security or offering, including but not limited to any offering which may invest in the geographic area(s) or asset type(s) mentioned herein, whether or not such offering is posted on the CrowdStreet Marketplace. Though CrowdStreet believes the information contained and compiled herein has been obtained from sources believed to be reliable, CrowdStreet makes no guarantee, warranty or representation about it. Any projections, opinions, assumptions or estimates used are for example only and do not represent the current or future performance of the subject thereof. All projections, forecasts, and estimates of returns or future performance, and other “forward-looking” information not purely historical in nature are based on assumptions, which are unlikely to be consistent with, and may differ materially from, actual events or conditions. Such forward-looking information only illustrates hypothetical results under certain assumptions.Nothing herein should be construed as an offer, recommendation, or solicitation to buy or sell any security or investment product issued by CrowdStreet or otherwise. This article is not intended to be relied upon as advice to investors or potential investors and does not take into account the investment objectives, financial situation or needs of any investor. All investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. All investors should consider such factors in consultation with a professional advisor of their choosing when deciding if an investment is appropriate. CrowdStreet’s review process of any issuer or deal should not be construed as a recommendation or a solicitation to buy. All investors should consider their individual factors in consultation with a professional advisor when deciding if an investment is appropriate. Investing involves risk, including the possible loss of money you invest, and past performance does not guarantee future performance. All investors should consider such factors in consultation with a professional advisor of their choosing when deciding to invest.
