Looking to the Past to Understand Today’s Real Estate Landscape More Clearly

Dec 15, 2022

With current interest rates soaring and predictions of an economic recession in 2023 making headlines, it’s easy to second guess your next move in the real estate market. In times like this, it can be tremendously beneficial to take a beat, zoom out and look at how today’s economic tumult fits into the larger historical picture.

For more than 80 years, Ryan Companies has navigated the peaks and valleys of the real estate marketplace. Our very own Dan Levitt, executive vice president of capital markets, brings more than three decades of real estate and capital investment expertise—and perspective—to the table as he oversees Ryan’s capital transactions across the country. We sat down with Dan to get his take on interest rate hikes, inflation, changing interest rates and a little perspective as we wrestle with the issues behind questions like, “What does it mean to be in a recession?” and “When will interest rates go down?”

Real estate is a cyclical business. Have we seen these patterns in the past?

Dan Levitt: In many ways each cycle is unique. Today for example, we are possibly entering a recession, yet we are seeing the Fed raise rates. This is not unprecedented. We saw the Fed raise interest rates into the 1974-75 and 1981-82 recessions to fight inflation. However, these periods created different capital challenges for business. During economic slowdowns like these, we typically see declining employment; we have not yet seen that this cycle. In other downturns the real estate market has had to react to oversupply and/or excessive leverage, but neither of these elements appear to be present today.

The run-up in interest rates hurts real estate two ways: first, the increase in the debt rate makes borrowing more expensive which drives down returns; second, it makes bonds an increasingly attractive alternative, absorbing capital that might have been allocated to real estate. One of the complications with investment real estate today is the volatility of the interest rate market—and the resulting uncertainty hurts investment. As the bond markets stabilize over the next year, capital should move off the sidelines and properties should become more liquid (though at prices below the peak).

Interest rates today are the highest we've seen in a decade, but still historically low. How is the sharp rise impacting deals today? How does this compare to strategies used in the past to combat rising interest rates?

DL: We have historically developed in interest rate environments much less hospitable than this one. But this requires us to be nimble, creative, and strategic in our approaches to new opportunities. The cost of development increases with the increase in construction interest. Even more significantly, the increase in longer term interest rates has raised cap rates, which in turn has lowered the value creation (unless accompanied by an increase in return). The dramatic rise in cap rates over the past several months has led to a significant erosion of value for investment properties. To create a financially viable project, we need to develop to a higher return. This is not impossible—far from it—and we will continue to selectively develop investment real estate.

How has Ryan navigated previous market downturns?

DL: Ryan has had consistent access to capital even in the some of the more significant downturns thanks to deep relationships with our banks, equity partners, and other capital sources. That isn’t to say we didn’t feel the effects of capital markets seizing up. We did, and we adjusted our approaches and strategies accordingly. Generally speaking, we continue to search for good opportunities within our existing strategies as well as those unique to the current circumstances for example, looking for and capitalizing on opportunities that that might not have been available in a more heated market but are now available because of the downturn.

The phrase “Negative leverage” is pretty hot right now—could you give us your take on it? What have we learned from past cycles where real estate investors faced interest rates outpacing cap rates?

DL: Historically, with interest rates below cap rates, putting debt on a project enhances the return on equity compared to an unleveraged project. The rapid rise in interest rates means that interest rates in some instances have gotten ahead of cap rates and that means using debt lowers the cash on cash return, an inversion that is rare historically. In these times, investors are occasionally willing to invest in real estate using negative leverage on the assumption net operating income will rise or debt will be lower in the future.

Today, the investors that are willing to look at negative leverage situations likely will only do so if they can underwrite the negative leverage to last around three years or less. But there’s more to real estate than just the cash on cash return over the first several years. Many investors look at overall IRR over a defined holding period. Assuming income growth or cap rate compression over the hold period, the unlevered IRR may very well be above the interest rate. This gives the overall investment positive leverage despite the initial hit to cash on cash.

How does our longevity as a firm and team expertise influence how we are getting deals done today?

DL: There’s no question that our longevity of successfully navigating past downturns gives confidence to our banks, equity partners, and other capital providers that they can lend or partner with us in good times and bad. Similarly, space owners and operators recognize our stability and longevity as additional assurance that if they enter into a lease or construction contract with Ryan, we will be around to fulfill our obligations.

Bottom line: Is now a good time to move forward with a new development?

DL: Real estate is a long-term asset. The development process itself—site identification, land entitlement, design, construction, lease up—also takes a long time. The life of a real estate asset will include many economic and capital cycles. Similarly, one never really knows the economic environment that a new development will deliver into. Accordingly, we generally do not look to time the market. We look for opportunities that should provide solid social and financial benefit, and at present we have a number of potential developments we are working on. While capitalizing them in the current environment may be more difficult, we expect to go forward with many.  

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