As with boiling a frog, if you spend enough time in a rising rate hot tub, you’ll eventually get scalded. You just may not realize it until it’s too late.

A recent Wall Street Journal report said CRE is “showing the first signs of cooling in more than a year, disrupted by rising interest rates that are already causing some deals to collapse.” According to MSCI Real Assets data, after 13 straight months of increases, property sales were down 16% compared with April 2021. Meanwhile Forbes recently quipped: “like cops pulling up to a rowdy frat house all-nighter, the arrival of unrestrained inflation and soaring interest rates may signal the party’s over.”

So, should you be buying, selling or holding right now? Don’t get angry at me, but the answer may be “All of the above.” However, I can assure you the Buyer-Seller gap which I addressed in my February blog post has arrived and the standoffs make the gunfight at the O.K. Corral look like child’s play. I’ve been an eyewitness to downward price concessions and dropped escrows due to investors need for higher risk premiums, which is correlated to rising rates.

As I outlined a few months ago, CRE is a good hedge against inflation since landlords who own apartments, self-storage, manufactured home communities and other assets with short-term leases can quickly raise rents to match inflation. But inflation is a different animal since a weak economy creates a decline in business and consumer spending, thus limiting the ability of landlords to raise rents.

In late 2020, when many property investors felt it was safe to get back into the water, there was hardly any steam coming off the interest rate tub. Investors took advantage of lukewarm interest rates and

started buying aggressively, expecting an eventual rebound. Multifamily and industrial property demand surged and helped fuel commercial sales last year and into this year. Gains from those sectors made up for underperforming office buildings, which continue to be hurt by the work from home trend.

Is the CRE rally running out of steam?

But now that interest rates are climbing aggressively with no sign of inflation hitting the brakes, many industry watchers are wondering if the post-pandemic CRE rally is running out of steam. The aforementioned WSJ report said hotels, office buildings, senior housing and industrial properties recorded big drops in sales last month. And while sales of retail properties were up thanks to strong household spending, and while sales of apartment buildings continued to rise due to strong tenant demand, The Journal said even those sectors may be slowing “as rising interest rates keep some investors from making competitive offers.”

In case you were still soaking leisurely in the interest rate tub, April’s 16% decline in sales came just 30 days after total commercial property sales rose 57% in March. “The speed of that transition is shocking,” quipped MSCI’s chief economist, Jim Costello, in a WSJ interview. Costello added that a drop in sales can be an early stressor in real-estate markets because prices are usually slower to change.

Like an ice bucket thrown into the hot tub, many people I talk to believe a slowdown or recession in the U.S. economy could lead to lower office, retail and apartment rents. As the Journal reported, “Property investors that relied on large amounts of cheap debt to purchase buildings have been some of the first ones to fall out of the market.” And from where I sit, no one likes “shrinkage” coming out of the pool.

Is negative leverage all bad?

With higher borrowing costs, some leveraged floating rate investors are already feeling the pressure with their near-term returns and proformas about to blow-up. That ain’t good. Even more shocking are some of the offering memorandums I review. They’re so mispriced that they come packaged with negative leverage. That’s like buying a half-eaten meatball sub at full price! By the way, negative leverage – when the use of debt decreases the advertised cap rate return – will not necessarily dissuade investors to buy a property. GlobeSt recently listed three important reasons why, which I’ll opine on as well: ​ ​

1. They have the capital raised in a fund or private placement and are eager to spend it. I tend to agree if the return expectation is small and you have enough equity to back into the required return.

2. They believe that rent increases will be high enough in future years to create positive leverage down the road. I’ve found that’s a fool’s game. Playing craps in Vegas will give you better odds of winning.

3. Many investors are seeking CRE investment for inflation protection, notwithstanding the negative leverage concerns. In my experience, this is a risky proposition in today’s high inflation environment. But, if you’re willing to risk a possible deterioration of your hard-earned equity infusion, then go for it.

With the Fed aggressively raising rate to combat inflation, many property investors must choose between losing their deposit or paying more than expected for their mortgage. Most investors seem to be moving ahead with planned purchases, but other investors are more cautious now about signing new contracts. I can’t see how this doesn’t start driving down prices.

WSJ recently reported that sellers are becoming increasingly likely to make concessions “to close deals as the buyer pool narrows and interest rates rise.” Could we possibly be seeing a buyer’s market? Case in point: Private investors are buying up shopping centers and other bricks-and-mortar real estate. “While many REITs and other big players remain cautious, retail property sales are increasing to family offices, wealthy individuals and small private investment firms,” The Journal added.

These smaller nimbler buyers accounted for nearly three-quarters of retail-asset acquisitions in 2021, according JLL data -- a 30% increase from the 10-year historical average. I know it’s hard to believe, but it seems many retailers are paying their rent on time and are even looking to expand during a time of limited square footage. Meanwhile investors are flocking to retail – that’s right retail -- because prices and returns remain relatively attractive in comparison to warehouses and rental apartments – the darlings of the early pandemic CRE landscape.

So back to my original question: Do we have a buyer’s market or not? Maybe.

“If a buyer’s market were universally acknowledged, the sales volume wouldn’t have nosedived off the thirtieth floor, Wolf Street recently noted. “Sellers and buyers would have been on the same page.” Essentially, Wolf Street believes we have a widening “bid-ask spread,” with sellers sticking with their summer prices and “cagey buyers either spooked or looking for big wintry discounts. This disconnect is the root of the precipitous sales decline,” Wolf Street opined.

As with the stock market, lower CRE prices offer opportunities for bargain hunters to “buy the dip.” To paraphrase Warren Buffett: “Be fearful when people are greedy and be greedy when people are fearful.”

Conclusion

No one wants to jump into the hot tub time machine more than me. Rates were astronomically low and it seemed like only yesterday that I was getting lender bids sub 3% with interest only. Those days may come around again after a deep freeze of Fed rate hikes throws us back into a recession. In the interim, CRE lending rates are still attractive historically speaking. Many of the lenders we work with have lowered their spreads as Treasurys spike. 30-year amortization, which helps counter the effect of negative leverage, is widely available for all asset classes.