Are CRE Prices Too High? It Depends on Your Mindset

There continues to be a disconnect between CRE buyers and sellers as both sort out the current economic climate, existing loans, interest rates, and the relative value of maintaining long-term perspective.

John Chang, Marcus & Millichap, said in a recent news video that prospective buyers keep telling him that commercial real estate prices are too high.

Meanwhile, sellers fall into two camps. There are the ones who are motivated because they have an issue with the underlying loan, they have some sort of ownership issues or it’s simply time to harvest the asset.

And there are those who aren’t motivated because they don’t have an impending debt issue or any real pressure to liquidate the asset.

“The sellers in the first group are generally moving to a market clearing price, while the owners in the second group, obviously won’t come to market at all, because they believe their property will be worth more in the future,” Chang said.

This disconnect has slowed sales activity. Marcus & Millichap reports that the total number of commercial real estate transactions over $1 million in the first half of this year is down a dramatic 41% compared to last year, but it has still seen nearly 30,000 properties trade hands in the first half of 2023 priced at $1 million plus.

Chang said that’s about the same as during the first half of 2015, and it’s about 20% higher than the 20-year average transaction velocity.

“So obviously there’s not a total disconnect between buyers and sellers,” he said. “Transactions are still getting done.”

Granted, most of the velocity is in the lower price tiers, Marcus & Millichap finds.

In the first half of this year, 87% of the transactions were between one and $10 million which is the highest share since 2010 when the US was coming out of the global financial crisis.

“This reflects the greater share of activity being done by private investors, the lower leverage requirements by lenders, and the greater lending liquidity at lower price points,” Chang said.

He said that buyers who are still on the sidelines keep saying the same thing: Why invest in commercial real estate when I can get 5.5% on a six-month treasury? And most commercial real estate properties on the market are offering a cap rate below the cost of debt.

Most commercial real estate loans are running within the 6% to 7% range, while the cap rates on most properties coming to the market are somewhere between the mid 5% to low 7% range.

“For many investors, that math just doesn’t work,” Chang said.

But given that almost 30,000 commercial real estate deals were done in the first half of this year, some are figuring this out.

Chang offered five reasons investors still see opportunities in commercial real estate and why they’re still buying properties.

For one, investors believe interest rates will come down at some point in the next couple of years and they’ll be able to refinance at a lower rate.

Secondly, the property being purchased might have an assumable loan that still has some term left that keeps the going-in rate on the debt below market, and the numbers still pencil.

Third, there are still value-add deals. Even if the going-in cap rate seems low, for the right investor there may be upside potential they can tap into through property upgrades, changes in leases, bringing in new tenants, creating management or cost efficiencies, or some other unique strategy.

Fourth, the buyer sees local, metro, or neighborhood-level changes coming in the future that will change the property’s dynamics. For example, the property may be in a neighborhood that the investor thinks will gentrify over the next few years.

Finally, the investor is thinking long-term. They’re considering where the market, sub-market, and property will be positioned in five to seven years or at some other anticipated exit point.

They may be looking at demographics, migration trends, employment trends, barriers to entry, barriers to the addition of new supply, or some other structural change that will affect the property.

“Today we’re moving back into what I would consider to be a more normal real estate investing climate where expertise, relationships, and knowledge carry a higher value,” Chang said.

“Investors have to be able to look at the asset and see a specific reason to make that acquisition. They have to see upside potential and unique market dynamics that will favor that property going forward.

“That makes market information, insight, and expertise particularly valuable.”