Kirk Malmrose, Executive Vice President and Director of CRE & Construction Lending, took part in the L.A. Times B2B Publishing panel to share insights on the Real Estate Industry. View the complete article here.
This year is shaping up to be one of transition. In late 2023, the industry was looking for a rebound with anticipated rate reductions but the Fed’s “higher for longer” stance has muted growth for 2024. The market is getting a reprieve as the Fed recently cut rates by 50 basis points. Cash is king. Investors with access to capital will begin seeing buying opportunities as relatively high interest rates currently in the 5.5% to 6% range have squeezed investors who levered up their properties three to five years ago with rates in the upper 3% range. These investors are facing a “cash-in” refinance scenario. Without cash, they are looking at either a sale of the property or hanging on with a high leverage/high interest rate loan with possibly an interest-only period.
Investment opportunities will be location and asset-specific. Well-located multifamily properties over the long term provide great prospects for cash flow and price appreciation. In all asset classes, excellent customer service and addressing needs will go a long way toward tenant retention and avoiding expensive turnover costs. Select retail demand has been strong, especially in neighborhood centers. E-commerce continues to draw spending away from soft goods retailers so large-scale retail landlords will need to reinvent themselves and improve the shopping experience to be successful. There has been some softening in the industrial markets, but this is just a pause. In the long term, we will continue to see technology and logistics drive the supply chain at all levels, which will support industrial demand. The changing work environment poses huge risks for the large block office sector.
While some see remote and hybrid work as a negative trend, it has positives and negatives — and is here to stay. Work/life balance may have improved but collaboration and creativity may have suffered. I go into the office every day and benefit from “water cooler” discussions with my peers and impromptu “hallway meetings” with others. It is important for young people entering the workforce to develop relationships and mentorships to help them navigate their careers. The pendulum swung far during the pandemic for work-from-home. In many industries, we won’t go back to the five-day workweek, but I hope we can strengthen the personal interaction and synergistic collaboration that brings out the best in us all.
The bid/ask spread between buyers and sellers has widened over the past 18 months. Tighter credit markets, higher interest rates, and divergent expectations between buyers and sellers have slowed sales transactions. Additionally, in conversations with developers and investors, I hear a common refrain that Measure ULA—which imposes a new transfer tax of 4.0% on property sales in the City of Los Angeles that exceed $5 million and 5.5% on those exceeding $10 million—is dampening activity. There is a true housing shortage in the Los Angeles metro area. With rising material, labor, and land costs, an additional 4.0% or 5.5% tax on the sale of a newly constructed building can be the difference between adding housing to the community and not.
With the collapse of four regional banks in 2023 and the recent FDIC takeover and sale of Republic First Bank in Philadelphia, regulators are closely scrutinizing banks’ CRE portfolios. This has a rippling effect of tighter underwriting and enhanced due diligence by financial institutions. Where a bank may have underwritten a loan at a 1.15x debt coverage ratio for a multifamily property, it may now underwrite to a 1.25x coverage. This limits loan proceeds. Add to that a higher interest rate than what was previously used and proceeds may be further limited. The Fed’s tightening to slow inflation is making an impact on CRE markets and driving more equity into deals.
Office leasing is going to be a challenge for the foreseeable future. Tenants have the upper hand in negotiations right now and Class A buildings in prime locations will win out. High levels of service, attention to detail, and upgraded amenities will help keep tenants in place; not having those things will motivate tenants to find better alternatives.
The office markets are a slow-moving trainwreck that will take years to sort out. Some have called this “The Great Reset” for office buildings. There are well-publicized sales in DTLA where buildings have traded for 50% or less than the current owners’ purchase price. These sales may be 20%–25% of replacement cost and could provide redevelopment opportunities for new owners — but a study by Gensler estimates possibly only 25% of office buildings are suitable for conversion to apartments.
Gregory Peck said, “Tough times don’t last. Tough people do.” I would add to that statement that it helps to have a cash reserve.
This article does not constitute legal, accounting or other professional advice. Although the information contained herein is intended to be accurate, Cathay Bank does not assume liability for loss or damage due to reliance on such information.
