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Tariffs on CRE

Impact of Tariffs on CRE

As you may already be aware, the Trump administration has implemented punitive tariffs on goods from Mexico, Canada, and China, sparking significant turmoil in the market as investors try to assess the potential future impact. Fear has entered the marketplace, and fear often leads to market disruptions and market selloffs. In response to the shifting policy, the stock market lost over $5 trillion in just 3 weeks, eroding 10% off its new record high. Tariffs with these major trading partners affect our trade volume, inflation, economic growth, and ultimately, bond yields as investors demand a premium over inflation to earn a real return. Since government spending is an input of GDP, inflation and growth are closely connected. The introduction of new, potentially temporary tariff policies will send ripple effects through the market, resulting in ongoing volatility and a pessimistic outlook. Consequently, investors are becoming more cautious, suppressing trade activity. While it's clear that the stock market needed a correction—given that many stocks were trading at unsustainable highs—the question remains: How will commercial real estate (CRE) be impacted?

Let’s break this down. As mentioned, investors demand a premium over inflation, with spreads reflecting acceptable rates of return for specific risk positions, be it equity or debt. Commercial real estate is priced by considering the weighted average cost of debt and the weighted average cost of equity, based on the proportion of equity and debt in the deal. To illustrate this, let’s take the example of $1. A portion of each dollar of net operating income from an asset goes toward paying debt holders first, followed by equity holders. If the total debt and equity annual obligations exceed the net income on an annual basis, someone isn’t receiving what they’re owed, simply because there is not enough income to pay the various capital partners who funded the deal. Lenders set their rates by adding spreads to benchmark rates, such as treasury yields, which are directly tied to inflation expectations. As inflation expectations rise, interest rates also rise, driving up the cost of debt for CRE, while reducing the leverage available to deals. As more net operating income is allocated to cover higher debt costs, the remaining returns for equity holders become smaller. And as more equity is needed to cover the capital stack, returns fall even further. Ultimately, investors may be forced to lower pricing to meet their expected return requirements on their equity.

Tariffs have a direct impact on inflation by affecting transaction prices, volumes, revenue, and overall economic productivity. Essentially, tariffs are taxes on imported goods that we produce domestically. While they may serve various purposes, they are mainly used to generate revenue, protect local industries, and influence foreign trade and policy behavior. When used effectively, tariffs can boost revenue, but if applied poorly for too long, they can dampen demand and harm domestic economies by reducing welfare. The most significant negative consequence of tariffs is the high likelihood that they will backfire on U.S. consumers. Since manufacturers rely on importing raw materials to produce local goods, when these imported goods become more expensive due to tariffs, producers will pass on these cost increases to consumers, leading to higher domestic prices.

Without an idea as to when tariffs will end, and if they will change, it is hard to quantify the impact on CRE directly. But, in the short-term we can assume that it will spike inflation, volatility, and negatively impact market sentiment. Interim stagflation, or inflation in lieu of sufficient growth, could be on the horizon as well. Worries of a recession will cause longer term yields to drop, and if so, the cost of debt could decrease, which would help alleviate structural capital stack issues in the market. However, too large of a recession will stifle demand, and growth, which is a big risk as it could challenge absorption and net operating income.

Without knowing when tariffs will end or whether they will change, it’s difficult to directly quantify their impact on commercial real estate (CRE). However, we can reasonably expect them to drive up inflation, increase volatility, and negatively affect market sentiment. Concerns about a recession could lead to a drop in long-term yields, which, if it occurs, may reduce the cost of debt and help ease some of the structural issues in the capital stack. That said, a deep recession could dampen demand and slow growth, posing a significant risk by potentially hindering absorption rates and net operating income.

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Why Residential?

By Christian O'Neal • February 13, 2025

The fundamental need for housing is universal—everyone requires a roof over their head. In the United States, however, we are facing a significant shortage of housing. According to the National Multifamily Housing Council, an additional 4.3 million units will be needed by 2035 to meet growing demand. Much of this demand is driven by migration to expanding lower cost cities and away from high tax, high cost metros, a trend accelerated by the widespread adoption of remote work during the pandemic. This trend has reshaped the housing landscape, creating a compelling opportunity for investors. While there are numerous investment strategies available, each with its own set of risks, residential real estate stands out. Over the past three decades, multifamily rentals have consistently delivered the highest risk-adjusted returns in commercial real estate. Why? Because housing is an essential need, regardless of economic conditions. At AEG, we are strategically developing both for-sale and rental housing, allowing us to adapt our approach to changing market dynamics and maximize returns while mitigating risk. Here’s why we are confident in the strength of residential housing as an investment: Land is Finite: Unlike many other asset classes, land cannot be created or expanded. The supply is fixed, and the demand for housing continues to grow. In the foreseeable future, virtual spaces like the metaverse will not replace the fundamental human need for physical shelter. Residential Housing is Non-Discretionary, and It's Supported by Government Liquidity: Housing is the only non-discretionary asset class. If it weren’t, we would see similar government support for other sectors like retail, office, or industrial real estate, but we don't. The federal government provides liquidity to the multifamily housing market because it is a fundamental need. This support drives down the weighted average cost of capital (WACC), making housing assets attractive to investors. This consistent access to capital compresses cap rates, creating a floor on the market (to an extent), fueling long-term growth and demand from investors big and small. Rents Tract with Inflation, and It is Rare to See Negative National Rent Growth: Rents reset every year as cost increases are passed off to tenants via annual lease contract resets. Since the beginning of recorded history, national rents have only gone negative year over year three times: the Spanish flu of 1918, the Great Financial Crisis, and during the Covid-19 pandemic. While yearly gains in rental cashflow streams will not make you wealthy, they are without a doubt very stable cashflows, historically speaking. There is no similar liquidity for for-sale housing, but its non-discretionary nature still gives it a strong investment profile. In growth markets like South Carolina's tertiary cities, the influx of new residents is fueling demand across all price points, further strengthening the residential sector. We believe in our residential investment thesis for both macro and local fundamental reasons. If interest rates remain high, new construction will slow even further. Meanwhile, homes in desirable locations will remain in high demand as many homeowners—especially those with low-rate mortgages—are unlikely to sell. According to the latest third-quarter data from the FHFA, 73.3% of U.S. mortgage borrowers now have an interest rate below 5.0%, a decline of 12.2 percentage points since Q1 2022. This significant shift in mortgage rates creates a unique dynamic: many homeowners are effectively "locked in" to their current homes, preventing them from moving and creating a looser supply in the for-sale market. As a result, home prices are expected to remain elevated in high-demand areas. While values may remain relatively flat in real terms over the next few years, on a nominal basis, they are expected to rise, particularly in growing markets. If interest rates decrease or economic growth drives up rental demand, build-for-rent communities could become more viable. However, they are not yet penciling out as attractive investments because growth has stalled - but, that is about to reverse. Thanks to our strategy and access to land—often without burdening our balance sheet or stretching our resources—we are able to remain nimble and pivot towards the most attractive risk-adjusted yields. As we navigate an uncertain economic environment, several factors support the ongoing strength of the residential housing market: slow housing starts, higher interest rates, and a large percentage of homeowners sitting on mortgages with sub-4% rates. These dynamics, along with strong demand in high-growth areas, reinforce our belief that residential real estate will remain a compelling investment in the years to come. At AEG, our focus is on developing attainable, high-quality housing, from custom spec homes, to mini-farm tracts, to higher density townhome projects. This flexibility allows us to serve a wide range of income levels and tailor our strategy to market conditions. With a commitment to quality finishes and high end products, we appeal to buyers regardless of economic conditions, providing us with a tighter, more predictable cash conversion and days on market cycle, unlike some of our competitors. By seeking out individually parceled deals, we reduce overall risk and remain agile in our decision-making.

CRE Price Discovery

By Christian O'Neal • February 3, 2025

Valuations & Investment Psychology

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