Although there is plenty of fuel for future momentum in commercial real estate with ample liquidity on the sidelines, investment sales activity appears to be heading for a summer slowdown as market participants grapple with high borrowing costs in an environment rising interest rates. Concerns about an impending recession only add to the industry’s unease for the second half of 2022.
The Federal Reserve has set the stage for commercial real estate transactions to largely come to a halt in the coming months after raising its benchmark interest rate by 75 basis points on June 15 – the central bank’s first three .
a quarter-percentage-point increase since 1994—to combat inflationary pressures. Fed Chairman Jerome Powell also laid the groundwork at the June meeting for interest rates to rise to 3.4% by the end of the year from their current range. from 1.5% to 1.75%, a stark contrast to previous March economic estimates that the federal funds rate would reach 2.5% by the end of 2022.
“When the cost of capital changes so drastically, it usually causes a bit of pause and indecision,” said Michael Gigliotti, co-manager of brokerage firm JLL’s New York office. “It’s a very, very strange time that we’re living in now. Rates have gone up, and some people are starting to think rents might stagnate or drop, and are looking at that as an underwriting consideration.
Another factor behind a short-term slowdown in business activity is widening credit spreads, which have narrowed in the past when interest rates have risen. Gigliotti noted that the dynamic has been different this time around, largely due to global unrest stemming from tensions over Russia’s invasion of Ukraine, coupled with fears of a possible recession.
Chris J. Coiley, Valley Bank’s head of commercial real estate for the New York and New Jersey markets, said his team puts its loans through stressed underwriting scenarios aimed at determining whether borrowers will do well during economic times. difficult, in terms of specific projects. items such as reserves and material costs. He said borrowers will have to adapt to the new interest rate reality by bringing in more equity or using interest rate swaps.
“When you have rising interest rates, you’re going to have a downturn in the sales market,” Coiley said. “There is going to be more due diligence for investors.”
Despite tougher loan terms, Coiley expects his business to surpass last year’s volume of $2.8 billion after executing $1.8 billion in the first half of 2022, which he attributes to a continued strong appetite for multi-family transactions and higher mortgage rates that are enticing more renters to continue renting apartments rather than buying homes. He pointed out that even though higher interest rates create more challenges for sponsors, borrowing costs are still “pretty low” compared to 10 to 15 years ago and do not will not prevent doing business.
Will Nelson, director of home loans at Columbia Pacific Advisors, said that while CRE had seen “fundamentally healthy underwriting” in recent years, the long period of low interest rates meant that many borrowers had become accustomed to lower interest rates. cheap capital with very few equity investments or alternatives. investments needed for their projects. Columbia is better positioned in a volatile market than other lenders, Nelson said, because it provides debt-free equity only. That said, Nelson stressed that he will also be more selective over the next few months and focus largely on industrial and multi-family transactions.
Sponsorship remains essential, and high-quality sponsors will continue to close deals without too much conflict, Nelson said.
“For quality sponsors and really good deals, there is still capital,” Nelson said. “Some of the deals that you maybe shouldn’t have been able to do, you were able to do in the last 10 to 12 years, and I think those projects are going to be impacted, but you always have the option You might not like the terms so much.
Current market conditions make it even more imperative that real estate investment firms diversify the sources and locations of their transactions, according to Bentley Zhao, CEO of New Empire Corp. Zhao noted that New Empire’s current property portfolio in New York consists of between 30-40% all-cash buyers, which has prompted him to build more luxury properties “in growth-ready areas. to attract investors who can provide the necessary capital in cash,” he said.
New Empire, which has renovated and built more than 100 multi-family projects throughout New York City, recently acquired three Queens properties, including a 19,000 square foot development site at 58-01 Queens Boulevard in Woodside for 16, $2 million at the end of June. Zhao, who has worked with a longtime partner on numerous transactions, stressed that building this type of relationship will play an important role in current market conditions, as will the revitalized EB-5 investment program, which allows investors to obtain green cards. in exchange for the financing of real estate projects.
“Depending on the size of the project, the capital needed may depend on long-term relationships and more individualized investors,” Zhao said. “We expect to see EB-5 as an alternative source of capital as existing regional centers can now operate and accept new EB-5 investors.”
Zhao added that the EB-5 program will play an important role in helping bring foreign investment back to pre-pandemic levels with sales of investments in the New York area, which could help offset some of the economic barriers. current issues faced by market players. The program returned in May after nine months of uncertainty after its congressional authorization expired and a federal court struck down its latest rules. Changes to the program include mechanisms designed to better deter fraudulent schemes and improve national security protections on incoming capital.
Despite some of the market headwinds CRE is currently facing, observers are also feeling plenty of tailwinds given all the dry powder on the sidelines that could offset some of the inflation fears. Gigliotti noted that there is $248 billion of capital in closed-end funds that will need to be deployed next year. It is also quite possible that the world’s three largest sovereign wealth funds in Japan and Norway, which currently allocate only 1.6% of their holdings on average to real estate, will increase their investments in the sector, according to Gigliotti. High net worth individual investors are also very underweight towards CREs, he added.
“It’s liquidity that drives transactions, not the cost of capital, and we have more liquidity than ever,” Gigliotti said. “Unlike 2010 when liquidity dried up, these groups had the option of not investing in real estate because it was not a recognized asset class. This is no longer the case.”