Ron Dickerman was among the early callers of secular repricing of real estate markets after geopolitical and macroeconomic turmoil this year led to rapid inflation. With central banks and governments around the world using monetary and fiscal tools in response, Madison International Realty‘s founder told PERE in September how markets were in the middle innings of a proverbial baseball game that would conclude with rebased real estate values.
With the situation continuing to change fast, we caught up again with Dickerman. He still thinks the next transactable period is “several calendar quarters” away. But he says now is a good time to prepare for when the time comes. Madison has up to $4 billion, including debt, in available capital. The trick will be recognizing when to deploy it smartly.
How has the market predicament changed since we spoke in September?
We’ve moved further into the baseball game. The prior thesis is absolutely bearing out and has the virtue of being true. We are seeing cap rate capitulation; we are seeing seller psychology begin to crack and change. One of the things that always happens in commercial real estate is people wait for a great buying frenzy. What happens is it doesn’t materialize so quickly and so obviously. Any well-capitalized owner of property that is performing and well leased is not going to capitulate into this market.
Anyone with variable rate debt or development or undercapitalization is likely to be impacted significantly. We’ve already seen cap rate expansion by 50-100bps at the leading edge from where deals were getting done. It’s a simple metric: if you think of real estate benefiting from positive leverage – in other words, cap rates higher than borrowing costs – you can buy at 5 percent and borrow at 3 percent; you lever your balance sheet and you magnify the current yield and the overall rate of return.
But in the current market, borrowing rates have doubled, if not are 2.5 times more, and cap rates have been slow to adjust. There is almost no asset class that exists right now where you can buy at a higher cap rate than the cost to borrow. That relationship just cannot be maintained.
So what gives first?
If inflation is sticky and the world’s central banks are still responding, the only thing that can happen now is that cap rates rise and values fall. That’s the thesis of secular repricing and that’s definitively happening right now. In terms of where we are, the US fed is leading the way. They’ve been extremely bold. These 0.75 percent increases in the Fed’s fund rate are unprecedented. The Fed is still going to raise, but they’re going to take their foot off the gas pedal and raise in lower increments through the springtime. In Europe, the Bank of England is playing from behind. Europe is also behind, based on embedded inflation, but those central banks aren’t acting so aggressively. You see this phenomenon in the strength of the US dollar.
Madison recently transacted on a European data center platform called Eco DC in a deal valued at $400 million. Did you renegotiate to get the deal done?
The public markets have seen multiples on some of the data center companies come down a bit. We definitely had that in mind when we made the investment. But we think it’s a unique deal. A fund was reaching the end of its life. Some investors wanted to exit, some wanted to remain. We acted as a cornerstone investor to manage and assist to effectuate a recapitalization into what we think is a dynamic business plan.
Given we came into the transaction early and as the lead, there wasn’t a renegotiation. But there was a negotiation. Negotiations take months and months these days. Transactions are going slowly. As a general rule, those deals that need to transact are the ones that we see transacting. It’s really the investors that need capital that are actually transacting.
How accommodating are the credit markets to these deals that need to transact?
We are reliant on moderate financing. Our leverage ratio across our portfolio is less than 50 percent, so not dramatic. The vast majority of our borrowings are also either fixed-rate or floating with a cap. We have been quite conservative. But there are refinancing assumptions sometime in the next one to three years which will be exposed to the current financing environment, so we are not immune for sure. But we’re very lucky we’re not in the transitional loan business, we’re not in the development business, we’re not in the value-add business: most of those strategies require variable rate debt for refinancings.
Rate caps are becoming increasingly important in the credit affordability equation. How do you see this area playing out?
It is one of the biggest things going on in financing right now. In a rising rate environment, everyone wants to lock in financing caps. But the fact of the matter is it is very challenging and very expensive. Most investors are loathed to borrow at variable rates. They want to lock in caps, but cap pricing is making that choice uneconomic. Cap prices have doubled, even tripled, over the last six months based on monetary policy.
How would you characterize the immediate future for your business and the wider private real estate market?
Our view is this is going to take several calendar quarters to run its course. The secular repricing probably isn’t going to conclude until next spring or summer. Then the buying opportunity becomes clear. Meanwhile, we’re seeing things, making offers, chipping away at the edges and are trying to position ourselves with partners and transactions which we think are poised well for the future.