The commercial real estate market should brace as the impact of higher interest rates is being felt across sectors, especially in light of the Fed’s recent announcement that it has raised interest rates by another 75 basis points. 3650 REIT co-founder and managing partner Toby Cobb cautions that even the high-flying multifamily sector could feel an effect.
While the fundamentals of the multifamily sector are strong, with solid demand drivers and steadily rising rents, this does not mean these properties are entirely insulated from the current environment.
“We do have some meaningful inflation protection in the form of rents in the multifamily sector, but it is not the case that they are going to move in perfect symphony with interest rates, especially now that rates have already risen by 150 bps year-to-date. Ask any multifamily borrower what it feels like to borrow at 5.5 percent and they’ll say, ‘What are you talking about? That’s 150 bps wider than the cap rate!’” Cobb says. “There is zero positive leverage, looking back probably 18 months on cap rates on multifamily and that is going to have a real material impact on the sector.”
The national manager has tracked strong rent growth and asset appreciation in markets in Florida, Texas, the Tennessee Valley and other parts of the South but Cobb said it would be naïve for market participants to expect this kind of growth to continue.
In the office sector, Cobb has seen lender pullback.
“What is happening in liquidity in office is real and, frankly, warranted. Anyone who tells you what is going to happen in office cap rates and office in general is either divine or full of crap. The question marks around who is going to go back to the office and how often and whether or not it will happen are too large,” Cobb says.
While there have been individual instances of strength in the office market, these situations are not the norm. “The prints people are talking about are very specific in very specific buildings – it is not uniform,” Cobb adds. “While I think the office market is going to be challenged, I don’t think this means the end of cities.
“I’m not sure anyone knows what this means. But I do know that we have spent 2,000 years gathering and crowding into cities for educational and social experiences and New York, San Francisco, Boston – all of those cities and more will have to be reimagined.”
Cobb believes there is too much office space that no longer has a purpose. “When we see the vast majority of the problems in real estate in my lifetime, at the core they were dominated by overbuilding. There was a functional obsolescence piece in the Resolution Trust era but what we are facing today is more difficult because growth doesn’t get you out,” Cobb says.
“I don’t think that three, five, seven or 10 years of growth gets people to go back into the office buildings and makes them office users at a lower rent. That means a building goes from being worth $400 per square foot to being almost worthless.”
Clouds on the horizon
As a veteran lender, Cobb is able to draw on current and historical observations in his assessment of the current market. In addition to economic concerns, there are generational geopolitical issues that could affect the global markets as the war in Ukraine continues. “We are potentially very realistically going into another Cold War – the last one lasted [many] years and impacted the global markets,” Cobb says.
Another factor that will continue to affect the markets is the Federal Reserve’s looming, long-term plans to potentially continue to raise interest rates – and the market’s reaction to these moves. Since the start of the year, the Fed has raised rates by a total of 150 basis points while the yield on the benchmark 10-year Treasury has risen by 175 basis points.
“There is no question the Fed will likely continue to raise rates, even in light of the recent 75 bps hike. When that happens, the investor community is aghast and we see a flight to quality in the stock market that is sometimes hard to understand because the Fed has been signaling these plans for months,” Cobb says.
“At some point, the investing public will understand the Fed will continue to take action by further raising rates, and that is the point at which inflation will come under control. And in the debt markets, I think there will continue to be consternation around lending in this environment.”
When we spoke with Cobb last month, he also raised the question of the continued volatility in cryptocurrencies, especially Bitcoin, which he made clear that he believed was concerning and a “bottomless pit” for investors. He also noted that a principal cause of the global financial crisis was a downturn in the residential market. Now that we have seen the trillion-dollar crash of Bitcoin unfold, Cobb’s earlier comments were prescient:
“At its core, the assets were overvalued at probably 30 percent or 35 percent – there was a $350 billion gap in the economy from the principal culprit of the downturn. This time around, Bitcoin could be a principal culprit. But you have to remember there is no home there – there is no there there. Simply a thing that everyone says is worth something because we say so. I fear there is very little or no bottom to Bitcoin or other cryptocurrencies,” he added.
Looking ahead, Cobb sees a world where it is harder to predict the winners and losers.
“The story really is one of varied outcome. It is the story of a wildly idiosyncratic asset class that has become even more so. Picking winners and losers in the go-forward environment is going to be incredibly difficult,” he says.