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In early November, the Federal Reserve raised interest rates for the sixth time this year to curb soaring inflation. The interest rate for federal funds to 3.75 to 4%, its highest level in 14 years. The Fed indicated more rate hikes are coming in 2023. The government’s fiscal policy shift has significant implications for the commercial real estate market.
The biggest issue is capital becoming less available to developers. Mortgage loan terms have increased alongside interest rates, making the debt used to finance projects more expensive. Moreover, Moody’s Analytics found interest rates have eclipsed capitalization rates for many commercial properties for the first time since the 1980s.
While the Fed’s efforts to relieve inflationary pressure are generating headwinds for the entire industry, it’s also disrupting certain specific asset classes.
Here’s a closer look at how rising interest rates will shape the commercial real estate market of 2023.
The Negative Leverage Problem
When considering new projects, developers must calculate a property’s cap rate to find its long-term value. The formula divides a site's projected net operating income by its total cost. So, a project with a $15 million price tag that generates $750,000 in yearly net income has a 5% cap rate. Unfortunately, the recent interest rate spikes have exceeded predicted returns on over 30% of commercial mortgage-backed securities (CMBS) in Q3.
In commercial real estate, that condition is known as negative leverage.
Moody’s believes the surge in negative leverage CMBS loans will prompt a slowdown in commercial real estate lending and sales. The firm also predicts that the situation will drive property values down. It further notes that while the negative leverage problem affects all asset classes, it’s hitting the industrial (35.9%) and multifamily (30.8%) segments the hardest.
The analytics firm forecasts that the loan-to-value imbalance will continue expanding until the Fed successfully curbs inflation and normalizes interest rates.
The industrial property market has been due for a correction because of its rapid, unsustainable growth during COVID-19. The segment will bounce back as e-commerce providers and retailers need warehouses to sustain their operations. But recession anxiety means that consumer purchasing won't drive the market's revival in the near term.
The big takeaway for developers is their project planning needs to account for the market’s increasing volatility. Many opportunities that might have been sure things in the summer now carry significant risk. In the current landscape, project teams would be best served by pursuing deals that involve recession-resistant property types.
As for the multifamily segment, the situation is … complicated
Multi-Family Segment Faces Uncertainty
In a recent post, J.P. Morgan Chase offered some meaningful insights regarding the immediate future of multifamily properties.
First, the bank noted that demand for affordable housing greatly surpasses available inventory. It also pointed out that Americans are migrating to the center of the U.S. to escape the higher cost of living on the coasts. And it highlighted the growing need for workforce housing, homes for families and young professionals that earn too much to qualify for affordable housing but don't earn enough to buy luxury properties.
The undersupply of affordable and workforce housing in America represents an obvious opportunity for real estate developers. However, the multifamily segment has significant risks in the current economic environment.
The most prominent issue is that high-interest rates mean less favorable lending terms for potential tenants.
ATTOM, a real estate data provider, reported a 47% year-over-year decline in mortgage origination in Q3 2022. Refinancing activity also fell by 68% during the same period. Rick Sharga, ATTOM's EVP of market intelligence, said the combination of high home prices and "unprecedented jump" rates had priced many consumers out of homebuying.
Until conditions improve, launching a successful multifamily project will be tricky. J.P. Morgan recommends carefully examining the particulars of a local market before investing time and resources in new apartment complexes or housing developments. A comprehensive view of a major American city's local real estate development dynamics is essential to a project’s success.
That said, finding actionable, meaningful insights about the real estate market can be a challenge. A good best practice is to cultivate sources with proven track records and industry experience. It’s also valuable to have a good mix of national trend reporting and regional development happenings to gain a proper 30,000-foot perspective on the market.
Healthcare is Doing Well Despite Multiple Challenges
Because of strong nationwide demand, medical and healthcare facilities are effectively recession-proof property types. Even with soaring interest rates, JLL anticipates the segment will post record sales this year, as transactions totaled $9.2 billion in the first half. However, the Fed's efforts to reduce inflation have negatively impacted parts of the commercial real estate market.
JLL noted the healthcare industry is still grappling with the ongoing effects of the coronavirus pandemic. Declining patient volumes, staffing shortages, and the payer mix becoming dominated by low-reimbursement government healthcare programs have prompted many medical providers to enter cost-cutting mode. Since real estate accounts for up to 40% of hospital and healthcare systems' costs, making changes to reduce that burden – like lease restructurings and portfolio overhauls – is seemingly inevitable.
In addition, Bisnow recently published an article explaining that capital becoming more difficult to acquire is hurting smaller medical service providers. Following the outbreak of COVID-19, specialists have sought to upgrade their facilities to serve their patients better, but debt is increasingly expensive, and limited inventory has exacerbated the problem. Developers have investigated converting traditional office space into healthcare facilities, but the requirements for certain features like fireproof structures have made that option exceedingly expensive.
Although financing challenges are a nationwide problem, new opportunities are emerging within the segment.
Trask Leonard, CEO of Bayside Realty Partners, has seen growth in smaller leases for discretionary medical providers. He believes plastic surgeons, fertility clinics, and behavioral health facilities will occupy a more significant position in the marketplace. Similarly, Unity Medical Properties CEO David Lynn noted his organization successfully financing its projects with the help of local banks.
The Fed’s recent and future interest rate hikes will create challenges and opportunities for real estate developers. Firms will need to tap robust data resources to create bulletproof proposals for institutional lenders. And project teams must harness modern technological resources to keep their projects on track in a demanding environment.
Ultimately, commercial real estate’s strong fundamentals mean that companies can achieve meaningful growth in 2023, but only those that take a forward-thinking approach.
Interested in getting an edge on the market amid unprecedented economic uncertainty? Check out our Resource Center to download reports, whitepapers, eBooks, and infographics that can help outpace the competition.
Tag(s): Real Estate Development
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