What interest rate hikes mean for multifamily property investors

As the Fed continues to ramp up interest rates, find out how increases could impact real estate investors.

Inflation—and rising interest rates—are at the center of the American economic conversation. And for good reason. In 2022, the Federal Open Market Committee (FOMC) raised rates by 75 bp four consecutive times between June and November.

In December 2022, the Fed raised rates by 50 basis points, bringing the target federal funds range to 4.25% to 4.50%.

While inflation has slowed in recent months, it remains near 40-year highs. Combined with historically tight labor markets that are driving higher wages, “we’re in uncharted territory,” said Ginger Chambless, Head of Research for Commercial Banking at JPMorgan Chase. “As a result, the Fed is currently tightening monetary policy as rapidly as ever.”

Rate hikes may not impact all financing structures

Interest rate hikes may impact short-term and adjustable rate loans more than long-term, fixed-rate ones.

“The Fed’s actions on short-term rates don’t directly translate to a like effect on fixed rates underlying commercial real estate mortgages. After any Fed rate hike, it’s possible that fixed rates might rise or fall depending on circumstances,” said Mike Kraft, Commercial Real Estate Treasurer for Commercial Banking at JPMorgan Chase.

For investors with fixed-rate loans, you may also want to keep an eye on the Treasury yields, which help determine mortgage rates. The Treasury yield is viewed as a sign of investor sentiment about the economy. Yields are driven by the market and aren’t directly under the Fed’s control. “Treasury yields depend on long-term inflationary expectations, on the market’s assessment as to whether an economic downturn is impending,” Kraft said.

As of December 2022, yields are near the low end of that range. “While they will certainly continue to move about, they are not likely to take off in the immediate future,” he said.

What interest-rate hikes mean for multifamily investors

“As one of the most sensitive sectors in the economy to changes in interest rates, housing activity has weakened significantly in the last few quarters of 2022,” Chambless wrote in her 2023 Outlook. “However, demand for multifamily housing has held up amid tight single-family home supply and affordability challenges, with multifamily housing starts still close to the highs of the cycle.”

The Fed anticipates more increases in early 2023. While multifamily property owners and investors may feel the negative effects of rising interest rates, there may also be some offsets.

Higher interest rates could price would-be homebuyers out of the single-family housing market, causing them to remain renters for longer. Inflation, along with rising costs and construction delays may increase existing properties’ rents.  

Multifamily property owners and investors with fortress balance sheets in particular can benefit from the current economic environment, offering an opportunity to grow their portfolio at a lower cost. 

Looking beyond interest rates

For those looking to purchase a multifamily property or refinance their apartment complex, there’s more to look at than interest rates. Consider other factors, including:

Supply, demand and demographic shifts: The housing inventory—especially affordable housing—is low, with demand outpacing supply. Likewise, more people have moved to the center of the country and are seeking workforce housing. Investors may also want to weigh the merit of a shift from suburbs to cities.

Local market: Real estate is a largely local business, so investors may want to take a close look at the specifics of the market before purchasing or refinancing. It’s also important to evaluate each property individually, including its capitalization rate, which generally goes up when interest rates increase.

What’s next for interest rates, inflation and the economy

“While inflation is likely to remain somewhat elevated through the end of 2023, we see signs that a moderation is already underway and that this cooling will become more prominent over time,” Chambless said.

Interest rate fluctuations could correspond. “The Fed’s own projections indicate that the target would top out at 5.25% by the end of 2023,” Kraft said. “Markets have treated this forecast with skepticism, with futures implying a maximum 5.00% target by May. Shortly after that, markets imply a ‘pivot’ by year end—at some point, the Fed could begin easing to accommodate a possible economic downturn. The Fed itself doesn’t project such a pivot, maintaining that it will be necessary to hold rates at a higher level for a while to bring inflation in check.”

Unexpected national and international geopolitical uncertainties may continually arise, resulting in market volatility and interest rate fluctuations.

Source: https://www.jpmorgan.com/commercial-banking/insights/rising-interest-rates-effect-on-commercial-real-estate

How Inflation Breeds Recession

This article is based on a paper delivered January 6, 1975, at a monetary conference in Miami Florida.

Both general economic and purely monetary theory are supposed to have made immense advances since the middle of the eighteenth century, yet the confusion and chaos in economic and monetary theory have never been greater than they are today. One would think, listening to television and reading the newspapers and mag­azines, that inflation — in the pop­ular sense of soaring prices —were some infinitely complicated, mysterious and incurable afflic­tion that had suddenly struck us from the blue, instead of simply what it is — the inevitable conse­quence of the actions of government in overspending and then printing paper money.

And as the cause is obvious and simple, so is the fundamental cure.

The direct cause of soaring prices is printing too much paper mon­ey; the direct cure is to stop printing it. The indirect cause of inflation is government over­spending and unbalancing the bud­get; the indirect cure is to stop overspending and to balance the budget.

But if the cause and cure of in­flation are so fundamentally sim­ple, why is there so much befud­dlement? One reason, of course, is that the problem is not merely economic, but political. The prob­lem is not merely, for example, to get the politicians to recognize the true cause and cure of inflation. It is also to get them to acknowl­edge that cause and adopt that cure. In brief, one reason so many politicians do not understand the problem is not merely that they are too stupid to understand it, but that they do not want to understand it.

They realize that inflation is a political racket. They find that the way to get into office is to advocate inflation, and the way to stay in is to practice it. They find that the way to be popular is to appropriate handouts to pressure groups who represent mass votes, and not to raise taxes except those that seem to fall mainly on some unloved or envied minority group — oil companies, corporations gen­erally, the reputedly “rich” or “superrich.”

The ultimate result of such poli­cies is to bring about exactly what we have today — inflation plus re­cession.

But we are brought back to the fact that politicians could not ex­ploit the befuddlement of the pub­lic about inflation if that befud­dlement did not already exist. So though we must not overlook the political side of the problem, we must recognize that our main task is still one of educating the public.

This is a much bigger problem than it is commonly thought to be. Even when we have explained to people that inflation is caused by excessive issues of paper mon­ey, and by budget deficits that lead to excessive issues of paper money, we have done only a small part of our task. We have ex­plained what causes inflation, but we have not explained why infla­tion is so pernicious. The truth is that the greater part of the pub-lie still thinks that inflation is on the whole beneficial. They know that it raises the prices of com­modities, but the chief thing they consider bad about this is that it may not raise their wage-rates or salaries to the same extent. Near­ly everybody thinks that inflation is necessarily stimulating to busi­ness, because they think it must raise profit margins and so lead to greater production and employ­ment.

This is indeed usually true in the first stages of inflation. But what is still recognized only by a tiny minority is that in the later stages of inflation this ceases to be true. In its later stages inflation tends to bring about a disorgani­zation and demoralization of busi­ness.

It tends to do this in several ways. First, when an inflation has long gone on at a certain rate, the public expects it to continue at that rate. More and more people’s actions and demands are adjusted to that expectation. This affects sellers, buyers, lenders, borrowers, workers, employers. Sellers of raw materials ask more from fabri­cators, and fabricators are willing to pay more. Lenders ask more from borrowers. They put a “price premium” on top of their normal interest rate to offset the ex­pected decline in purchasing pow­er of the dollars they lend. Workers insist on higher wages to compensate them not only for present higher prices but against their expectation of still higher prices in the future.

The result is that costs begin to rise at least as fast as final prices. Real profit margins are no longer greater than before the inflation began. In brief, inflation at the old rate has ceased to have any stimulative effect. Only an in­creased rate of inflation, only a rate of inflation greater than gen­erally expected, only an acceler­ative rate of inflation, can con­tinue to have a stimulating effect.

But in time even an accelerative rate of inflation is not enough. Expectations, which at first lagged behind the actual rate of inflation, begin to move ahead of it. So costs often rise faster than final prices. Then inflation actu­ally has a depressing effect on business.

A Crucial Oversight

This would be the situation even if all retail prices tended to go up proportionately, and all costs tended to go up proportionately. But this never happens — a crucial fact that is systematically con­cealed from those economists who chronically fix their attention on index numbers or similar aver­ages. These economists do see that the average of wholesale prices usually rises faster than the aver­age of retail consumer prices, and that the average of wage-rates also usually rises faster than the average of consumer prices. But what they do not notice until too late is that market prices and costs are all rising unevenly, dis­cordantly, and even disruptively. Price and cost relationships be­come increasingly discoordinated. In an increasing number of in­dustries profit margins are being wiped out, sales are declining, losses are setting in, and huge layoffs are taking place. Unem­ployment in one line is beginning to force unemployment in others.

All this is the consequence of an inflation in its later stages. But the irony is that this conse­quence is systematically misin­terpreted. The real trouble, every­body begins to think, is that there is not enough inflation; it must by all means be speeded up.

This is the stage at which we have now arrived. A swelling chorus of voices has been de­manding that the Federal Reserve “temporarily,” at least, increase the growth rate of the money supply. It is almost universally believed that the reason the banks’ prime lending rate was recently at 12 per cent is that the Federal Reserve was following a “tight money” policy. The Federal Re­serve authorities even themselves seem to believe this. In early December they reduced the discount rate from 8 to 73/4 per cent, and a month later to 71/4 per cent, to prove that they meant to follow a less stringent money policy.

The truth is that market money-rates have been high precisely because we have been inflating, precisely because the Federal Re­serve has for too long been fol­lowing a recklessly loose money policy. As compared with the 8 per cent discount rate of the Fed, the discount rate of the Bank of England was last year between 111/2 and 121/2 per cent, the dis­count rate of the Bank of Brazil 18 per cent, the discount rate of the Bank of Chile 75 per cent.

Discounting Inflation

None of these rates was a result of a tight money policy in the countries concerned. Quite the contrary. The greater the past or present rate of inflation, the high­er the present prevailing interest rate. This is because, in the later stages of an inflation, people ex­pect the recent rate of inflation to continue. If they believe, for ex­ample, that the dollars or pounds or cruzeiros or escudos that they lend today will have a purchasing power of x per cent less when they get them back a year from today, they will add that x per cent to the normal rate of interest they would otherwise have ex­pected. If their expectations are justified, though they will be get­ting a very high nominal rate of interest, their real rate of interest will not be above normal. But the high nominal rates of interest will none the less tend to discourage borrowing.

Again, as I have already point­ed out, labor unions will begin to demand so-called “protective” pay increases sufficient not only to compensate them for the commod­ity price increases that have taken place since their old contract was signed, but for the price increases that they fear will take place in the future life of their new contract. Union demands will tend to become increasingly unreasonable. The number of strikes will tend to increase. Profit margins will be squeezed or wiped out arbitrarily. Price-and-cost relationships among different industries will become increasingly unsettled, unpredict­able and disorganized.

In short, “protective” actions and other compensatory reactions to inflation and expected inflation will often turn inflation in its later stages from a stimulating force to a depressing and demor­alizing force. But the public and politicians will increasingly be­lieve that these depression conse­quences of continued inflation are the consequences of insufficient inflation. They will demand that the inflation be still further accele­rated.

The reason an inflation is not stopped is that people begin to dread more and more what will happen if it is stopped. They fear a stabilization crisis. They fear mass unemployment. The only al­ternative seems to be to accelerate the inflation. But, as we see, this simply leads to increasing disor­ganization and demoralization of business. In the end, we begin to get mass unemployment anyway.

Suppose, by some miracle, the government stopped inflating —now. Would the consequences real­ly be as bad as most people fear? There is every reason to think that they would be incomparably better than if the demoralizing ef­fects of the inflation are allowed to continue.

German Hyper-Inflation

We can get some light on this if we study what happened in the great German hyper-inflation which ran roughly from 1919 to the end of 1923. In the course of that inflation the German paper mark fell to a purchasing power equal to only one-trillionth of what it had been before the inflation set in. This is another way of say­ing that prices soared a trillion-fold.

In the last stages of that infla­tion production became disorgan­ized and unemployment soared. In­dustrial production plunged from an index number of about 125 in 1921 to about 60 in 1923. Unem­ployment among trade union members, which had been as low as 0.6 per cent in July of 1922, rose to 19.1 per cent in October, 1923, to 23.4 per cent in Novem­ber, and to 28.2 per cent in De­cember. The index of the real in­come of the German industrial population plunged from a range of 75 to 105 in 1921 (with 1913-14 equal to 100) to a range of only 36 to 47 in November of 1923. These figures are taken from Prof. Frank D. Graham’s 1930 book on the German inflation. They show how inflation in its later stages can demoralize pro­duction, real income and employ­ment.

Was the stabilization crisis so dreadful when this inflation was finally brought to a halt? I regret that the commonly available fig­ures are not quite adequate to an­swer this question satisfactorily. Practically all the tables published in the books of both Frank D. Graham and Costantino Bresciani­ Turroni end at December, 1923. But supplementary evidence indi­cates that the stabilization crisis was brief and the recovery quick.

The index of the physical vol­ume of industrial production per capita, taking 1913 as a basis of 100, had fallen to 54 at the peak of the inflation in 1923. It rose to 77 in 1924, to 90 in 1925, and to 111 in 1927. This was a better com­parative record of recovery from 1913 than that of England , Italy , or West Europe generally.

Heavy Unemployment?

C. W. Guillebaud of Cambridge University , in his book The Eco­nomic Recovery of Germany (1939), tells us that “The cessa­tion of inflation brought with it as its immediate effect a large in­crease in recorded unemployment, which rose to 1,533,000 on Janu­ary 1, 1924.”

The justification for this state­ment depends on what date we place on “the cessation of infla­tion.” The monetary reform was introduced by a decree issued on October 15, 1923. The actual in­troduction of the new currency, the rentenmark, did not come un­til November 20, 1923. But the Reichsbank kept grinding out pa­per marks at accelerative and as­tronomical rates continuously through the end of December.

If we consult the monthly sta­tistical series (not given in any table in Guillebaud’s book) from which his January figure was ap­parently taken, we find that re­corded unemployment in October, 1923 was 534,000, in November 955,000, and in December 1,473,­000.

So the January figure of 1,533,000 of recorded unemployment was not much above this. In any case this unemployment was short-lived. In spite of interest rates, in terms of the new currency, as high as 100 per cent in January, and even from February to May at an aver­age, figured annually, of 35 per cent, Guillebaud tells us that “ac­tivity revived, and unemployment for the first time since August, 1923 began to decline, and was not more than 700,000 in April, 1924.” It fell to 328,000 by July, better than a normal average.

Rapid Recovery

A similar picture of recovery is given by Costantino Bresciani­Turroni, in his book The Econom­ics of Inflation (1931) . This is the most thorough and the most fa­mous of the books written on the great German inflation. Bresciani-Turroni tells us that in the first months of 1924, when the in­flation was over, there was “a re­markable increase in wages,” and that this “big increase in the av­erage income of workers was the combined effect of the rise in wage-rates and the fall in unem­ployment” (p. 396). And in the final summary paragraph of the book he writes:

“At first inflation stimulated production because of the diver­gence between the internal and external values of the mark, but later it exercised an increasingly disadvantageous influence, disor­ganizing and limiting production. It annihilated thrift; it made re­form of the national budget im­possible for years; it obstructed the solution of the Reparations question; it destroyed incalculable moral and intellectual values. It provoked a serious revolution in social classes, a few people ac­cumulating wealth and forming a class of usurpers of national prop­erty, whilst millions of individ­uals were thrown into poverty. It was a distressing preoccupation and constant torment of unnumer­able families; it poisoned the German people by spreading among all classes the spirit of speculation and by diverting them from proper and regular work, and it was the cause of incessant political and moral disturbance. It is indeed easy enough to under­stand why the record of the sad years 1919-23 always weighs like a nightmare on the German peo­ple.”

The lesson is clear. We should stop our own inflation now. Not some time in the future, but now. We should not slow down the rate gradually over the years, but stop inflation now. And this means, to repeat, two main measures: first, balance the budget, balance it wholly by slashing expenditures and not at all by raising taxes; and second, stop expanding bank credit and printing paper money.

Some other measures will be necessary to make these two basic steps effective, but I will mention only one of them, because of its overriding importance. We should repeal all the labor laws, passed over the last forty years, that build up the power of labor un­ions, strengthen the extortionate strike-threat system, and in effect force employers to capitulate to labor union demands. This means the repeal of the Norris-Laguardia Act, of the Wagner-Taft-Hartley Act, of the Davis-Bacon Act, and probably a nest of others.

Winston Rowe and Associates is a business consulting firm. They are not a lender and do make loans of any type or credit decisions in connection with loans of any type

Commercial Real Estate Mid-Year 2022: The Big Slowdown

Winston Rowe and Associates

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.

Property Performance Supported by Demographics and Jobs

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.

Why the U.S. Economy Won’t Fail

Why the U.S. Economy Won’t Fail

In fact, the U.S. economy is doing fine. Here are the top 10 reasons why it won’t collapse. Included are rebuttals to the negativists’ claims.

The U.S. debt is $21 trillion, more than the economy produces in a year, but although the debt-to-GDP ratio is in the danger zone, it’s not enough to cause a collapse. First, the United States prints its money. That means it is in control of its currency.

Lenders feel safe that the U.S. government will pay them back. In fact, the United States could run a much higher debt-to-GDP ratio than it does now and still not face economic collapse. Japan is another strong economy that controls its currency. It has had a debt-to-GDP ratio above 200 percent for years. Its economy is sluggish but in no danger of collapse.

The United States won’t default on its debt. Most members of Congress realize a debt default would destroy America’s credibility in the financial markets. The tea party Republicans in Congress were a minority that threatened to default during the 2011 debt ceiling crisis and in 2013.

China and Japan are the biggest owners of the U.S. debt, but they have no incentive to create a collapse. The United States is their largest market. If it fails, so do their economies. Furthermore, China is not selling all of its dollar holdings. It has remained above $1 trillion since 2013. For more, see U.S. Debt to China.

If anything, the dollar would slowly decline instead of collapse. It fell 40 percent between 2002 and 2008. It has gotten stronger since then because of the financial crisis. Investors flock to ultra-safe U.S. Treasury’s and the U.S. dollar as a safe haven.

The dollar won’t be replaced as the world’s global currency. The doomsayers point to gold, the euro, or Bitcoin as a replacement for the dollar.

China has said it would like the yuan to replace the dollar. It’s true that the dollar’s value is supported by its role, but none of these other alternatives have enough circulation to replace the dollar.

The Fed’s quantitative easing program and low fed funds rate won’t cause hyperinflation. If anything, these programs have created a liquidity trap.

That’s when people, businesses, and banks hoard the extra cash instead of spending or lending it. The real cause of hyperinflation has been debt repayments to fund wars.

The stock market hit new highs in 2018. Stock prices are based on corporate earnings, so that’s a sign of business prosperity.

Consumer confidence hit an 18-year high in 2018. Consumer spending drives almost 70 percent of the economy.

Economic growth is slow but stable. Since the Great Recession, the economy has grown between 1.5 – 2.7 percent per year. According to business cycle theory, a bust only occurs after a boom. That’s when GDP is more than 3 percent. It hasn’t been that high since 2005 according to a review of GDP by year.

President Obama added to the debt to get us out of recession, not send us into collapse. Many of these doomsters accuse Obama of deliberately increasing the debt to destroy the United States.

What It Means to You

Before you run out to buy gold or stock up on canned goods, do two things. First, read the articles linked in the 10 points above. They will give you the facts the naysayers ignore. Or read “How the U.S. Economy Works.”

Second, see what a real economic collapse looks like. On September 17, 2008, the U.S. economy almost collapsed. That’s when companies pulled out trillions of dollars from money market accounts. It would have created a severe cash crunch had it continued.

The nation’s trucking industry would have ground to a halt. Gas stations would have gone dry. Grocery stores shelves would have gone empty. But those things didn’t happen because the Federal Reserve prevented the collapse. It guaranteed money market accounts and restored confidence.

Iceland’s economy collapsed in 2008. Its banks had defaulted on $62 billion of foreign debt. They had used the debt to finance foreign acquisitions. But Iceland’s entire gross domestic product was only $14 billion. When the banks defaulted, foreign investors fled. Within a week, the krona lost half its value. The stock market dropped 95 percent. That’s when almost every business in Iceland went bankrupt.

Although the Great Depression wasn’t a collapse, it was close. GDP fell by half. Global trade dropped almost two-thirds. Unemployment was 25 percent. What caused it? Government actions turned a recession into a depression.

First, the Fed used contractionary monetary policy like raising the fed funds rate to protect the gold standard. Congress cut back on spending as soon as the New Deal got the economy back on its feet and that contractionary fiscal policy brought back the depression in 1937. It didn’t end until the military build-up to World War II, but we aren’t headed for a second Great Depression.