Phoenix Commercial Real Estate News
Commercial real estate interest rates are trending upward, and the Federal Reserve shows no signs of stopping its efforts to tame inflation by making borrowing more expensive. Federal Reserve officials are trying to avoid a vicious cycle in which the current annual inflation rate of over 9% fuels expectations of further inflation, which in turn causes prices and wages to spike. Several more rate hikes are expected for the remainder of 2022, bringing the federal funds rate to 2.5%, the highest since 2018. How are these changes expected to affect investing in Phoenix commercial real estate?
The relationship between interest rates and commercial real estate (CRE) is complicated to say the least, given that there is no crystal ball to predict where inflation will head. Conventional wisdom holds that, as a real asset, CRE is inflation-proof. At a time when Wall Street is looking for big money to be put to work after a terrible few months, CRE yields and appreciation potential look especially attractive.
The three main effects of rising interest rates on real estate
However, inflation and rising interest rates do not affect all CRE asset classes, market participants or regions equally. Factors to look out for include:
Rising costs. Higher labor, materials and borrowing costs are not just a problem for real estate developers, owners and operators. These pricing pressures will ripple through all parties in the real estate ecosystem and can eventually ripple through the economy, fueling the inflationary spiral mentioned above. And of course, profitability will become more difficult. Increased competition. With interest rates expected to rise, the need to deploy capital is increasing. In the Greater Phoenix market, the industrial sector is experiencing historic levels of investment and pricing tailwinds, but it is also increasing competition. Multifamily is also booming, but competition (especially Class A product flooding the market), plus continued interest rate increases and skyrocketing apartment rents, will make it more difficult to buy a home. Cap rates. In theory, rising interest rates should drive cap rates higher (sellers will have to offer higher yields and lower prices to attract buyers), but there is no 100% correlation. With abundant available capital, cap rates have remained stable or slightly compressed and spreads over short-term Treasury bills have narrowed. A competitive market for yield is pushing down yields, especially in industrial and multifamily properties, where vacancy rates are low and rents are rising healthily, but rising interest rates could cause the cap rate pendulum to swing the other way.
Overall, higher borrowing costs could make more deals less meaningful or impossible to execute. On the lender side, rising rates could raise concerns about borrowers' ability to repay. Floating-rate loans, in particular, are demanding a premium as lenders try to protect themselves from the Fed's promised rate hikes.
Mid-2022 Summary: State of the Market
Another note about inflation is that it also impacts investor returns, so it's important to focus on which asset classes will be the best safe havens regardless of how the Federal Reserve sets interest rates.As the first half of 2022 draws to a close, here's a summary of the Greater Phoenix market's current performance and outlook.
Phoenix Multifamily Real Estate
The segment has been overbuilt for quite some time, but it hasn’t been affected as much as expected. Sales volumes and prices have remained strong, with many savvy multifamily owners selling within a year of ownership for excellent profits. But some cracks are starting to show as more properties hit the market this year and even more are due to be delivered in the first half of 2022. (Just under 38,000 units are under construction and more than 26,000 are in some sort of planning stage.) Of note, record rent growth has also slowed, with vacancies increasing slightly. Overall, the multifamily market is benefiting from rising interest rates keeping people in the rental pool. While many former California homebuyers have plenty of cash, not everyone moving to Arizona does. Multifamily developers and investors are hoping that the movers will absorb the extra units.
Phoenix Office Real Estate
While reported office vacancy rates are lower than expected, at around 20%, a walk through many office buildings housing professional and financial services tenants reveals significantly lower physical occupancy rates and correspondingly significantly higher physical vacancy rates. Business owners are still locked into lease agreements even if they are unsure of what to do with the space. Last year, employers/tenants postponed the issue with one-year extensions and landlords complied in lieu of outright termination. When lease renewal time comes around this year, many companies will look to reduce their footprint, especially with the possibility of a recession. This will likely lead to a repurposing of office space, and we are already seeing a trend towards smaller office spaces in better-located, better-equipped buildings, the so-called “flight to quality.” Building owners will renovate to get tenants to renew, and employers will do everything they can to get employees back to the office.
Phoenix Industrial Real Estate
Industrial real estate has surpassed multifamily as the asset class of choice for investors. Investment demand remains strong, and with big plans to make Arizona a logistics hub, a significant amount of new space is being built. There are approximately 36.5 million square feet of property under construction, about 9.2% of total inventory, with a significant amount being speculative. The market has had no trouble absorbing industrial real estate so far, but it will be interesting to see how the inflow unfolds.
Phoenix Retail Real Estate
Retail has been one of the most troubled asset classes during the pandemic, so it's good to see some resurgence. In particular, investor interest has increased in neighborhood retail, multi-tenant retail centers, and triple net lease deals. Prices are rising and cap rates remain low, creating a lot of opportunity. It's important to note the big shift in what's succeeding: tenants that provide services rather than products, so-called internet-resistant tenants.
The conventional wisdom that CRE is used as an inflation hedge is so widespread that it can be misleading and even become a self-fulfilling driver of investment behavior. Regardless of which direction interest rates are headed, there is no substitute for understanding the fundamentals of a sector, submarket, or specific business deal or property.
Contact ROI Properties
Are you looking to buy or sell commercial property in Phoenix? Contact us today to help you find the perfect investment property or help you sell your existing property for the highest and best price. [email protected] or call 602-319-1326.