Rising interest rates have commercial real estate players adjusting their expectations about cap rates and internal rates of return. A majority of participants in Altus Group’s recent survey of industry insiders foretold yesterday’s 75 basis point (bps) increase in the Bank of Canada’s overnight rate, taking it up to 3.25 per cent, and nearly one quarter anticipate a further uptick before the end of 2022.
The survey distills input from 126 respondents, including investors, developers, lenders and brokers/consultants, who were queried last month for their readings on how market trends are flowing through to real estate values. Generally, survey participants perceive a riskier environment, with 88 per cent of respondents concluding a recession is somewhat or very likely within the next six months, but there is ongoing consistency in the assessment of stronger and weaker performing asset types.
“Respondents overwhelmingly indicated that they believed cap rates will increase for office and retail assets in both major urban and secondary markets as a result of rising interest rates, while they were less sure when it came to industrial and multifamily residential assets, particularly in major urban markets,” states the summary of survey findings. “Survey respondents also agreed that assets in secondary markets are more vulnerable to rising cap rates as a result of increases in interest rates.”
Among investors, lenders and broker/consultants, 90 per cent of respondents foresee higher cap rates on office assets in major urban markets, while 97 per cent project higher office caps in suburban and secondary markets. A more sizeable minority predict stable cap rates for industrial (41 per cent) and multifamily (35 per cent) located in major markets. They also show more confidence in these asset types, versus office and retail, within secondary markets, with 20 per cent suggesting industrial cap rates will hold steady and 17 per cent voicing that expectation for multifamily cap rates. Meanwhile, 80 per cent anticipate rising cap rates on retail assets in major urban markets and 95 per cent make that prediction for secondary markets.
Most investors and lenders concurred they now apply a higher internal rate of return to assess the viability of an asset, but, again, are more likely to do so for office and retail properties, and in secondary markets. Notably, 39 per cent of respondents report they have not adjusted internal rate of return expectations upwards for industrial and multifamily properties in prime markets.
Developers express the most confidence in multifamily rental and mixed-use projects in prime markets with around two-thirds of those surveyed saying they have not adjusted discount rates for those types of initiatives. That slips to 57 per cent for condominiums in prime markets and down to 50 per cent for new condo projects in secondary markets.
In keeping with that finding, just 6 per cent of developers said they might respond to future pressures by increasing the portion of condos relative to rental units that they’ll bring onto the market. However, 17 per cent would consider increasing their planned quotient of rental units relative to condos.
“Some of the most interesting data to emerge was learning what strategies developers may deploy as a result of the rising cost of new real estate development associated with interest rate hikes and a possible recession, including that almost one-fifth (17 per cent) of developer respondents have yet to form a strategy at all, ” the survey summary reiterates.
Passing costs through to buyers was the most cited tactic with 44 per cent of developers saying they would increase unit prices. Upwards of one-third suggest they’ll pull back on development activities — pausing projects, reducing the number of projects or cutting back on land acquisition — while others said they’d attempt to maintain current prices for buyers through reduced unit sizes (29 per cent) or lower quality construction (11 per cent).
