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The Federal Reserve raised interest rates seven times in 2022 to combat inflation that reached a 40-year high. This strategy roiled the global financial system and upended the U.S. real estate industry, cooling a red-hot housing market, greatly reducing commercial/multifamily lending volumes, and diminishing commercial property values across the board.
Unfortunately, the U.S. Central Bank recently indicated the key rate isn’t going back down anytime soon.
Consequently, developers need to be prepared to do business in an adverse environment for the foreseeable future. But acknowledging that reality doesn’t mean accepting lower returns as a given. With the right approach and modern real estate development tools, teams can mitigate the effect interest rate hikes will have on the viability of their projects.
The Relationship Between Interest Rates and Commercial Property Earnings Potential
The Fed’s battle against inflation recently impacted the real estate sector by making capitalization rates (cap rates) unstable. That shift has been a big problem in commercial real estate as developers use cap rates to assess a deal's viability. The calculation divides a property's annual net operating income by its acquisition price, so a $13 million apartment building with a yearly revenue of $600,000 has a 4.61% cap rate.
However, the cost of federal funding increasing seven times last year disrupted the marketplace by driving up mortgage rates.
Many owners were caught off guard in 2022 when the debt service of their property loans exceeded their yields – negative leverage – and undercut previously lucrative deals. Negative leverage quickly became widespread, affecting 30.3% of all CMBS loans by last fall, the high level since the 1980s. The Wall Street Journal noted the problem had an outsized effect on multifamily rental complexes as the property type experienced a near doubling of purchasing activity between 2019 and 2022.
Landowners can fight negative leverage by increasing rents, but inflation and recession anxiety have made that strategy unworkable. Apartment rents declined nationwide last year amid a 50-year high in multifamily housing construction and declining occupancy rates.
The re-emergence of negative leverage, increasing interest rates, and inflation flattened demand for commercial and multifamily properties. Analysts estimate mortgage activity for commercial and multifamily properties fell 14% – $125 billion – annually in 2022. Bloomberg reported institutional investors moved to pull $20 billion in property funds late last year. As a consequence, Green Street recorded a 13% decline in property values across all asset classes in the United States last year.
The real estate market's complexity means there isn't a one-to-one relationship between interest rates and cap rates. Burrower creditworthiness, property type, location, material costs, and government subsidies factor heavily into a property’s earning potential. But the record high cost of capital is weighing on the entire commercial market and making it harder to assess project profitability.
When Will the Real Estate Market Go Back to Normal?
Because the sector is so volatile, it’s unclear when it will return to relative stability. Several conditions must change before development teams can resume using cap rates when determining a project’s ROI. That said, there is good reason to believe the real estate market will settle within the next few years.
The Fed’s aggressive monetary policy garnered positive results recently, as inflation eased up for the first time since May 2020 last December. Unfortunately, the U.S. Central Bank didn’t believe the 0.1% monthly CPI drop justified lowering its key rate. Officials indicated that interest on federal funds - currently at a 15-year peak of 4.25% to 4.5% - could hit 5.25% this year. Even without a reduction, the normalization of interest rates could make investing in property more appealing to risk-averse lenders.
If that happens, ULI’s prediction of a rebound in commercial property mortgage activity will rebound in 2023 could be realized.
On the other hand, Moody’s Analytics expects depressed cap rates will curb real estate transaction volumes and totals through 2023. Landowners don’t have the space to raise rents because of the unstable economy, putting downward pressure on property values. Consequently, poor rental revenue growth and stubbornly high interest could push more loans into negative leverage and prompt a wave of CMBS mortgage defaults. In that scenario, buyers and sellers won't be incentivized to make deals until yields start outpacing debt service costs again.
Either way, the real estate segment will continue to face significant headwinds. Until inflation or interest rates decrease, banks and investors will continue viewing the sector with unease. The looming threat of a recession will exacerbate the stresses afflicting the market, even if it's as mild and brief as economists predict.
It’s important to remember that COVID-19 has significantly changed multiple property types. The office sector is undergoing a systemic transformation in response to the rise of the remote and flex work model. Even after last year's market correction, demand for e-commerce logistics infrastructure has become a major driver for the industrial space. And the hotel segment, still recovering from historic losses, is facing a near-term profitability crisis.
The reality is the sector isn't returning to normal; the changes it experienced in the last few years are irrevocable. Based on current data, it isn't going to stabilize until sometime next year. Accordingly, real estate teams need to evolve their strategy and adapt to the dynamics of the new marketplace.
Utilizing Modern Real Estate Development Tools to Overcome Modern Challenges
With the industry’s outlook uncertain amid multiple headwinds, development teams must increase their agility to stay competitive. The ability to process new information, adjust strategy, and act quickly is more important than ever in such an unpredictable environment. And the most effective way to improve operational flexibility is by implementing modern real estate development tools.
As opposed to legacy solutions, contemporary artificial intelligence-driven platforms are built specifically for real estate development, meaning their features are geared towards accelerating and improving existing processes.
These tools use A.I. to collate company data and enable teams to run faster and more accurate project scenarios. That means seeing how changes like an increase in loan repayment rates will impact a budget for days, weeks, and months in the future. It can also generate alerts about cost-saving opportunities and provide vendor procurement options that can lower development expenses. With those advantages, leads can ensure their project are more profitable, resilient to market shifts, and appealing to lenders with high underwriting standards.
Developers should know that the benefits of modern development tools aren’t theoretical.
Real estate companies across the country are using these platforms to overcome pandemic-related challenges and scale into new markets. Ernst & Young learned that the strategic advantages offered by intelligence platforms are significant enough to prompt 70% of firms to apply new technologies to their operations. Given the current volatility of the industry, no one should want to be in the 30% that doesn’t see the importance of modernization.
Want more insights on how to succeed in an unstable real estate market? Download our 4 Recession-Proof Asset Classes whitepaper to learn which property types are best suited to endure a downturn.
Tag(s): Real Estate Development
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