No one, not even the most seasoned commercial real estate investor, has the ability to time the market. It’s anybody’s guess as to when the current real estate market turns from a seller’s market to a buyer’s market. It could happen today, next week, next month or five years from now. No one knows. That said, there are five obvious indicators that the market is in the process of turning to the dark side.
1. For most property types, the real estate market has peaked
I believe the real estate market peaked last year in the Pacific Northwest. The one exception could be industrial properties which are still going strong. But for all other properties, rent increases have begun to slow down, and vacancy rates have bottomed out. With some property types vacancy rates have increased modestly in recent months as new product comes on line. As additional new properties continue to be completed expect this trend to accelerate with concessions a likely outcome.
2. It’s still a seller’s market – for the time being
Even with these changes, buyers have been slow to acknowledge that the market has begun to change. I can see why sellers are living in denial. They want this market to continue so they can sell their properties for top dollar. Very little product is for sale and what is available is being gobbled up quickly by buyers. But even so, I am being told by real estate brokers that there are far more sale fails this year than what they’ve experienced in the recent past. Intuitively this makes sense to me. Buyers get a property under contract and then they dive deep into the property’s numbers. And what they are finding is that the numbers are not as good as they hoped so they back out of the deal. Makes perfect sense to me. If I were a seller, I would sell while the market is favoring them.
3. Interest rates are continuing to rise
This year we have seen a slow but steady rise in interest rates and there doesn’t seem to be any let up to this trend anytime soon. With rising interest rates, come higher mortgage payments resulting in lower returns on an owner’s equity. At some point buyers will take notice and stop buying. While the lemmings are still buying now is the time to off load those properties onto the unsuspecting.
4. Cap rates are inextricably linked to interest rates
If interest rates rise and continue to remain at these levels, eventually cap rates must follow. As I explained above a higher interest results in lower returns on an owner’s equity. In a high interest rate environment, in order to get the same return on an owner’s investment the price of the property must decrease. The higher the interest rate goes the higher the probability that property values will fall because at some point buyers will stop buying. When that happens, you don’t want to be a seller. You want to be a buyer and eventually that will happen. It has to. In my opinion they should have stopped buying months ago. Eventually there will need to be a correction in property values as cap rates and interest rates are inextricably linked.
5. For the first time in years we are experiencing negative leverage
I’m currently in the process of finding the best possible financing for one of my clients. While I was comparing different leverage scenarios, I discovered something I hadn’t seen in years. As more debt was added, i.e., the property was leveraged more, the return on owner’s equity decreased. This runs contrary to what we’ve seen for the past decade. Up until recently, the more debt you put on your property, the higher return on your equity. Not any longer. We are now in a negative leverage environment. This is happening because interest rates have risen while cap rates have stayed at historically low levels. What do you think will happen once buyers become aware that they are now in a negative leverage environment?
My personal strategy
Like many of you I’ve sensed in the past year that the real estate market was turning. Again, no one including me can time the real estate market. But I sensed the inevitability of the market trending down and because of it I sold two properties that I didn’t want to own when the market turns. You see these properties won’t do well in a recession. They will at best limp along until things turn around. The property that I sold last week I decided not to do a 1031 exchange. Instead I’ll pay the capital gains as it’s very difficult these days to find properties worth buying. I’ll use the net proceeds after I pay the capital gains tax:
- As a rainy day fund to help me pay my bills during the next recession or
- Hopefully I’ll have this money available when the real estate market bottoms out and we can once again buy properties at bargain prices.
Now is the time to sell
Now’s the time for you to sell those properties in your portfolio that you don’t want to be stuck with during the next economic recession.
These are my thoughts. I welcome yours. Where do you think we are in the real estate market cycle?
Do you have a need for financing? Contact me at email@example.com to set a time for us to talk.