The Seller's Conundrum
In underwriting commercial deals, bankers are always mindful of mismatches: mismatches between projections and reality, mismatches between what the most recent tax returns might say versus the current income statement, even mismatches between what the enterprise requires compared to the skills and experience the borrower is bringing to the table.
A new mismatch that has emerged over the past 6-12 months is that of the difference in price expectations between sellers and buyers. To be sure, on the residential side, this has not become clearly evident yet as demand appears to be more or less holding up. Prices have not declined significantly in most U.S. markets (yet), as according to the National Association of Realtors prices in March 2023 were down just 0.9% nationwide versus March 2022. Considering how much higher interest rates are today than a year ago, it is a pretty strong sign of demand that prices have not actually dropped by more.
Why have residential prices not fallen more significantly? Well, the labor market and the overall economy have been holding up fairly well over the last year despite the impact of inflation and the Fed’s corresponding efforts to slow down the economy and reign it in. When people are feeling financially secure, they are more likely to make significant life decisions like the purchase of a new home. Demand is there and it’s holding on.
The other significant variable at play in propping up home prices is that home inventory is just so low. That same National Association of Realtors report that showed prices down 0.9% also shows the number of transactions down by an astonishing 22.0% year-over-year. Part of that slowdown in transactions is buyers being more patient and simply staying away with interest rates being so high, but a big part of the story is a lack of homes for sale. With fewer homes on the market and plenty of buyers who are doing well enough financially to buy a new home, prices are hanging tough. Until there is a meaningful drop in employment or some other form of widespread economic peril or a massive building boom, prices are likely to hold up reasonably well (although I am on record from January predicting that home prices will drop nationwide in 2023, which I still believe because I think the Fed has overshot it on rate hikes and the economy will take a modest swoon later this year).
By the way, here in Maine from where I write the story is about the same as the nationwide one. According to the Maine Association of Realtors, home prices in March were up 3.85% over March 2022, but the number of transactions was down by 16.78%. In none of Maine’s sixteen counties was the number of homes sold greater in March 2023 than in March 2022. So transactions are falling, but prices are holding up.
On the Commercial Side
Where mismatches between buyers and sellers are starting to become more evident is on the commercial side, including residential rental properties.
There are a lot of different ways for a real estate investor to evaluate an investment opportunity including capitalization rates, internal rate of return (IRR), debt service coverage ratio (DSCR), and many more. But with all of these calculations, if the cost of the inputs goes up, the net return on investment goes down.
And costs for many real estate investors have been going up. The cost of borrowing is the big one, with rates on commercial loans increasing from the 4.0-5.0% range a year ago to 7.5-8.5% today (or even more in the case of some private money and hard lending). Consider this: a $1 million commercial loan with a 20-year term at a 4.5% interest rate from April 2022 would have a monthly payment of $6,236. Over the life of the loan barring any extra principal reduction payments or interest rate changes, the total interest paid would be $518,358. That same loan at an 8.0% interest rate today would have a monthly payment of $8,364 and the total interest paid over the life of the loan would be $1,007,456. It could be the same property with the same loan terms with the exception of the interest rate, and the monthly payment is over $2,000/month greater today than it would have been a year ago, and the total interest paid is nearly $500,000 more over the life of the loan. That is real money, to say the least.
So how has this new borrowing environment impacted the market? Well, it’s certainly one of the reasons why the number of transactions has slowed down. Deals just do not cash-flow as well at these higher interest rates, plus some borrowers just don’t qualify anymore as the DSCR ratio the bank looks at its underwriting may no longer be strong enough on certain deals. This cooling off is, of course, exactly what the Federal Reserve wants to see happen in its efforts to cool off the entire economy and tamper down inflation. When fewer commercial deals are taking place and businesses are less able to borrow money to invest in themselves to fund their expansions and acquisitions, the ripple effects from all of that increased economic activity are lost and growth decelerates.
Keep in mind, too, that borrowing costs are not the only things that have gone up over the past year for businesses and real estate investors. Inflation has hit in all kinds of ways including higher costs for capital upgrades and renovations, greater labor costs, higher utilities, and more property taxes, which I wrote about a few weeks ago. The net result of this is that many commercial borrowers including real estate investors are re-orienting their price points. If the inputs on one side of the equation are becoming more costly, to achieve a necessary rate of return to justify the risk, the other lever to pull is to pay less for the asset.
And therein lies the conundrum for sellers. The story in the real estate world not to mention people selling non-real estate commercial entities like long-time family owned small business over the past few years has been one of frenzies of buyers, highly competitive bidding wars, and rapidly appreciating values. Fueled by the run-up in prices, sellers may be psychologically anchored to high prices that they believe they can achieve. But there is a mismatch developing between what sellers want to get and what buyers are willing to pay. The shorthand version I’m hearing in the industry these days from some is, “Sellers are anchored to 2022 prices but buyers are in 2023.”
I speak with a lot of real estate agents on a regular basis, and although I think most are, in fact, trained to always be as positive and optimistic about the market as possible, I have enough friends in the business who will give me the straight story on the state of the market. Somewhat to my surprise over the past few weeks, it feels like the residential market is finding a floor. 30-year fixed mortgages are around 6.4% right now, which is down from just over 7.0% in November, and as mentioned above the economy is holding up well enough to give buyers confidence to pursue the homes of their dreams.
However, on the commercial side, I am definitely seeing things slow down. Buyers are being patient and the smart money is wary of overpaying. On 1-4 family rental properties and multi families with 5+ units, you do still see occasional bidding wars and offers above asking price; but it’s not like it was a year or two ago.
My advice to people wondering whether to sell is that there are still enough buyers out there that make this an attractive enough market to sell in, but a lot of the savvy real estate investors I work with are taking a step back and waiting things out. The benefits of seasonality to the seller are also hitting right now, with more buyers typically in the market from May to August. So my advice if you are thinking about selling is to do it now. By September or October things may be slowing down even further. What buyers are waiting for more than anything is either interest rates to drop so that deals cash flow better, or for prices to come down to balance out the rise in costs including the increased cost of borrowing. With it appearing that we may still be 6-10 months out from any sort of meaningful decline in rates, the lever on prices may be the one that gets pulled. Whether you are considering selling your home, rental property, or business, sellers should sell while the selling is good.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com. Follow Ben on Twitter, Facebook, or Instagram. Opinions and analysis do not represent First National Bank. © Ben Sprague 2023.
The Weekly Round-Up
Here are a few things that caught my eye around the web this week.
In March I wrote about the collapse of the 17th largest bank in the United States. It now appears that the 14th largest bank in the United States has also failed. By the time you read this, a shotgun marriage to JP Morgan or PNC Bank may have been executed to try to salvage what can be saved from First Republic Bank. Joey Politano of Apricitas Economics has the full story on the bank’s collapse if you want to read more here. (Note: I would be doing a disservice to the regional and community banking sector if I did not clearly note that Silicon Valley Bank and First Republic are both extremely unique, nichey banks. Despite their previous standings among the top twenty largest banks in the country, they are not representative banks. Although the entire banking sector is indeed under stress, most depositors at local and community banks have little to worry about, in my opinion).
More on First Republic: the company’s stock traded around $16/share on Monday, April 24th. Five days later it closed After Hours at $2.33/share, a drop of 85% from Monday to Friday. And if you think that’s bad, the stock had been over $140/share as recently as February. Stay diversified, my friends, and beware of black swans.
Via Bill Trotter in the Bangor Daily News, a judge has upheld restrictions enacted by the residents of Bar Harbor, Maine to limit vacation rentals. Read more here.
Have a great week, everybody!
Having lived through the S&L collapse when my bank changed hands 9 times and had 11 different names (in three years!) I don't think depositors have anything to worry about. I do think the endless fountain of nearly-free lending has dried and we're finding out whose business model and big successes were entirely dependent on ultra-cheap lending/a de facto subsidy from the Fed.
elm
the sub-2% inflation with free money only works if nobody sneezes