Stay Alive ‘til ’25 (?)

One of the common mantras we heard early on during the Fed’s interest rate hiking cycle was “stay alive ‘til ‘25”.

With 2025 only a few weeks away (crazy, right?), this came up again in a recent conversation, with someone at the table saying they didn’t understand that mantra. Their perspective was that interest rates were still high, rental rate increases were yet to return and construction prices have not come down at all. So, how could we be better off next year than today?

Another common comment we heard during the Fed’s hiking cycle was from someone who owned a home or was ‘in the business’ in the 80’s saying something along the lines of “I don’t understand what all the fuss is about, I bought my first home with an 18% interest rate and I was fine” or “we still did deals when interest rates were ‘X’, these are still cheap”.

Point taken, but it was not the nominal interest rate that caused stress. It was the speed and overall increase of rates. The Effective Federal Funds Rate had been near zero since April of 2020 and started rising in March of 2022. Between then and August of 2023 (~18 months), the rate jumped to 5.33%. Groups who had floating rate debt that were unable to refinance into fixed found themselves in a major crunch.

Why did the Fed have to raise so aggressively? Inflation. All roads lead back to inflation. This makes sense when we consider why we invest in the first place. Inflation eats the buying power of the dollar, therefore to maintain our buying power, we need to invest in things that outpace inflation (at a minimum).

What is the safest way to outperform inflation? Treasury Bonds. Treasury Bonds typically float somewhere around 150 – 200 bps above inflation and are fully guaranteed by the United States government. To entice people to invest in things riskier than treasury bonds, there needs to be an opportunity for higher returns.

We know what you’re thinking - great guys, but what does any of this have to do with real estate? Good question. One of those things riskier than treasury bonds is real estate. In investment real estate, the property’s cap rate is comparable to the yield on a bond – what kind of return can I get on my money after all operating expenses are paid?

Cap rates vary based on product type, the quality of the product and where it’s located, but they typically float above the 10-year treasury yield due to the added risk that comes with investing in real estate. When inflation is less than 1% and 10-year treasury bonds are yielding less than 1%, people go in search of other ways to generate returns.

Why? The Fed has a stated goal of 2% for the long-term rate of inflation, so investing in anything that yields less than that will lose value in the long run. Investing at par with inflation when the rate is below the long-term average/goal isn’t likely to have a desirable outcome. By purchasing a bond, you may earn a return at or above inflation, but the bond’s principal value is still diminished by inflation over the term of the bond.

What does all of this have to do with 2025? Optimism in the development market peaked early in 2022. Most developers are merchant builders – meaning they buy a piece of land, build their project and sell it when it’s stabilized. There are variations of that strategy, but that’s the general gist of a merchant build.

The developer runs their calculations, takes an educated guess on what they can sell it for when completed (based on expected cap rate, which is projected NOI/projected sale price), builds in a spread for the additional risk inherent in development (called yield on cost, which is projected NOI/projected cost to build), back out their costs and gets to a residual land value.

Example:

$1,000,000 projected NOI / 4% expected cap rate = $25,000,000 projected sales value

Now let’s look at the yield on cost:

$1,000,000 projected NOI / 5% yield on cost = $20,000,000 necessary build cost

Which gives the developer:

$25,000,000 sales value - $20,000,000 build cost = $5,000,000 projected profit

Looks like a great project. But what happens when the yield on the 10-year (and therefore cap rates) runs higher and higher. If those 4% projected cap rates jump to 5.5%, now the developer is looking at:

$1,000,000 projected NOI / 5.5% expected cap rate - $18,181,818 projected sales value

In that scenario, the day the developer breaks ground, their project is $1.8M+ in the red. So oftentimes those projects get mothballed until the development environment is better or sold to someone else. We’ve written more in-depth about that process here.

So, let’s tie this all together. Most of the projects we had in escrow in 2022 held on through that summer but ended up dropping or being heavily renegotiated between the fall of 2022 and spring of 2023. Some renegotiated, then ended up dropping out of escrow anyway. We don’t have the fondest memories of those times.

Until the Fall of 2023, nobody was certain how high the Fed raises would go. Uncertainty is a killer for development. Eventually the raises stopped, inflation started coming down and groups felt they had a solid footing from which to jump, even if it wasn’t as friendly an environment as 18 months prior.

With a clearer picture of where the financial markets stand and adjustments to land values, more developers got back in the game in early 2024. Given land’s notoriously long escrows, those transactions are likely to close in 2025.

That timeframe coincides with a period when we should start to see new product deliveries slow down and by the time those projects are delivered, likely in 2026-27, they should be successful. Even with higher interest rates and less favorable market dynamics, having more clarity/stability provides an environment where development can thrive.

And next year, we’ll be listening to all the 18%ers from the 80s say, “I told you so…”

Thanks for reading and as always, please reach out with questions or comments, we love to hear from you all!

Stay alive ‘til ’25 (almost there) 😀,