Inflation is Risk Number One for Private CRE Investors
Inflation tops the list as the biggest economic risk for private real estate investing in 2022, says Origin Investments. Noting that inflation grew at the fastest pace since 1982 over the 12 months that ended November 2021, the Chicago-based fund manager says sustained growth in this metric will affect everything from value-add and ground-up construction to capital expenditures and cap rates.
While supply chain costs could extend volatility pricing well into 2022, higher wages will have a prolonged impact that the Federal Reserve may miss its opportunity to curb. “It goes back to labor and the supply chain,” says co-CEO David Scherer. “The only way to incent labor is higher wages, which is good for workers but also inflationary. Yet higher wages are one-directional; inflation and the volatility pricing it breeds will be more enduring.”
Although inflation may represent the biggest risk for private real investment this year, it’s not the only one. Origin expects the Federal Reserve to begin increasing the federal funds rate in May or July of this year, much earlier than previous expectations held.
Third in Origin’s roster of economic predictions for 2022 is the continuing impact of COVID-19 on real estate, “as it changes where we live and how we work.” Origin doesn’t see the workplace changes as transitory: “a hybrid environment may be the only route to attracting the most in-demand candidates.”
The current year will bring a lower level of appreciation. “Valuations are at the high end of their expected range,” Origin says. “It’s a time to be cautious, use low levels of leverage and buy only assets with potential for good cash flow.”
Meanwhile, says Origin, continued virtual and hybrid work will accelerate the migration from gateway cities to warmer Southern states with lower housing costs and lower taxes. “Affordability eventually will moderate these price distortions, but that moderation is years away,” Scherer says.
Also unlikely to change this year are incentives around investment in Qualified Opportunity Zones. The U.S. Treasury and Internal Revenue Service may exercise their rulemaking authority, but no QOZ rules will change in 2022. Democrats like the fact that the program creates investment in developing communities, while Republicans will defend its tax reductions, explains Scherer.
Origin expects multifamily to see modest valuation appreciation and strong rent growth in 2022, with suburban assets outpacing urban. “Higher interest rates will put upward pressure on borrowing rates and cap rates, and if cap rates go higher, it will reduce the multiple on earnings,” says Origin.
Regionally, multifamily rents in the Northeast and Midwest will underperform the Southeast, Southwest and Texas. By asset class, Origin says, “urban Class A buildings remain strong but still will underperform urban Class B and suburban properties due to the latter’s affordability.”
The investment thesis favoring value-add is giving way to ground-up construction. “There still will be value-add opportunities,” says Scherer. “But because acquisitions now are priced at or above replacement cost, value-add renovations must have real competitive advantages to warrant private equity investment.”
Accordingly, the pace of ground-up development will pick up this year. Scherer says that’s because development fundamentals are favorable for both equity and debt financing, and there’s so much capital to put into these investments. “For now,” he adds, “ground-up development can fetch 10% to 30% above replacement cost while value-add is trading at or just above replacement cost.”
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