Dry powder is at an all-time high in the US private real estate market, and IRR hurdles are partly to blame, according to Aaron Jodka, director of national capital markets research at Toronto-based commercial real estate services firm Colliers.
“One of the reasons we’ve heard that there’s a record amount of capital in the sidelines is that [investors] can’t hit their return thresholds,” he notes. Instead of all of the capital being deployed, as it would in an efficient market, “those return thresholds are a hindrance. And a lot of it comes down again to those well-occupied properties that are perfectly functional. If I don’t have to sell today, I’m generally opting not to.”
Along with cap rate and price per unit, IRR is considered one of three major factors in a real estate investment, according to Jodka. “Right now, the market is finding challenges with several of those points depending on where you are,” he says. For example, a buyer looking at a newly built multifamily asset may like the price per unit since the property is priced at a discount to replacement costs, but the lease-up in the market may not be as strong today as it was 18-24 months ago, so cap rates have come down, he explains.
Jodka does not have specific examples of managers adjusting their return hurdles, but says: “I do think 2024 will be where we’ll continue to see that bid-ask spread narrow, and those IRRs will start to be more achievable, as some sellers are forced to the table. A lot of it will probably come down to the pricing situation on some of these stressed assets and challenged assets.”
Although large-scale distress has not emerged to date despite a high volume of expected loan maturities this year, “what makes 2024 different is we’ve had that additional year of a higher for longer mindset” regarding interest rates, Jodka notes. “There’s been a continued adjustment for market expectations and those extensions that were happening upfront, kicking the can [down the road] a year, what happens when that one-year extension is due in June? Is your property in better shape, or is it not? In some cases, it is, and we’ll find a way to refinance. In other cases, it isn’t any better; it potentially is worse.”
Continued loan extensions on troubled properties do not make sense, he adds. With more comps coming in on transactions, lenders can now better predict where the market is going. “They also don’t want to sit on lousy loans, so they’re looking to move those and get those off their books and start to look at potentially expanding their lending portfolio elsewhere, or just reining it in entirely,” he remarks.
Jodka therefore expects to see more transactions next year, particularly in the office sector, because borrowers will be forced to transact. “However it will be worked out with the lenders, those transactions will move,” he says. “I’m not saying they’re billion-dollar transactions. The momentum will certainly pick up with lots of smaller transactions at lower dollar figures, which starts to really make that basis play extremely attractive. Now the IRR hurdles are achievable.”
Jodka sees various ways in which potential buyers will be able to meet return thresholds going forward. One is declining cap rates in various markets and sectors. “If I’ve been buying, say, those 4 [percent] caps that we saw so prevalently over the last few years, and now, all of a sudden, I can get an 8 cap, my return starts to look better,” he says. “In some cases, those lower targeted funds have opportunities to outperform.”
In other scenarios, “you can get into development and see really strong returns when that wasn’t part of your original fund threshold,” Jodka notes. “So generally, it’s finding new opportunities that weren’t originally part of your mandate that will help you to get those returns.”
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