Reining in Inflation
Monetary and fiscal policies are the primary tools to ameliorate a country’s economic challenges, such as inflation, sluggish growth, or high unemployment. Fiscal policy refers to a government’s taxing and spending functions, while monetary policy primarily sets interest rates and the total money supply. Fiscal policy has critical economic implications (the Federal deficit for the fiscal year 2023, which ended September 30, was $1.7 trillion).
Still, monetary policy may affect the bond, stock and real estate markets more immediately. Interest rates and their associated borrowing costs act more quickly on the direction of asset prices than fiscal spending. The Federal Reserve sets an interest rate policy that determines the rate for bank borrowing. The Fed’s interest rates also determine borrowing rates in other markets, such as home mortgages, consumer credit and corporate bonds.
The Fed began to raise its benchmark interest rate, the Fed funds rate, in 2022 due to extremely high inflation, which peaked at 9.1% (year over year) in June 2022, and pledged a hawkish “higher for longer” policy. The U.S. Consumer Price Index (CPI) was 3.4% in December 2023.
The Fed hiked rates 11 times from April 2022 until this past September, and the Fed funds rate now is between 5.25% and 5.5%, the highest since 2001. As a result of higher interest rates, inflation has declined considerably. The U.S. Consumer Price Index (CPI) rose 0.3% in December 2023, with the annual rate climbing to 3.4%. In 2022, inflation was 6.5%. The Fed has helped lower inflation while the economy remains resilient, i.e., featuring low unemployment and robust job creation.
The Fed’s preferred measure of inflation, The PCE price Index (personal consumption expenditures), was up 2.6% in December compared to the same year-ago period, down from its 7.1% peak in June 2022. However, it’s still slightly higher than the Fed’s target 2% annual inflation rate.
On a positive note, the Fed announced on November 1 that it decided to keep interest rates at current levels. That raised hopes that the Fed was close to the end of tightening rates and would cut rates in 2024. In addition, a crucial measure of salary inflation—unit labor costs—fell in the third quarter. The stock market rallied on the news, and bond yields declined.
Late in January, the stock market was disappointed when Federal Reserve Chair Jerome Powell announced that the Fed would probably not lower rates in March as widely anticipated. Powell emphasized that the Fed wants additional evidence that 2023’s decline in inflation will continue in the new year and begin to lower rates in May. Equity investors were disappointed, and the S&P 500 fell 1.6% on the day of the announcement. The yield on the Treasury declined slightly to close at 3.965%.
Hard-Hit Housing Market
Housing has suffered the most in real estate due to higher interest rates, though the situation is improving. The average U.S. interest rate for 30-year fixed-rate mortgages, which tracks the 10-year Treasury, was unchanged at 6.78% in the week ended January 26, 2024, according to data from the Mortgage Bankers Association. Mortgage rates barely budged in the last three weeks despite a small rise in Treasury yields. However, mortgage rates remain below a 23-year high of 7.90%, reached in mid-October 2023. Mortgage rates fell in late 2023 as the 10-year Treasury rallied on the hopes of a lower Fed funds rate.
Many homebuyers were not able to buy a starter home in 2023. Higher rates have also discouraged many homeowners with relatively low long-term mortgage rates—perhaps 3%-4%—from selling. This trend, in turn, has kept the supply of new homes at low levels.
Higher interest rates also caused a slowdown in existing home sales. In 2023, sales of previously owned homes fell 19% compared to a year earlier to 4.09 million, according to the National Association of Realtors (NAR). The inventory of existing homes on the market also declined. At the end of the third quarter, 1.13 million homes were on the market, an 8% decline from a year earlier. This represents the lowest sales figures since 2010.
Median existing-home sales price rose 4.4% in December 2023 from December 2022 to $382,600, the sixth consecutive month of year-over-year price increases, according to NAR. The inventory of unsold existing homes declined 11.5% from the previous month to 1 million at the end of 2023, equal to 3.2 months’ supply at the current monthly sales pace.
Another consequence is that consumers shopping for their first new home find it challenging to obtain a mortgage and may choose to continue renting until rates fall. The recent decline in the 30-year home mortgage may assist these buyers in 2024. Existing multifamily property owners may benefit from the trend because higher costs and delays for new construction may enable these owners to raise rents. Despite higher yields leading to elevated rates for consumer loans, the overall economy is chugging along with a robust labor market and vibrant consumer spending.
Impact on Commercial Real Estate
Commercial real estate prices fell as interest rates climbed from 2022-2023, but prices may have stabilized. Investors usually buy commercial real estate with a combination of debt and equity. As interest rates climb, the cost of purchasing or owning real estate may also rise. Almost 50% of commercial real estate debt is at a floating rate, according to the Mortgage Bankers Association. This means that rising interest rates can cause many private commercial property owners to be financially stressed.
To demonstrate the higher costs as interest rates climb, each 25-basis point increase in interest means an additional $25 per year in interest on $10,000 worth of debt. A $10 million loan equates to an additional $25,000 each year in interest payments. If interest rates climb 2.8 percent, it would add $280,000 per year in interest. According to data company Trepp, more than $2.2 trillion in commercial debt maturities is expected to be due between now and the end of 2027. Most owners of commercial mortgages pay interest only. The borrower must refinance or pay the entire principal when the debt matures.
The real estate research firm Green Street’s Commercial Property Price Index rose 0.3% in January. The all-property index—a pricing measure for institutional-quality real estate—is 21% below its March 2022 peak. The company wrote that “for most property types, pricing has probably hit its low. The office sector is an exception to that. Values in the office sector are expected to continue to decline.”
Unlike the 2008 crisis, when a lack of credit negatively impacted the value of all real estate assets, today’s downturn has negatively impacted some property categories more than others. Al Brooks, Head of Commercial Real Estate at JPMorgan, wrote that there is great demand for affordable multifamily properties while there is “some downward cyclical pressure on luxury properties.” Industrial real estate is performing well, but retail performance has been mixed, “depending on location and concept.”
Another sector to consider is hospitality. As demand continues to rise in the post-pandemic environment and supply remains limited, investors have potential upside in owning hotel assets.
Finally, office property faces headwinds as workers continue to work from home or are on hybrid schedules. The national office vacancy rate reached 19.2% in the third quarter of 2023, according to Moody’s Analytics. That is higher than the second quarter and approaching 1991’s historic peak of 19.3%.
Sales and transactions may be down due to higher interest rates and inflation. However, a new report from PWC, “Emerging Trends in Real Estate,” states that The Emerging Trends Barometer for 2024 registered its highest “buy” rating in 14 years due to recent and possible additional price declines. Now, prices may be at a more favorable price level. In addition, almost 50% of respondents to PWC’s survey expect cap rates to rise further in 2024-2025, which places downward pressure on values.
Strategies for Coping with Higher Interest Rates
As interest rates rise, it becomes more costly for owners and investors to obtain loans, which can cause a drop in commercial real estate investments. New construction may slow because developers do not want to shoulder the higher costs. Lending volume for commercial and multifamily properties in the fourth quarter of 2023 dropped 25% compared to a year earlier, though it increased 13% from the previous quarter, according to the Mortgage Bankers Association’s (MBA) Quarterly Survey of Commercial/Multifamily Mortgage Bankers Originations.
Nevertheless, real estate owners can take steps to cope with a period of higher interest rates. One is to obtain a long-term fixed-rate loan rather than a lower floating-rate loan. These floating-rate loans may have a lower initial rate, but the loan’s interest rate can climb as the prevailing interest rate rises.
Commercial real estate investors can pursue a few strategies as interest rates climb. For example, they can choose alternative financing, such as private equity or mezzanine debt. Pitchbook explains that mezzanine financing, “situated in a company’s capital structure between senior debt and common equity, has found new life” due to higher interest rates and tighter lending requirements imposed by traditional lenders. In fact, global mezzanine funds raised $30.1 billion in 2022, almost twice the amount in 2021 and the highest since 2016, according to PitchBook data. Mezzanine debt is usually not secured by real estate assets.
Another option is to select a seller financing arrangement. In this scenario, the property owner is the lender and offers financing to the buyer. Seller financing is advantageous for commercial real estate investors when interest rates are high or when traditional lenders impose stricter borrowing standards. This arrangement can offer more flexibility in the loan terms and even reduced upfront costs compared to traditional lenders.
In recent years, investors have also tapped real estate crowdfunding portals, such as CrowdStreet and Fundrise, to obtain financing. With these platforms, investors can participate in real estate investments, often with less capital than conventional methods. As a result, they have lower exposure to one particular property.
In addition, investors can research properties and locations experiencing strong demand and the potential for rent increases.
Conclusion
The Fed rate hikes in the past year and a half have lowered inflation, though inflation is still slightly higher than the Fed’s ideal level of 2% annually. The rate hikes have significantly impacted commercial real estate values and investment. However, a wise investor can choose many strategies to mitigate today’s higher interest rates, such as choosing alternative funding sources or seller financing. Today’s new technology also allows investors to make use of crowdfunding resources. Investors certainly have to be more creative and conduct careful due diligence. Nevertheless, there are profitable deals for investors who are prepared to cope with the current market conditions when obtaining financing.
About Caliber (CaliberCos Inc.) (NASDAQ: CWD)
With more than $2.9 billion of managed assets, including estimated costs to complete assets under development, Caliber’s 15-year track record of managing and developing real estate is built on a singular goal: make money in all market conditions. Our growth is fueled by our performance and our competitive advantage: we invest in projects, strategies, and geographies that global real estate institutions do not. Integral to our competitive advantage is our in-house shared services group, which offers Caliber greater control over our real estate and visibility to future investment opportunities. There are multiple ways to participate in Caliber’s success: invest in Nasdaq-listed CaliberCos Inc. and/or invest directly in our Private Funds.
Investor Considerations
The information contained herein is general in nature and is not intended, and should not be construed, as accounting, financial, investment, legal, or tax advice, or opinion, in each instance provided by Caliber or any of its affiliates, agents, or representatives. The reader is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances, desires, needs, and requires consideration of all applicable facts and circumstances. The reader understands and acknowledges that, prior to taking any action relating to this material, the reader (i) has been encouraged to rely upon the advice of the reader’s accounting, financial, investment, legal, and tax advisers with respect to the accounting, financial, investment, legal, tax, and other considerations relating to this material, (ii) is not relying upon Caliber or any of its affiliates, agents, employees, managers, members, or representatives for accounting, financial, investment, legal, tax, or business advice, and (iii) has sought independent accounting, financial, investment, legal, tax, and business advice relating to this material. Caliber, and each of its affiliates, agents, employees, managers, members, and representatives assumes no obligation to inform the reader of any change in the law or other factors that could affect the information contained herein.
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