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The Impact of Interest Rate Hikes on the Real Estate Market

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The Federal Reserve will likely raise its target federal funds rate by another 0.75 percentage point as early as next week, according to news reports. Fed officials have already raised benchmark short-term borrowing rates 1.5 percentage points this year, including June’s increase of 0.75 percent, the largest hike in nearly three decades. Within this context, we are seeing a real estate market that is slowing down and in transition. While there are pockets that are doing well and will likely continue to do well, there is increasing distress and uncertainty across the industry.
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In response to the market slowdown, we are seeing two perspectives. One is that this is a temporary slowdown to adjust to higher interest rates and to do a reset on pricing. This view believes the slowdown will last a few months and the market will get back on track before the end of the year. 

The second view, which I share, is that this is the beginning of a longer-term slowdown which will contribute to and be impacted by an overall economic slowdown as a result of higher rates, continuing supply shortages, and obstinate inflation. This view anticipates a recession beginning sometime in 2023. 

What follows is a summary of specific observations after talking with colleagues and industry experts:

  1. Mezzanine defaults have already begun. These loans pose the most risk to borrowers and the broader industry. 
  2. New construction is slowing down due to inflation and market uncertainty. New Construction loans are slowing and therefore so is new construction activity. Strong sponsors are able to put together the capital and debt for development deals but that trend seems to be coming to an end. Construction loans are also much lower leveraged requiring equity to put in more funds. There have been some defaults on construction loans as well as a greater level of claims and litigation.
  3. There is turmoil in the acquisition market. With increasing rates, deals are being repriced to lower purchase prices or they are dying. It has become more of a buyer’s market quite rapidly.  Some in the industry are seeking to sell their long-held properties to maximize value before things get worse. There are still buyers who are willing to lower their price as a result of higher rates. However, banks are also pulling back and requiring lower leverage on deals. This has killed some acquisitions. One bank has stopped lending in commercial real estate for the rest of the year. Life companies are expected to continue to lend. In addition, the CMBS market has slowed considerably,  providing opportunities for our banks with strong borrower relationships. Debt funds have also slowed their lending activities. Overall the perception is that acquisitions are slowing down. 
  4. An increase in the price of interest rate derivatives has also killed some acquisition transactions. 
  5. Real estate entities that may be flush with cash are in a good position to make opportunistic purchases as they are not as reliant on high-leverage loans. Entities that rely on high leverage loans are slowing their activities.  
  6. Foreign investment in income-producing real estate has been fairly robust. During uncertain times, United States real estate is viewed as a safe haven internationally. This investment trend somewhat mitigates the decline in investment by domestic entities.
  7. The retail market is facing many challenges. There is decreased demand due to online shopping, less foot traffic, and a recent lowering in consumer spending. There are supply disruptions. Lower revenue is combined with increasing expenses due to inflation in general and rising labor costs. ArentFox Schiff Partners George Angelich and Brett Goodman have written a comprehensive article about distress in the retail industry in anticipation of an increase in bankruptcies. 
  8. Borrowers are rushing to lock in interest rates as fast as possible. This creates intense short-term activity but it portends an eventual slowdown.
  9. As homes become more expensive and with higher rates, more people are renting. This has created a lot of demand in the multifamily market. This should remain a relatively strong sector. However, the residential sector is beginning to struggle and is anticipated to face distress. 
  10. Voluntary refinancings in all sectors have slowed significantly, although some stronger positioned clients are now rushing to refinance before rates get even higher. This trend mitigates to a certain extent the pulling back of domestic entities. 
  11. For obvious reasons, the office sector is undergoing a challenging transition as tenants are reassessing their needs going forward and as costs are rising. Tenant improvements are becoming more costly with landlords resisting the high price needed to induce tenants to lease space. As tenant leases are expiring, tenants are generally looking to shrink their space. Staying with the existing landlord is an option being explored. 
  12. The value of industrial properties seems to be holding up so this sector continues to do well in the acquisition space. 
  13. The manufactured housing space continues to be active as is affordable housing, particularly where either HUD, state, or municipal subsidies are available. 
  14. Hospitality has been strong particularly due to leisure travel. Entities that are not dependent on debt are doing very well. However, it is anticipated that as expenses and wages increase, hospitality entities dependent on bank debt are likely to slow down. In addition, as consumers tighten their spending due to inflation it is anticipated that leisure travel will decline resulting in lowered demand for hotels. 
  15. New high-yield municipal bond transactions have come to a near halt because deals do not underwrite at higher rates. Struggling revenue combined with higher expenses due to inflation is creating distress in the senior living and student housing sectors. 

In summation, inflation, fueled by continuing supply shortages, the war in Ukraine, increasing wages, and oligopolies taking advantage of the situation to increase prices and market expectations, will be difficult to control. Supply shortages and disruptions will likely continue due to the Covid-19 pandemic, creating an inflation tenacity that will be difficult to conquer. This will likely result in continuing higher interest rates and financial uncertainty. A recession is likely, but it is uncertain when it will begin, how long it will last, and how deep it will be due to the unprecedented nature of the events we are experiencing.

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