Will rising interest rates and surging inflation spell trouble for the sector? Not according to SparrowHawk

It’s a pivotal moment for the U.S. economy. Will surging inflation and geopolitical shifts spell trouble for the sector? Not necessarily.

Chicago Industrial Properties recently consulted SparrowHawk Founder Alfredo Gutierrez to discuss the current outlook, including how to parse truth from tale when it comes to investing in today’s market.

The Concern
Much of the concern has less to do with volatile economic factors, but the lack of clarity surrounding them, Gutierrez said. The economy is murky, and everyone seems to have a different opinion regarding what might or might not happen. It’s true that some of the traditional items the real estate industry looks to are in flux—like the 10-Year T—but no one knows for sure how things will play out. Still, whatever does happen will have an impact, and lenders, in particular, are widening their spreads to give themselves room if there’s an upward shift.

“Because of this, no one knows exactly how to underwrite a deal. From the matrix of traditional cap rate underwriting, if you only took a property’s first-year NOI, the majority of deals don’t pen out in terms of what they’re truly worth.  Meaning cap rates as a function may have moved up, due to what’s happening in the economy, but so have rental rates resulting in value to be captured in the future.”

Real estate values haven’t deteriorated, and much of the investment community has shifted their focus to three-year windows as opposed to 12 months because of rent inflation, which Gutierrez said is predicted to continue to significantly inflate as a result of low vacancy and limited supply of space. New buildings are quickly absorbed, as the sector continues to see positive absorption.

“Everyone’s predicting there’s going to continue to be upward pressure on rents, making way for a landlord’s market,” Gutierrez said. “But is that enough to justify the potential cap rate increase? There’s just not enough clarity. No one has a crystal ball, so there’s a little skittishness in the market but property values based on price per square foot continues to be maintained .”

What Sets Industrial Apart
Each sector is different, and thus, it’s fair to wonder if the above economic concerns will have different effects on each. That said, Gutierrez said no. It’s important to focus on the basics and fundamentals.

“Industrial continues to have legs to it,” he said. “It’s a favored sector. Commercial real estate traditionally has been  highly levered. Whether its 50–60%, the leverage is a part of the investment and in the low interest rate environment real estate values benefited.  We had almost zero cost of capital for many years and even with relatively flat rental rate escalation cap rates continued to decrease, and lenders spread decreased.  Now we are seeing the opposite situation and a lot of cash buyers who see the value due to extremely high rental rate growth and potential to add leverage later. Historically life companies and banks based their interest rates upon the 10-Year Treasuries.  The 10- Year Treasuries being a longer-term number and while the Fed fund rates have significantly increased the 10 year  doesn’t move basis point by basis point, it does move in tandem to some degree.  We did see the 10 Year Treasuries push 3.75%–4% with a 200 basis point spread on it for the lender, lenders are quoting 6% interest rates. A traditional highly leveraged buyer can’t buy deals at 4% yield because the equation doesn’t work with negative leverage. We have seen the 10-year rate pull back significantly even in the face of rising Fed Funds which have resulted in an inverted yield curve and the 10-year T currently at about 3.4%. When the lenders narrow the spreads, you will see debt at sub 5%.   With double digit rent inflation leverage deals will trade and strong returns will continue even if the CAP rate move up slightly.”

Now there is a cost, and Gutierrez said the short term objective is to get the industry on the same page. Unfortunately, it is like turning a big ship, it takes time, and slowly, it will turn.

Another thing worth noting is the Fed’s recent adjustment of interest rates but less aggressive, as they’ve scripted a 5% interest rate to offset the risk of flaring inflation.

“I think you’re going to see inflation quickly come into line,” Gutierrez said. “Current inflation isn’t an interest rate issue, but rather a supply issue brought about by the pandemic. It’s solving itself and as supply grows, you’ll start to see downward pressure on price of commodity goods.”

Information Overload
There is so much information out there—every article slightly different—contributing further to the previously-mentioned lack of clarity. When asked for insight by investors with regard to trying to navigate the space in the current market, Gutierrez emphasized patience. 2H2022 came with a lot of speculation and worry, but the fundamentals speak for themselves.   

“The fundamentals in the sector are stronger than I’ve ever seen them in my 35-year career,” he said. “Low vacancy, good product, the growth of e-commerce and reshoring are all positive for owners of industrial real estate.  We just have to step back. Those of us that have been in the business for long enough realize we need to do our job to increase NOI and, as a result, increase value. It’s important to be patient, pay attention to the fundamentals and remind ourselves that it’s still a strong market.”