Commercial real estate: buy, sell or hold?
The commercial real estate market was beaten, broken and left for dead by COVID in 2020 but roared back to life in 2021 with record-breaking sales of $809 billion.
I was a seller’s or buyer’s broker of investment property sales totaling $55 million last year, and the phone calls haven’t stopped. When consulting my investor clients, the most frequent question I get is, “Should I buy, sell, or hold?” My answer is, “It depends.”
Privately owned commercial real estate has historically offered a strong hedge against inflation. The owners of properties with short-term leases such as apartments, self-storage and manufactured home communities can quickly raise rents to match inflation, as measured by the Consumer Price Index. That’s a significant advantage as the CPI topped 8% in March and April, the highest rate since 1981.
While inflation is the friend of many landlords, recession is not. During a recent trip to Los Angeles, I stopped by the office of an 84-year-old manufactured home community owner I know with an extensive national portfolio. I learned the owner — one of the savviest investors I know — plans to sell his entire portfolio for an estimated $400 million.
During lunch, I sensed he believed the commercial real estate market may have reached a cyclical peak, and the threat of recession was growing. A recession has followed every sharp increase in inflation over the past 75 years, and the current gravity-defying trend shows no sign of fading. Wholesale price inflation — what manufacturers pay for raw materials — is now at 11%, and those costs will be passed on to the consumer, driving the CPI yet higher.
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Also, considering that sudden spikes in energy costs preceded six of the last seven recessions, another recession seems inevitable. My friend is selling at the cyclical peak of market values while he can fully control the allocation of proceeds — tax-free — to create a more diversified and less management-intensive real estate portfolio. My advice (not that he needed it) was, “You’ve made a wise decision.”
The decision was, for him, a good one because what is bad for the economy is most often bad for commercial real estate. Investment real estate performance and GDP rise and fall together. A weak economy means a decline in business and consumer spending, limiting the ability of landlords to raise rents. Investors with a Dollar General or Walgreens, with rents fixed for 10-15 years, will be losing money every year. So will big-box shopping center and medical office building owners with long-term leases not indexed to CPI.
The Fed’s more aggressive monetary policy will create higher long-term interest rates, provoking a recession and stricter commercial lending requirements. Higher rates and loan equity requirements result in lower returns, causing investors to retreat and property values to decline. For most clients with such assets who are alarmed by a disintegrating economy and contemplating a sale, my advice is to hold.
The cycle of decline and recovery often occurs over a decade or more. Property owners under 50 can afford to wait for the next upcycle if the market sees a significant correction. My advice to those younger investors contemplating new investments is to buy while interest rates are still lower than they may ever be again in our lives. Commercial real estate always trends up over decades and for 25 years, has outperformed the S&P 500 Index, with average annualized returns of 10.3% and 9.6%, respectively. And, unlike stocks, bonds and cryptocurrency, real estate has never been worth zero.
But what about the boomers? If you’re a doctor over 60 wanting to cash out the equity in your medical office building to facilitate a more comfortable retirement, now may be the time to sell and lease back. Owners with management-intensive assets like single-family rentals, manufactured home communities and small apartment buildings may want to relax, travel, and otherwise enjoy the result of decades of hard work. They can use IRS Code Section 1031 to trade into management-free “absolute net,” single-tenant retail, enjoying historically low interest rates, avoiding capital gains and pocketing tax-free cash.
Being sensitive to economic cycles when buying, selling or hanging on is essential for success in commercial real estate.
Chris Zarpas is a commercial real estate broker at S.L. Nusbaum Realty Co. For more information, visit chriszarpas.com.