Yellen Approves, But for the Real Estate Industry It’s Far More Complicated
While hardly anyone in commercial real estate is hitting the panic button, it seems the cost of doing business will only go up from here.
The Federal Reserve announced on Dec. 16 that its Federal Open Market Committee will raise short-term interest rates by 25 basis points from near zero—marking the first benchmark interest rate bump in almost a decade. Looking ahead, Fed officials expect short-term rates to increase by roughly one percentage point a year for the next three years.
Fed Chairwoman Janet Yellen said the central bank’s decision came as a result of steady job growth and an overall robust U.S. economy. But what does the increase mean for the red-hot real estate industry?
That largely depends on who is being asked and where that person most heavily invests. While some borrowers, lenders and debt brokers told Commercial Observer that the Fed move is a net positive, others said the long-term effects of rising rates could start to put new pressures on construction and acquisition deals and commercial mortgage-backed securities.
Other market players dismissed the minor rate hike as a non-issue, while the responses from rating agency and trade group members were mixed, with some giving a thumbs-up and others giving a thumbs-down.
All in all, a 0.25 percent increase in short-term interest rates is small change for seasoned borrowers, several industry insiders told CO. Still, those who may see the biggest impacts are less established sponsors and major corporate real estate investment trusts, which often buy, sell and refinance real estate in bulk at a rapid pace.
“In any deal that we’ve looked at over the last five years, we always modeled in, somewhere along the line, an increase in short-term rates,” said Rudin Management Company’s chief executive officer and vice chairman William Rudin. “And a quarter or a half shouldn’t really impact a well-underwritten, well thought-out deal. This is a signaling for people to make sure that they are using reasonable assumptions.”
While most established borrowers take potential economic shifts into consideration when sizing up various loan offers, many of the real estate players CO spoke to say they also tend to finance their properties on a long-term basis. As it stands, the short-term rate hike will have a bigger impact on those who borrow for immediate gains.
“Short-term rates have affected corporate borrowers, and the REIT space a little bit—those that borrow more on a shorter term basis,” said Rick Lyon, head of commercial real estate at Capital One. “But most real estate tends to go more towards fixed-rate, longer-term loans.”
George Doerre, a team leader in M&T Bank’s New York commercial real estate group, said that both the lenders and borrowers would be watching movement in longer-term interest rates. For the time being, borrowers seeking construction and bridge loans will feel the brunt of the rate hike.
“The impact on borrowers for now is relatively small, although we know clients are looking across their portfolios of floating-rate debt,” Mr. Doerre said. “If we start to see long-term rates spike, that’s where it could get a little bit interesting in terms of refinancing debt. The other thing to look at would be folks who have construction or bridge loans [that are nearing maturity]—their ability to borrow is going to be reduced.”
While the recent rate hike mostly affects the inter-borrowing between the Federal Reserve and big commercial banks, “such monetary policy changes have unintended consequences,” said Dan Gorczycki, a senior director in the capital markets group at Avison Young and a Commercial Observer columnist. “For smaller borrowers, if you buy something on a low capitalization rate, you will lose some positive leverage, which is something to look out for in 2016,” Mr. Gorczycki said.
Higher leverage loans pose additional risk to borrowers since those deals have tighter margins when it comes to meeting debt payments, according to market players. The strength of the economy is the only factor borrowers can rely on to balance out a rate increase on those loans.
“Higher leverage loans don’t have as much of runway to work with in terms of rate increases,” Mr. Rudin said. “It depends. If rates go up and rents go up, then you’re okay. If rates go up and rents stay flat or go down, people will have a problem.”
Steven Kohn, president of equity, debt and structured finance at Cushman & Wakefield, said that because the rate increase was expected, the short-term effect would cause little reverberation.
“A quarter-point is not going to make or break a deal,” he said. “The Fed’s original plan with quantitative easing originally called for a quarter-rate raise per quarter, so if the plan is followed through with, that long-term rate hike could have more of an effect on the market. Certainly a 3 point increase over the next three years is meaningful and could increase borrowing costs.”
At the end of the day, lenders may have it the best. While a 0.25 percent interest rate increase is not enough to deter borrowers from buying and refinancing, it is enough to give a small boost to debt yields. In the near future, lenders should at least see some upside on floating-rate loans, Mr. Doerre at M&T noted.
“As a bank in the short run, the rise in rates is mildly helpful,” he said. “There’s a little more earnings on our floating rates as they re-price faster than deposits. In the long run I don’t think we’re going to be lending any different in the next six months than we have been in the last six months. It’s from the discipline of always keeping an eye on debt yields.”
Beyond those slight returns, the fact that rates have remained so low for nearly a decade, the next Fed hike seems imminent. Many economists expect another increase by March 2016, according to recent reports.
“We’ve had low interest rates since the recession,” said Mr. Lyon at Capital One. “It’s one of the Fed’s tools to help moderate the recession—they uncoiled the interest rate spring and lowered rates, which helped steady the market and the economy. Until interest rates rise, the Fed has nothing to uncoil in the next recession.
“We’ve seen net operating income growth with low rates, which has benefited cap rates,” Mr. Lyon added. “Those are the things you have to balance. Any kind of fast and steep upward movement would be disruptive.”
Other lenders expressed that they have been preparing for the interest rate hike—whether big or small—by accounting for changing debt yields in their underwriting. Jeffery Hayward, Fannie Mae’s head of multifamily, said that when underwriting a mortgage, the agency is “agnostic to the interest rate climate.”
“When we underwrite a mortgage, we underwrite assuming that interest rates will go up over time so that we know when the loan exits ten years later, there is a high probability that the borrower can refinance,” he added. “Even if a mortgage has an interest-only period, we underwrite it like it’s amortizing.”
At the same time, if rates continue to climb in the near future, demand from borrowers could gradually decline and the higher price of loans would paint a less rosy picture for lenders. Those changes could offset a bank’s increased borrowing cost because it will affect the lender’s “shelf line” or cost of money, according to Mr. Gorczycki.
“That’s how most debt funds leverage their returns,” he said. “Banks can lend cheaper because they were effectively borrowing at zero, but that’s going up too.”
Nonetheless, industry insiders agree that changes to long-term rates will move the needle the most and that the Fed has its own role in the game, which lenders and borrowers should be mindful of.
“Looking ahead, the economic growth the Fed is tracking is likely to be more of a driver for commercial real estate markets than the decision on short-term rates,” said Jamie Woodwell, an economist and the vice president of commercial and multifamily research at the Mortgage Bankers Association.
“MBA’s forecast anticipates a slow rise in longer-term interest rates, which could put upward pressure on cap rates and borrowing costs,” he said. “From a mortgage perspective, as we move forward, it will be important to monitor the Fed’s plans with respect to their balance sheet investment in Treasuries and mortgage-backed securities, and how those decisions affect longer-term rates.”
Commercial Mortgage-Backed Securities
The CMBS industry will likely see the biggest downsides, several of the industry observers pointed out. The securitized commercial real estate debt market is already failing to meet issuance expectations, even with the built-in refinancing demand from maturities, and new deals have been pricing increasingly wider.
“Now that the Fed has increased short-term interest rates, we expect the long-term rates used to set loan coupons and capitalization rates for valuing commercial properties to start increasing as well,” said Tad Philipp, senior vice president of the Structured Finance Group at Moody’s Investors Service.
“This could lead to increased default risk for loans supporting future commercial mortgage-backed securities relative to recent loans with debt service coverage sized to lower rates,” he added. “Also, default risk will increase for seasoned deals because rising cap rates will ultimately make it harder for borrowers to qualify for refinancing.”
That could mean more risk for more borrowers, especially with the maturity wave. In 2006, more than $201 billion in new CMBS loans were issued, followed by more than $229 billion in 2007. While a large number of borrowers defeased or refinanced early to lock in low rates, many are still looking to refinance in the next two years.
“You hear about the wall of maturities in CMBS—there were folks who thought low rates would be their salvation because that would give them the room to not have to resize a loan on an over-leveraged property,” said Mr. Doerre at M&T. “It’s not to say that they missed the opportunity, but if new 10-year money goes from the high threes to mid-fours and fives, that vastly changes the ability to refinance.”
Still, some in the CMBS world see the interest rate hike as a positive.
“At the end of the day, interest rate rises are a positive because they reflect a growing economy,” Huxley Somerville, head of the U.S. CMBS group at Fitch Ratings, told CO in early September—before an anticipated announcement from the Fed on rates. “A rise will be a good thing for CMBS if it encourages people to pause for a moment. Commercial real estate and CMBS are currently, on a relative basis, high yielding assets.”
However, if other options open up because of rising interest rates, “it will take some of the heat out of the commercial real estate market,” Mr. Somerville said at the time.
The Real Estate Market As a Whole
“Real estate at the end of the day is a product and a necessary consumer need,” said Eran Polack, co-founder and chief executive officer of the international real estate development firm HAP Investments. “There is a strong demand in the middle market, which the change in the interest rate will not likely effect. The overall health of the economy and increase in consumer wealth has a greater effect on the real estate market.”
The MBA’s Mr. Woodwell said that a healthy real estate industry coupled with the market’s expectation of a rate increase leaves little reason to worry.
“The Fed’s move is an outcome of steady economic growth and of expectations that growth will continue,” he said. “Given how widely anticipated the move has been, it is unlikely to have much of a near-term impact on commercial real estate fundamentals—long-term rates remain low, property values and operating conditions are strong, and transaction values are running at a brisk pace.”
Mr. Hayward of Fannie Mae echoed the sentiment, noting that the market has a long way to go until the nail biting should begin.
“Before the recession, rates were up to 7 or 8 percent and the market was still healthy,” he said. “While interest rates will go up, it could mean in some places that rents will go up. By and large, the market has lived in an area where rates have been higher before, so there’s no reason we couldn’t live there now.”
Gateway cities in the U.S. have seen strong demand for financing and are in the best position to absorb higher rents as a result of rising interest rates. But while an increase in the short-term rate may not harm markets like New York, the effect on secondary markets facing economic woes may be far greater.
“Each market has its own fundamentals,” Mr. Rudin said. “If you’re in Houston because of the oil drop there’s not significant demand. If you’re in New York, Los Angeles or Boston, to some degree you absorb an increase in rates. Obviously, the Federal Reserve doesn’t look at one particular market, they look at the overall economy. There are always winners and losers in the process.”
Danielle Balbi contributed reporting for this story.