Q2
2023
the look ahead
Several indicators were more robust than expected in Q2. New home sales, builder confidence, and earnings data were all higher than anticipated. In addition, the unemployment rate fell. Each of these points to more growth and upward price pressure. In contrast, we also saw consumer spending ease slightly, some early signs of labor market cooling with fewer jobs added, and fewer job openings. These factors contributed to the inflation reduction we saw reflected in June’s Consumer Price Index measurement, but they are still relatively elevated and will need to ease further. Recession fears still linger as strength on the retail side, particularly services, is contrasted with weakness in other sectors such as manufacturing. Rates will continue to remain elevated as the Fed waits for more data to decide the terminal rate for this hiking cycle.
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We examine the material prices of lumber, steel, and concrete in this issue’s Current Events.
In this Spotlight, Michael Walden and Chris Hermreck of JE Dunn Capital Partners (JEDCP), discuss commercial development trends they are seeing in several markets. JEDCP is the real estate investment arm of JE Dunn Construction and to date, they have sourced over $1 billion of equity and debt in construction projects through developer partnerships and a strong lending network. They will also share their strategies to navigate the latest challenges of real estate lending.
As the supply chain has stabilized, material prices have not receded as you would hope. Why? In our regular calls with trade partners and material suppliers, it comes down to fear. Fear of committing to a price and then experiencing large swings or volatility in pricing. The outlook is improving as 75% of our trades report steady pricing last quarter. In this section we will dig into what we are seeing in the market for lumber, steel, and concrete and the subsequent effect on pricing.
The Producer Price Index for softwood lumber resembles a roller coaster since the beginning of the pandemic.
Unlike lumber, steel has stayed closer to its mid-pandemic peak, and though it did trend downward for eight consecutive months, it has since rebounded again.
Ready-mix concrete (RMC), along with steel, copper, and lumber, is one of the “big four” components of our Quarterly Cost Index, accounting for roughly 7% of the materials featured in the index. Prices for RMC are roughly 28% higher today than pre-pandemic levels so this one element can have an outsized impact on the total bill for construction.
Click for Market-Specific Data
Cap rate is short for capitalization rate. It’s used to evaluate risk, determine what kind of return on investment a property can provide, and provide insight into the type of market that you’re dealing with.
You can calculate the cap rate by dividing whatever net income an asset generates by the value of the asset. For example, an apartment building that brings in $600,000 in rent per year and has $200,000 worth of expenses per year has a cap rate of 8%. You would first subtract expenses from the $600,000 of gross income to get $400,000 in net income. You would then divide net income by the value of the asset, which is the current market price ($5M) in this case, to get a cap rate of 8%.
You can use cap rates to estimate your return on investment for a property. In our example, if we bought the apartment building for $5M, we could expect a return of 8% per year on that investment since the net income it generates is 8% of the purchase price. Another way to think about this is that it tells you how long it would take for you to recover what you paid. With an 8% rate, it would take 12.5 years to recoup your investment.
This of course is an extremely subjective question that would depend on the investor’s goals. The rule of thumb is that lower cap rates mean lower risk and higher prices while higher cap rates mean higher risk and lower prices. Depending on the asset, a cap rate of 5% or below would be considered low risk and 7% or above would be considered high risk. If an investor is looking for a deal on a piece of property, they would likely try to find it in the high cap rate ranges but if they wanted a safer investment, a low cap rate would be more appropriate. Most often we are working with clients/owners who are developers who will want to sell a completed project for a low cap rate.
The cap rate can reveal risk built into the market value (or sales price in our scenario). The market value for our apartment building was a little high at 8% when the price was $5M. What if the price were $10M? Then our cap rate goes down to 4%, something we would label as less risky. The price is higher in the second example and that’s where the risk is hidden. It could be because the apartment building is in a different area; maybe in the first scenario (priced at $5M) the area has a high crime rate, is in an out-of-the-way location, or the building is run-down. Whatever it is, something is driving the price down compared to the second scenario (priced at $10M) and that something can be thought of as the theoretical risk that isn’t always explicitly disclosed. Cap rates give you the ability to compare that non-numeric attribute quickly and easily.
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