Monday, June 17, 2024

The Breakfast Blogs #1: Hessam Nadji

In the wake of two years of high interest rates, the U.S. commercial real estate market is still in the midst of price discovery, characterized by a huge bid-ask spread and little immediate pressure on sellers. That’s about to change dramatically, as a wave of CRE debt valued at about $2 trillion is set to mature over the next 2-3 years.

Marcus & Millichap CEO, Hessam Nadji, and I recently discussed the implications of this trend, particularly for Southern California, when we caught up recently over breakfast.

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Cracks in the CRE market are starting to emerge

In the SoCal region, one in five apartment loans will mature over the next two to three years, amounting to $15 billion of loans in LA and Orange Counties alone. This figure increases when considering the broader seven-county area where we invest.

This looming deadline will present a substantial challenge for existing property owners, many of whom are small-scale operators due to the preponderance of smaller asset sizes in the SoCal market. Many will face considerable difficulties refinancing their loans since the operating cash flow generated by their properties will no longer support the same loan amounts at today’s higher interest rates.

Many small-scale operators will be forced to sell

Facing this impending wave of debt maturities, owners will be left with two primary options: inject additional capital to secure refinancing at today's higher interest rates or sell their properties. Hessam and I share the sentiment that many small-scale “mom-and-pop” operators in Southern California may have no choice but to sell, lacking the necessary funds for refinancing. We discussed the potential for Marcus & Millichap’s transaction volume to double this year as a result of these market pressures.

Attractive buying conditions will emerge

A silver lining in this situation is the reduced number of buyers in the market today. A few years ago, low cost high-leverage debt financing was readily available to virtually any sponsor, with up to 70-80% LTC bridge financing plentiful at interest rates in the 4-5% range. Today, 70% bridge financing is priced 300-400 bp higher or more, which has greatly reduced the number of value-added buyers in the market. However, a wide range of high-net-worth exchange buyers still remain active, albeit at a much smaller volume than before (e.g., apartment transaction volume in LA County was down well over 60% in 2023 compared to the prior year, according to M&M).

This scenario benefits institutional managers like Paladin, as our reputation and 30-year history position us as one of the stronger buyers in the market. We're already beginning to see a meaningful uptick in deal flow with much more favorable pricing, including higher cap rates, compared to 2021 and 2022. Depending on net operating income (NOI) trends, this could mean a 10% to 30% discount on asset valuations.

Meanwhile, the fundamentals for Class B and C apartments in Southern California remain robust. This “workforce housing” provides an essential need: the only affordable housing option near employment centers for the region’s large permanent renter class.  Occupancy rates are still in the 97-98% range, with minimal new supply coming online. Decades of strong supply-demand fundamentals support the resiliency of these assets, and we expect this trend to continue.

We are optimistic about the second half of the year, anticipating that we will resume buying after more than a year-long pause in activity.

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