Q+A With Franklin Street’s Joseph Landsberg on the Rising Cost of Capital

Franklin Street also specializes in insurance, which gives the firm particular insight into commercial real estate deals where insurance is an important component, Landsberg said, which increasingly, is all of them, as insurance premiums are also rising across the board — be it catastrophic, liability or disaster coverage. 

Franklin Street is active in South Florida, with offices in Miami and Fort Lauderdale, and throughout the Southeast. In one recent deal, Franklin Street helped secure financing for Sharon Sharaby’s kosher hotel in Hollywood, Fla. 

Landsberg spoke to Commercial Observer in late January.

The following has been edited for brevity and clarity.

The biggest economic story these days is rising costs across the board. We have inflation, labor shortages and the Fed’s plan to raise interest rates in order to counteract all of that. So let’s jump right into what you’re seeing on the ground in terms of capital costs. 

I can tell you that interest rates have [already] gone up, 30 to 40 basis points for pretty much all markets. We have had banks change their tune in between term sheets and commitments. I have a deal right now in Miami, it’s multi-tenant retail, and the bank gave us one set of terms just before Christmas [2021], and have now given us a completely different set of terms, as of this week, because of the increase in costs and the increase in the treasuries as well.

So it’s having a very negative effect especially for the deals that are in process. 

I have a CMBS loan right now, where the going-in rate was 3.65 percent. Now the exit rate is going to be 3.99 percent. That makes a big difference. In this instance, the bank signed up the loan and the client signed the loan at the time where the index rate was at 3.65 percent. But the rate is only fixed at closing. And now we’re coming up to closing next week, and the 10-year Treasury has gone up 30, 40 basis points. So now instead of closing at 3.65 percent we’re closing out close to 4 percent, which has added in essence, an additional $200,000 to an interest that [the client] now has to pay. 

Why is this happening?

I think the reason for that is because of obviously what’s happened with the Fed, right? Jerome Powell [​​chair of the Federal Reserve of the United States] is very hawkish now. They have said they’ve got to be increasing rates several times this year. In addition to that, we’ve got inflation, inflation’s now at 6, 7 percent. That affects costs, that affects everything. So that isn’t just affecting costs on the lending side, but it’s also affecting the underwriting of which is involved to do these deals. 

Construction costs are up significantly. Insurance has gone up, up to 20 to 30 percent. So these deals, while historically the interest rates are low, that means more people can stretch for larger deals — now they are finding an issue, which is that their insurance premiums are going up, their costs are going up, their payroll and managerial costs have gone up, their supplies costs have gone up. So people who are investing are having to be more diligent in terms of the deals that they are buying and what they can afford, or what their affordability is on these deals.

Can you elaborate on what increases you’re seeing in insurance rates, and why?

So premiums across the board are going up everywhere, both residential and commercial. The reason for that is, in essence we’ve had nuclear or catastrophic claims across the United States in terms of hurricanes, types of natural disasters, forest fires. And insurance companies are the ones that are having to write the check. If you look historically, since the last six or seven years, the cost of insurance has remained steady and is actually in some instances dropped. But the cost of the claims that these insurance companies are paying out has gone up, and the insurance companies have to be able to recover their costs somehow. 

Then, with COVID business interruption payouts as well, that’s pretty much affected the whole nation. The whole premise of insurance companies is risk: that the chances of this happening to a certain percentage of people is this amount of risk. But COVID affected everyone. There was not one person on this planet that was not affected by COVID in some way, and insurance companies in some way had to pay out claims related to COVID whether it was business interruption, whether it was liability, whatever it was. So the point I’m making is that the insurance companies have to now make up for that money that they have paid out on lots of claims, and that has caused insurance premiums to rise across the board. 

Do these insurance increases have anything to do with climate risk? Do you see the regime shifting to take into account these more extreme weather risks?

I can’t comment exactly on how climate risk is affecting insurance premiums, I’m sure that it is a major factor. Especially as the world changes, the world just got hotter, the sea levels are rising — I don’t know that it’s enough to make a colossal change in premiums now. But I do feel that buildings are getting older. Right? In Florida homes were built in the 70s and 80s. We’re now in 2022. These buildings are not in the same shape as they used to be, and that is especially [the case] in coastal cities like Florida, where seawater and hurricanes can affect the integrity of these buildings. Look what happened to the Champlain Towers, right? 

Has the Champlain Towers tragedy led to any changes in underwriting from lenders?

A lot of lenders haven’t forgotten what happened last year. Lenders previously have been more forgiving of buildings that weren’t in shape, because there’s a value-add component to it. [But there hasn’t been as much change in their underwriting. What they’ve done is that Fannie Mae and Freddie Mac agency lenders are now doing a pre-screen for these deals to make sure that there is no significant deferred maintenance or structural issues with their properties. So if there’s massive deferred maintenance, Fannie Mae and Freddie Mac have been very restrictive in terms of their lending in that regard.

Let’s go back to where we started, in regard to interest rates. If or when interest rates do go up, what does that mean for deals that are done with those rates baked in?

I think the economy has recovered enough and the job market is strong enough to a place where it could accommodate increases. There’s enough liquidity in the market in order to help cushion the blow of increased interest rates. 

But the effect of that is more money has to be proportioned to paying off the debt service. So instead of your mortgage being $2,000 a month it’s now $3,000 a month, for example, but that means I have to come up with an extra 12 grand a year just by that increase. So what that means is loan to values will be stretched.

The reason why that’s significant is because when interest rates go up, the amount of money I have to be able to have in the deal, the actual net operating income (NOI) has to be high enough to facilitate increased rates that I’m having to pay because it’s an increased debt service. So that means the loan to values that I was trying to achieve before are now going to be lower because the building doesn’t support as much of a loan amount because the loan interest rate is higher. 

How does all this interplay with the massive increase in rents and property values we’ve seen in South Florida over the last two years? 

We’re kind of in this weird position where rents have gone up, which means that there’s more cash flow. But everything’s gone up — rents have gone up, costs have gone up, values have gone up. And now interest rates are going up. Which means that whilst there are still deals to be done, the deals aren’t as good.

That means that buyers have to be more scrupulous in terms of the deals that they are buying, because there is less future upside than they initially thought, because values are continuing to increase and now interest rates are going to continue to increase. So they have to be a lot more selective on how they go about it. 

So looking ahead to the rest of the year, what do you see?

People are going to have to get more creative about their cash flow, about how they’re getting sources of cash flow. I don’t know how sustainable the continually rising rental increases are. But at some point, they’re going to catch ahead where rental values can’t go up that much more. But interest rates will continue to rise. And so there is less and less NOI, and that’s going to inform prices. I’m hoping that this year we are going to see a more rebalancing of property values. Lenders are not pulling back. They’re just having to readjust their pricing for the new normal. And we are seeing new normals every day. And that’s part of the evolution of the market. Florida is a very strong market. And I expect that to continue.