Fed’s Own Economist Warns of “Severe Recession” From Chair Powell’s Rate Hikes

On Thursday, following reports that the Federal Reserve would likely soon jack up the federal interest rate again — this time by 0.75 percentage points — Chair Jerome Powell tried to allay fears that the Fed’s strategy would cause an economic downturn, insisting that another rate hike was unlikely to cause a deep recession.

The interest rate hikes, which nominally serve as a way for the Federal Reserve to tamp down inflation, are also a way to put economic power back in the hands of the very rich by driving up unemployment, since higher interest rates make it more expensive for banks to loan people money, leading to scarcer investment and therefore fewer jobs.

Powell downplayed the effect the Federal Reserve’s moves were likely to have on working people. “We think we can avoid the very high social costs that Paul Volcker and the Fed had to bring into play to get inflation back down,” Powell said, referring to the period in the 1980s when the Fed similarly hiked interest rates and engineered a recession.

The Fed’s own research suggests otherwise. Powell’s remarks reflect an attitude common among financial elites that the Fed can execute a “soft landing” in which enough pain can be inflicted on the economy to reduce inflation but not so much that the economy slides into recession. But an extraordinary yet little-noticed Federal Reserve study undercuts the exact case Powell is trying to make — published while he was making it. The study warns that the Fed’s aggressive interest rate hikes this year echo a strategy it undertook a century ago that led to a depression because the Fed did not account for how quickly unemployment can spike in response to rate hikes.

“Strong (tight) labor markets can become weak (slack) faster than policymakers may anticipate,” the authors write. “Indeed, our results demonstrate that labor demand reacted sharply and quickly to the tightening of monetary policy, at a speed which can outpace policymakers’ abilities to track current economic conditions.”

The study, published July 27 by the Federal Reserve Board of Governors, looks at the depression of 1920, the circumstances of which are eerily similar to today. The Federal Reserve Board, the main governing body of the Fed, has over 400 economists who conduct research for consideration by other economists, a board spokesperson, Joseph Pavel, explained.

The U.S. had just come out of a pandemic — the Spanish flu — that killed 657,000 Americans. Since many of those who died were workers, this meant that there were more job openings than workers to fill them, granting the surviving workers more bargaining power. “A tight labor market naturally led to high employment and rising real wages,” the study notes. (Though the study doesn’t mention it, labor strikes were also proliferating, spurred by the low unemployment rate.)

Like today, consumer spending was also recovering — then because World War I had ended; now because the disruptive effects of the coronavirus pandemic are wearing off. Despite the strong job market, inflation was also relatively high, and for similar reasons. “At the end of World War I, the United States was experiencing strong growth and unruly inflation, driven in part by an expansionary fiscal policy and an accommodative monetary policy,” the study observes.

In March 2020, the U.S. government likewise responded to the plunging economy brought on by the pandemic with an unprecedented financial stimulus package in the form of the $2 trillion Coronavirus Aid, Relief, and Economic Security Act — “expansionary fiscal policy,” to borrow the study’s words — while the Fed kept interest rates at historic lows — “accomodative monetary policy.” Together, these policies averted an economic downturn.

While the Fed’s aggressive policy in 1920 did succeed in tamping down inflation, the study found that it also had a devastating effect on workers. “In 1920, the Federal Reserve Banks hiked their discount rates to tame inflation, and the U.S. economy entered a severe recession, now known as the Depression of 1920,” the study says, drawing on labor market data that was only systematically assembled in recent years. The result was that “labor demand sharply contracted, with manufacturing and other industrial sectors leading the way with large reductions in job vacancies.”

Asked how the Fed squares its rate hikes with the contrary findings of its own study, Pavel, the spokesperson for the Fed Board of Governors, pointed to a disclaimer on the study that states, “The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors.” The study’s authors, Jin Wook B. Chang, a Federal Reserve Board of Governors senior economist, and Haelim Anderson, a Federal Deposit Insurance Corporation economist, did not respond to requests for comment.

Though the authors of the study aren’t opposed to Fed interest rate hikes wholesale, they caution against using rate hikes in rapid succession — as the Fed is currently doing — due to the delay it takes for the economic effects of rate hikes to register.

In December 1919, the Federal Reserve Bank of New York hiked interest rates from 4 percent to 4.75 percent and then, in June 1920, all the way up to 7 percent. The study explains what happened next: “As the Federal Reserve Banks were increasing rates, a sharp, deep recession began in 1920 lasting until 1921,” the study says. “Up to that point, the recession was one of the deepest measured and is still often referred to as the Depression of 1920. Manufacturing production declined by 22 percent, and unemployment rate rose by 11 percent, from 5.2 percent to 11.3 percent.”

“The Federal Reserve miscalculated the lag times inherent in monetary policy changes, leading the central bank to raise interest rates during the early stages of a recession,” the authors continue. “While it is important for the Federal Reserve to tighten monetary policy and manage inflation, it is also important to adjust policy rates at an appropriate pace.”

The warning seems prudent in light of the fact that the U.S. gross domestic product just contracted for a second consecutive quarter — the traditional definition of a recession.

The Federal Reserve has hiked rates four times this year so far: in March, May, June, and July, cumulatively bringing the federal interest rate from 0.25 percent to between 2.25 percent and 2.5 percent. These represent the first rate increases since 2018; the hike in June was the largest rate hike since 1994. During his closely watched annual address at the Jackson Hole Economic Symposium late last month, Powell indicated that the rate hikes would continue. “Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions,” the Fed chair said. “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation.”

By contrast, the Federal Reserve hiked rates in smaller increments of 0.25 percent on seven occasions between 2017 and 2018, reaching 2.25-2.5 percent by December 2018 — the same rate levels we’re at today. Then-President Donald Trump responded by launching a relentless pressure campaign to get the Fed to lower rates, going so far as threatening to fire Powell. By August 2019, the Fed began to reverse course, gradually slashing interest rates until March 2020, when it rapidly dropped the rate to nearly zero, where it remained until earlier this year.

Powell has been plenty candid about his intentions, declaring his desire “to get wages down and then get inflation down.”

President Joe Biden has shown no such willingness to publicly criticize the Fed, an institution that, much like the Supreme Court, has historically styled itself as above the political fray. In May, Biden vowed “never interfere with the Fed’s judgments, decisions, or tell them what they have to do.” Biden came under criticism by progressives for reappointing Powell, a registered Republican first appointed Fed chair by Trump. Sen. Elizabeth Warren, D-Mass., opposed Powell’s renomination, calling him “a dangerous man to head up the Fed.”

“Renominating you means gambling that for the next five years, a Republican majority at the Federal Reserve, with a Republican chair who has regularly voted to deregulate Wall Street, won’t drive this economy over a financial cliff again,” Warren told Powell while he testified before the Senate Banking Committee in September 2021.

Powell has been plenty candid about his intentions, declaring his desire “to get wages down and then get inflation down” at a press conference in May. As Powell sees it, worker pay is too high. “Wages are running high, the highest they’ve run in quite some time,” Powell said. “And they are one good example of — or good illustration, really — of how tight the labor market really is, the fact that wages are running at the highest level in many decades.”

Anxiety among financial elites about the tight labor market — i.e., workers having some relative leverage — has scarcely been concealed. Also on Thursday, Larry Summers, a top economist in both the Obama and Clinton administrations, said that tackling inflation “will likely require a significant recession.” In recent months, Summers has also called for a 10 percent unemployment rate — a figure that would mean putting millions of Americans out of work.

In a corporate earnings call last month, the CEO of the multibillion-dollar real estate company Douglas Emmett remarked that a recession could be “good” for the commercial real estate business “if it comes with a level of unemployment that puts employers back in the driver seat,” as The Intercept reported. Though recessions can be bad for business in many ways, they’re great for crushing growing labor power.

While it’s true that inflation hurts workers by making consumer goods more expensive, inflation disproportionately hurts the rich and benefits debtors. The effects of inflation are not evenly felt across the board. For example, wage hikes are outpacing inflation in some of the lowest-paid jobs, like leisure and hospitality workers. What’s more, the minimum wage hasn’t kept pace with inflation for decades.

This summer, Warren again raised alarm about Powell, this time over the risks of the Fed’s rate hikes, warning that the decision to increase rates “risks triggering a devastating recession.”

According to the Fed’s own research, Warren is correct.

Commercial Lending to Hit Record $1 Trillion in 2022

There was an impressive 79 percent year-over-year jump in originations in fourth-quarter 2021, completing what MBA estimates was total volume of $900 billion for the year. 2022 is forecasted to be even higher.

Total mortgage borrowing and lending is expected to break $1 trillion for the first time, a 13 percent increase from 2021’s estimated volume of $900 billion. This is according to MBA’s new forecast released last month at our 2022 Commercial/Multifamily Finance Convention and Expo.

Commercial real estate lending volumes are closely tied to the values of the underlying properties. In 2021 those values rose by more than 20 percent, and those increases will fuel further demand for mortgage debt in the coming years. Continued increases in property incomes, and stability in the ways investors value those incomes, should also support solid demand for mortgage capital, even in the face of modest increases in interest rates.

One important item to note. MBA’s commercial real estate finance (CREF) forecast is updated this year to target total commercial real estate lending. In past years the forecast targeted lending by dedicated lenders, which excluded mortgages made by many smaller and midsized depositories. The lending volumes in this year’s forecast incudes those institutions.

For the office and industrial sectors, the final three months of 2021 show evidence of continued strong lending activity in 2022. Fourth-quarter originations jumped 122 percent and 113 percent (on an annual basis) for office and industry properties, respectively.

There are now 210 U.S. housing markets at risk of 15% to 20% home price declines, says Moody’s

We’re beyond questioning whether the housing correction will push home prices lower. Falling home prices are already here. Heading forward, there are just two big questions: How many regional housing markets will see home price declines? And how far will those markets fall?

Moody’s Analytics chief economist Mark Zandi tells Fortune he expects national home prices to decline up to 5% from peak to trough. That assumes no recession. If a recession hits, Zandi expects a 5% to 10% national home price decline.

But that’s nationally. In some parts of the country this ongoing home price correction—which Moody’s Analytics doesn’t expect to bottom out for another 12 to 18 months—is expected to be much steeper. In “significantly overvalued” housing markets, Moody’s Analytics expects 5% to 10% home price declines. If a recession hits, Moody’s Analytics expects home prices to decline between 15% to 20% in those “significantly overvalued” housing markets.

Every quarter, Moody’s Analytics assesses whether local economic fundamentals, including local income levels, can support local house prices. If a housing market is “overvalued” by more than 25%, Moody’s Analytics deems it “significantly overvalued.” Back in the first quarter of the year, 183 of the nation’s 413 largest regional housing markets were overvalued by more than 25%. But this week, we learned that that figure grew to 210 regional housing markets in the second quarter of 2022.*

Simply put, over half of the nation’s largest regional housing markets are vulnerable to home price declines of 15% to 20%. For perspective: Peak to trough, U.S. home prices declined 27% between 2006 and 2012.

These 210 “significantly overvalued” housing markets include places like Boise (overvalued by 72%), Charlotte (overvalued by 66%), Austin (overvalued by 61%), Las Vegas (overvalued by 59%), and Phoenix (overvalued by 57%).

The pandemic saw a perfect storm hit markets like Austin and Phoenix. Not only did these markets get blindsided by the pandemic’s work-from-home revolution, which attracted hordes of expats from California and New York, but they also saw a flood of investor buying. These investors, often flippers or landlords, wanted in on historically low mortgage rates and record home price appreciation.

Underlying housing fundamentals tell us that many locals, in places like Austin and Phoenix, were already priced out even before we entered 2022. But now that mortgage rates are spiking, many of the would-be WFH buyers—who were attracted to markets like Boise because of their relatively affordable real estate—are also priced out. Cue steep price cuts in markets like Phoenix.

Falling home prices might be exactly what housing markets like Las Vegas and Boise need in order to get going again. At least that’s according to Rick Palacios Jr., head of research at John Burns Real Estate Consulting.

“The longer that [mortgage] rates stay elevated, our view is that housing is going to continue to feel it and have this reset mode. And the affordability resetting mechanism right now that has to happen is on [home] prices. And so there are a lot of markets across the country where we’re forecasting that home prices are going to fall double digits,” Palacios tells Fortune.

*”The Moody’s Analytics housing valuation measure is the percent difference between actual house prices and house prices historically consistent with wages and salaries per capita and construction costs. The price of a house is ultimately determined by the value of the land upon which it resides which is tied to the opportunity cost of the land as measured by wages and salaries, and the cost to build the home.

Nationwide, approximately one-half of a home’s value is the land and the other half the structure, but this varies considerably across the country.  In San Francisco, for example, the land is far and away the biggest part of the home’s value, while in Des Moines, Iowa, it is the opposite. Our housing valuation measure accounts for these differences,” writes Moody’s Analytics chief economist Mark Zandi.

How To Make A Real Estate Investment Business Plan, And Why It’s Important

A real estate investment business plan is an important step if you’re looking to get started in the industry. A real estate development business plan can help you decide what form of real estate you’re looking to invest in. Real estate has a wide array of opportunities, so it’s important to narrow your focus. It’s very difficult to be successful in several different areas of real estate at the same time. A business plan can help you decide what it is specifically that you’re doing.

What Is A Real Estate Investment Business Plan?

Put simply, a real estate investment business plan is a document that lays out how a real estate investor intends to run their business. The plan should illustrate the investor’s goals for investing in real estate as well as business strategies and timelines they intend to implement to achieve those goals.

There’s not a specific format you have to follow to create a real estate investment business plan. Instead, you can pick and choose sections that are important to you. A business plan is primarily a document that can help you decide what your business is going to focus on, whether that’s rental properties, investment properties or flipping houses. You can also use a real estate investment business plan to help secure funding from investors or business partners.

Why Do You Need A Real Estate Investment Business Plan?

Having a plan is important because it can act as a blueprint or road map when starting a new business. It can also give it a sense of legitimacy when talking about your business with others. This is especially crucial when trying to attract business partners and investors or getting a small-business loan.

11 Essentials For A Real Estate Investment Business Plan

As we mentioned earlier, there isn’t a specific format you must follow when creating a real estate investment business plan. Plans can be as unique as each company they outline. Here are a few sections that you might consider including in a real estate investment business plan.

1. Executive Summary

An executive summary should illustrate things like the company’s mission and vision statement. Depending on how long your real estate investment business plan is, most people are not going to read the entire thing. So, an executive summary should sum up the investment company as a whole and provide a snapshot of the company’s financial plan, marketing plan and other key factors.

2. Company Description

A business plan should include a description and history of the company as well as the target market. This lets people who read the plan know basic information about the company as well as its principal members. The company description section is a great place to give biographical information about each member of the company’s leadership team.

3. SWOT Analysis

A SWOT analysis looks at a company’s strengths, weaknesses, opportunities and threats. Analyzing each of these categories is important to include in a business plan. This will help you make sure you’ve adequately considered each of these categories, and these are things that potential partners will definitely ask about before investing in your company.

4. Investment Strategy

Detailing a company’s intentions with investment properties is another important part of a real estate investment business plan. Real estate is a broad term that covers a wide variety of different activities. Each of these real estate activities is different and will take a different strategy to be successful. This section will stipulate if you intend to invest in rental properties, flip houses, etc.

5. Market Analysis

You’ll also want to include a market analysis in your business plan. This shows potential investors that you know the real estate market. The three most important words in any real estate plan are “location, location, location,” and including a market analysis will show what conditions are like in the areas where you’re looking to invest. Investing in a high-priced area like New York or San Francisco is much different than investing in a rural area with much lower market prices.

6. Marketing Strategy

Most business plans will also include a marketing strategy. The marketing strategy will show how and where you plan on marketing and attracting new clients. The specific area of real estate you’re focusing on will drive how much you focus on marketing. Someone looking to become a real estate property manager will need to do more marketing than someone who’s buying rental real estate to hold.

7. Financial Plan

Your financing strategy and financial plan might illustrate income and cash flow statements. This could include historical records like bank statements or profit and loss projections. You might also include a balance sheet showing the company’s assets and liabilities. The financial plan section is intended to give potential partners or investors a snapshot of the company’s overall financial health.

8. Organization And Management Structure

A business plan should also include a company’s organizational structure, management team and ownership details. These items are mentioned in the initial executive summary; in this section you can go into more detail about each member of the management team. One thing that is good to include here is a listing of the various qualifications, licenses and/or certifications that each member of the team holds.

9. Real Estate Acquisition Strategy

A business plan should include a strategy for acquiring investment properties, if that’s something that the company plans on doing. There are many different ways to buy real estate, so you’ll want to detail which strategy or strategies you plan on using in your real estate investment business plan. Some strategies may include going through a real estate agent or broker, as well as wholesaling and target marketing.

10. Goals And Timelines

A business plan should clearly state a real estate investor’s goals for their company. One way to show this is to make a 1-year, 3-year or 5-year plan. Detail your plans for the business over a variety of different timelines. You’ll also want to include some strategies and details for how you plan on meeting them.

11. Exit Strategy

Having an exit strategy is important for a business plan. This can include items such as knowing if and when to sell an investment property.

The Bottom Line

Having a real estate investment business plan is an important part of owning a business. Creating a written business plan when you’re starting a business will make your business feel more real.

Commercial Real Estate Mid-Year 2022: The Big Slowdown

Commercial Real Estate Mid-Year 2022: The Big Slowdown

To paraphrase Ernest Hemingway, distress in commercial real estate markets typically develops gradually, then suddenly. Perhaps that is because we spend a long time talking about trends, and then suddenly investors wake up to a more risky market and spreads instantly widen. In our 2022 outlook, we explored the hightened complexity within the real estate markets as economic dynamics alter the math in predicitng investment yield. Most importantly, we are transitioning from an artificial landscape of monetary and fiscal stimulus that inflated returns and asset values toward a market-based interest rate and pricing environment as both the federal government and the Federal Reserve withdraw. At the beginning of the year we knew interest rates would rise, but we didn’t know the pandemic would continue to unleash waves of new variants around the world, exacerbating global supply chain disruption. And we couldn’t know that the first major war in Europe in eighty years would erupt, causing unimaginable human tragedy, dislocating the energy markets, and intensifying already high inflation. What a difference six months has made. The magnitude and unpredictability of change has resulted in a riskier investment market for all asset classes and the accompanying requirement for higher risk adjusted returns.

The immediate impact of this more challenging investment environment, particularly the higher cost of capital, has been a slow down in transactions. Higher interest rates to real estate are like fire to a scarecrow. They reduce profit margins on new deals and can spoil the anticipated exit on existing deals. Accordingly, investors and their lenders are taking more time to model cash flows and valuations. The longer-term impact will bring both opportunity and pain. As the market transitions so will owners and investors, from the sprint of the last few years to a marathon. As we wrote in January, focusing on the longer-term horizon is not only an appropriate strategy in a period of volatility but healthy for the markets. In the next few years, as market participates adjust to the new reality, it will likely take more capital and sweat to achieve success in real estate investing.

Despite the economic volatility, most properties continue to outperform expectations. The fundamentals of real estate remain strong, creating somewhat of a disconnect between the property markets and the capital markets. Of course, real estate is a leveraged business, and each must exist with the other. The strength in market liquidity and property performance heading into this period of change will soften the blow of the newly emerging interest rate and inflation environment. This article will highlight the factors investors will need to consider in response to a new investment environment. While investors are currently taking a risk-off approach, long-term real estate investment opportunities remain.

The Exogenous Factors – Economic Volatility

The inflation caused by supply chain disruptions during the pandemic and exacerbated by the war in Ukraine has proven to be stubborn. The 7.5% annual Consumer Price Index (CPI) was expected to fall during the year but instead rose to 9.1% by June.1 The Wall Street Journal’s June Economic Survey indicated an average estimate of year-end inflation of about 7% (the lowest estimate was 4.5% and the highest 9.9%), twice the 3.4% estimated in January. Interestingly, the same group’s estimate for year-end inflation in 2023 is a relatively modest 3.26%, but the markets do not appear to be thinking that far ahead.

Inflation is often the real estate industry’s friend, enabling increases in rents that are hopefully higher than increases in operating costs. Hence the view that real estate is an inflation hedge, particularly for properties with short-term leases. But the sword cuts both ways as the market’s response to inflation has been significantly higher interest rates, both through the Fed’s aggressive remedies and the market’s anticipation of further Fed rate hikes. Recent fears of recession have tempered interest rate escalation. With first quarter Gross Domestic Product (GDP) down 1.6%2 and second quarter estimates hovering around neutral, the recession may already have arrived. The probability of a recession rose from 18% in January to 44% in June in the WSJ Survey. But not all recessions are alike, and whatever comes will likely be far more benign than our memories of the Great Recession fifteen years ago. Today’s buffers against a severe economic downturn are immense liquidity and a strong job market. At the same time, reductions in the Fed’s balance sheet and investor concerns have the potential to gradually, then suddenly, pull capital out of real estate.

The 10-year Treasury rate started the year around 1.6% and ended the second quarter around 3%, reaching a peak of 3.5% mid-June (awkwardly during the CRE Finance Council’s annual meeting, putting the group in a rather somber mood).3 At the time this article was written the rate had fallen to about 3.0%. Reflecting higher risk in the system, credit spreads have also widened, resulting in a cost of capital double whammy. According to data from Trepp, CMBS AAA spreads have widened between 70 and 90 basis points since the beginning of the year and BBB spreads have widened between 185 and 215 basis points, depending on the issuer of the bonds.

It is important to remember that real property performance, with the exception of hospitality, is far more correlated to job growth than GDP. The June job creation number surpassed analyst expectations. We are enjoying record low unemployment. There are over 11 million job openings nationally.4 As long as Americans have jobs and their wages grow more than long-term inflation, the performance of most property sectors should be sustained through a mild recession.

The higher cost of capital, rather than real estate fundamentals, is what is slowing down real estate investment. Of course, inflation and a recession could dampen demand for some property types; as discretionary spending decreases more people may stay home rather than spending money on retail and hotels. But overall, demographics and other demand generators are keeping occupancy up and rents high.

Multifamily and industrial continue to be the two most desired property types. The rapidly rising cost of owning a home is further fueling multifamily demand. The Case Shiller U.S. Home Price Index rose more than 20% year-over-year through April. On top of continued higher prices, the 30-year fixed rate mortgage rate rose from about 3.2% at the beginning of the year to 5.7% at the end of June.5 The upshot is that the National Association of Realtors Housing Affordability Index fell 24% between January and April, which does not reflect the steep rise in rates in June. Based on home prices, down payment requirements and mortgage rates, only a quarter of American households qualify for a mortgage on a medium-priced home.6

Multifamily demand is being further bolstered by new Gen Z household formation. A study by Cushman & Wakefield estimates that Gen Z will comprise over 30% of renting households by 2025, roughly equivalent to Millennials. Additionally, more Boomers are taking advantage of the hot market to sell their homes and rent for a while. Each of these factors has driven up apartment rents and pushed down vacancies. A recent analysis by Moody’s indicates that national rents are up about 17% in the last twelve months. As apartments become unaffordable, household creation is likely to slow. Rents will continue to grow, but at a slower pace.

Industrial demand also remains strong. While there are risks of over-building in several markets, many companies are increasing product inventories to avoid supply chain disruptions and extending their reach toward customers through last mile distribution centers. According to Marcus & Millichap, a record 551 million square feet of industrial space was absorbed in the twelve months ending April 2022. Robust property performance is expected to continue.

Retail has been the problem child of the real estate industry for many years as oversupply is slowly and painfully wound down and retailers adjust to new consumer behaviors and preferences. The University of Michigan Consumer Sentiment Index fell from 67.2 in January to 50.0 in June, the lowest in the history of the index, and the Conference Board’s Consumer Confidence Index fell from 113.8 to 98.7 during the same period. These gloomy statistics are not surprising given the recent spike in inflation, particularly gas and food prices, and recession fears. Yet retail sales are holding remarkably well, with only a small decline in May. The good news is that online spending as a percent of all sales has been flat as consumers are eager for in-store shopping experiences with family and friends. Even malls have recently had more traffic. This recent in-store performance does not suggest retail real estate is poised for growth; a recession would put continued stress on retailers and the nation continues to be severely over-stored.

The office market continues to pose significant risks for investors and owners. The number of workers going back to the office is increasing every month. However, most workers no longer want to be in the office full-time, especially as gas prices increase the cost of commuting. Office tenants are listening to their employees and watching their checkbooks. Many are trying to renegotiate rent and reduce space prior to the expiration of their leases. Others will clearly reduce space and move to higher quality properties as leases turn. A recent tenant study by CBRE found that over 50% of respondents expect to reduce office space over the next three years.

Despite this, we read a lot about new office leases. Almost all companies need office space, and many of those new leases are companies moving to better quality space. The net effective rents achieved on new leases are not part of the press release, so rent trends are not clear. And national vacancy remains stubbornly high, particularly in gateway cities. According to CoStar, office availability in New York City has risen almost 40% since the beginning of 2020. Hemingway was not an office investor, but his adage holds particularly true for this segment of the market. Owners will go through the drip, drip of lease negotiations until suddenly, over a period of years, they run into trouble with their lenders. We are already seeing, very early in this process, a slight uptick in office loan delinquency. A recent study by New York University predicted an average 30% reduction in office values. The pain will be mostly felt in older, lower quality buildings that lack what tenants now demand: excellent design and floorplans, state of the art air flow, excellent light, building amenities, and environmental and wellness certifications.

Whenever the investment environment becomes riskier, investors differentiate assets and markets in the pursuit of rent growth. Sun Belt and Mountain markets continue to experience in-migration and above average job creation, and investment dollars will follow those trends. Around the nation suburban markets are outperforming the cities they surround as people work and play closer to home. Property users are more focused on environmental vulnerabilities and impact, as well as health and wellness. In a recession there is always a flight to quality, including higher quality properties. These and many other variables will be used to distinguish investment options for the foreseeable future.

Capital Flows and Valuations in an Upside-Down Market

Rent and cash flow growth is even more critical for successful investing as the cost of capital rises. Investors are currently faced with the unusual inversion of lending rates and capitalization rates, or negative leverage. Theoretically, cap rates reflect the aggregate of required returns of both equity and debt. But during the past decade a wave of capital, fueled by artificially low interest rates, compressed cap rates below their historical averages. Many investors believe that liquidity has made cap rates invulnerable to rising interest rates. However, when lending rates rise and yields fall, capital often seeks a new home in other asset classes. Real estate is always cyclical. The only way to deal with the current rate environment is through cash flow growth, which will vary greatly by property type and market and may be mitigated by a prolonged economic slowdown. Hence, the investors are pausing to re-evaluate their strategies.

The cost of debt becomes even greater when considering the higher cost of locking in rates. Many investors want the flexibility of mortgage prepayment and therefore prefer floating rate loans. Uncertainty in the rate market has blown out the cost of swapping from floating to fixed or buying interest rate caps. This is putting further pressure on transaction yields and making investment in transitional properties more difficult.

Of course, the other impact of rising cap rates, particularly without adequate rent growth, is a fall in valuations. This is perhaps the most alarming development for investors. We are currently in a period of price discovery where buyers are looking for deals and sellers are unwilling to reduce asking prices. It will take many months and many transactions to fully assess the impact on valuations, but anecdotal evidence suggests modest cap rate increases to date, with the resulting diminution in value.

Given these new dynamics, perhaps the most difficult part of the investment process is estimating the exit. Existing investment syndicates planning to improve and sell a property within the next few years may not be able achieve the expected exit price, reducing investor returns and sponsor promotes. And predicting exit prices on new deals is next to impossible. Hence, the major slow down in transaction volume ahead of us until rates and valuations find their new equilibrium.

Real estate lenders, which provide most of the capital that fuels the industry, are also slowing things down. With higher rates and recession concerns lenders have tightened underwriting, often reducing proceeds and adding structure to bolster credit. Lenders are particularly focused on debt service coverage given the potential for weaker cash flows and the certainty of higher rates. They are also laser focused on near-term maturities and the ability of borrowers to refinance the loans in a higher rate environment. Transitional lenders, particularly debt funds, are carefully monitoring the performance of their collateral, and requiring more frequent reporting from borrowers on their ability to achieve their business plans.

Not all transitional loans will make it. Despite the many tailwinds supporting property performance, the new interest rate regime is certain to result in pockets of distress. As mentioned, loans with near term maturities are the most vulnerable, but lenders will likely kick the can down the road for a while and see what happens before racking up defaults and impairments. Loans collateralized by retail properties offering the wrong product in the wrong market will continue to default. And office loans are waiting in the wings. The proliferation of debt funds in the last two years (Commercial Mortgage Alert listed more than 150 in a recent issue) have a tough road ahead. They are not only providing loans to fund property repositioning, but mezzanine loans at a time when values will likely fall. Unlike banks, the funds are reliant on warehouse lending to originate loans, and often refresh capital by selling loans into the commercial loan obligation (CLO) market. On the front end the borrowing rates on the lines have rapidly risen, and on the back end the CLO market is practically closed. Again, things are slowing down, and the more complex transactions will move particularly slowly.

Finding a New Path Forward

The suddenness of rate increases and recession concerns in the second quarter has left many real estate investors and operators in the doldrums. The Commercial Property Executive’s CPE 100 Quarterly Sentiment Survey in June revealed that 92% of respondents believed real estate performance will weaken in the next six months versus only 23% in their first quarter survey. Despite the gloomy outlook there are always opportunities. As we concluded in our January market review, investors need to work harder to navigate the uncertainty and risk in commercial real estate. Investors can no longer paint with a broad brush, but must differentiate by property and market, seeking quality in the path of growth.

The math in real estate investing has changed. Transitioning to higher interest rates and cap rates, lower valuations and less robust yields will be a painful process. Once things have settled down and investors are accustomed to the new reality, liquidity and transaction volumes will return. Patient investors with longer term horizons will win out, as long as they have short-term leases and long-term debt maturities, and have avoided the office sector. Above all, investors need to be nimble and rapidly adjust their strategies. We are entering a new real estate cycle, not because of real estate supply and demand but because of economic volatility and a regime change in government support for liquidity. The respective timing of rising cap rates, rising rents, lease renewals, and loan maturities will sort out the winners and losers.

Source: http://www.eisneramper.com