Interest rate hikes create unease in the real estate sector

The Federal Reserve will likely raise its target federal funds rate by an additional 0.75 percentage points as early as next week, according to news reports. Fed officials have already raised benchmark short-term borrowing rates by 1.5 percentage points this year, including June’s increase of 0.75%, the biggest rise in nearly three decades. . In this context, we are witnessing a sluggish and transitional real estate market. While there are pockets that are doing well and will likely continue to do well, there is growing distress and uncertainty in the industry.

In response to the market downturn, we see two perspectives. The first is that this is a temporary slowdown to adjust to higher interest rates and to reset prices. This view estimates that the downturn will last a few months and that the market will get back on track before the end of the year.

The second view, which I share, is that this is the start of a longer-term downturn that will contribute to and be impacted by an overall economic downturn due to higher rates, ongoing supply shortages and stubborn inflation. This view anticipates a recession beginning sometime in 2023.

The following is a summary of specific observations after talking with colleagues and industry experts:

  1. The mezzanine faults have already started. These loans pose the most risk to borrowers and the industry as a whole.

  2. New construction is slowing due to inflation and market uncertainty. Loans for new construction are slowing down and, consequently, so is new construction activity. Strong sponsors are able to raise capital and debt for development deals, but this trend seems to be coming to an end. Construction loans are also much less leveraged, requiring equity to invest more funds. There were some defaults on construction loans as well as a higher level of claims and litigation.

  3. There is turmoil in the acquisition market. As rates rise, offers are re-evaluated to reduce purchase prices or they die. It quickly became a buyer’s market. Some in the industry are looking to sell their long-standing properties to maximize value before things get worse. There are still buyers who are willing to lower their price due to higher rates. However, banks are also pulling back and demanding less leverage on trades. It killed some acquisitions. A bank stopped lending in commercial real estate for the rest of the year. Life insurance companies should continue to lend. Additionally, the CMBS market has slowed significantly, providing opportunities for our banks with strong borrower relationships. Debt funds have also slowed their lending activities. Overall, the perception is that acquisitions are slowing down.

  4. A rise in the price of interest rate derivatives also killed off some acquisition deals.

  5. Real estate entities that can have cash are in a good position to make opportunistic purchases because they are not as dependent on highly leveraged loans. Entities that rely on highly leveraged loans slow down their business.

  6. Foreign investment in income-producing real estate has been quite robust. In times of uncertainty, real estate in the United States is considered a safe haven internationally. This investment trend somewhat mitigates the decline in investment by national entities.

  7. The retail market faces many challenges. There is a drop in demand due to online shopping, lower foot traffic and the recent drop in consumer spending. There are supply disruptions. With lower incomes come higher expenses due to general inflation and rising labor costs.

  8. Borrowers are rushing to lock in interest rates as quickly as possible. This creates intense activity in the short term but portends a possible slowdown.

  9. As homes get more expensive and with higher rates, more and more people are renting. This has created a lot of demand in the multifamily market. This should remain a relatively solid sector. However, the residential sector is starting to struggle and is expected to struggle.

  10. Voluntary refinancing across all sectors has slowed significantly, although some better-positioned clients are now rushing to refinance before rates rise even further. This trend mitigates to some extent the decline of domestic entities.

  11. For obvious reasons, the office sector is going through a difficult transition as tenants reassess their needs going forward and costs rise. Tenant improvements are becoming increasingly expensive as landlords resist the high price needed to entice tenants to rent space. As tenant leases expire, tenants are generally looking to downsize their space. Staying with the current owner is an option under consideration.

  12. Industrial property values ​​seem to be holding up, so this sector continues to do well in the acquisition space.

  13. Prefab housing space continues to be active, as does affordable housing, especially where HUD, state, or municipal grants are available.

  14. Hospitality has been strong, especially thanks to leisure travel. Entities that are not dependent on debt are doing very well. However, it is expected that as expenses and salaries increase, hotel entities dependent on bank debt should slow down. Additionally, as consumers tighten spending due to inflation, leisure travel is expected to decline, leading to lower demand for hotels.

  15. New high-yield municipal bond transactions have all but stopped because transactions are not underwritten at higher rates. Struggling incomes combined with higher expenses due to inflation are creating difficulties in the senior living and student housing sectors.

In summary, inflation, fueled by continued supply shortages, the war in Ukraine, rising wages and oligopolies taking advantage of the situation to raise prices and market expectations, will be difficult to control. Shortages and supply disruptions are likely to continue due to the Covid-19 pandemic, creating an inflationary tenacity that is difficult to overcome. This will likely lead to a continued rise in interest rates and financial uncertainty. A recession is likely, but it is unclear when it will start, how long it will last and how deep it will be due to the unprecedented nature of the events we are experiencing.

© 2022 ArentFox Schiff LLPNational Law Review, Volume XII, Number 203

Stephen V. Lee