Market Takes Fed Hike in Stride
Southern California’s commercial real estate markets are plenty strong enough to withstand last week’s half-point hike in interest rates by the Federal Reserve, and plenty of capital is available to finance commercial property transactions.
But the rate boost could further slow some segments of the market where the number of transactions already was in decline. It means investors will have to put more of their own money into deals and/or settle for lower returns on their investments.
That’s the consensus of commercial lenders, mortgage brokers and industry analysts, who agree that the underlying forces driving the region’s real estate market remain intact and that interest rates are still tolerable despite last week’s Fed hike.
“The fundamentals are still sound,” said Tom Whitesell, a senior vice president at the Santa Monica office of Anaheim Hills-based Fremont Investment & Loan.
Those strong fundamentals include a steady demand for office, industrial and retail space in the region, along with rising demand for apartments, according to Doug McEachern, head of the Western region real estate practice for Deloitte & Touche.
Strong real estate markets both here and across the nation have translated into new construction, renovation projects and investment sales that in turn have boosted total commercial real estate lending in the United States from $20 billion in 1995 to $163 billion last year, according to the Federal Reserve. In two of those years--1996 and 1998--the annual total of commercial mortgage lending doubled from the previous year.
Real estate experts expect commercial mortgage lending to continue growing, albeit at a slower rate than the torrid pace of previous years, because last week’s rate hike as well as previous interest rate increases have already slowed some segments of commercial lending.
The impact of last week’s rate hike “will take a month or two to filter through to the commercial mortgage community,” said Earl Webb, CEO in charge of the Americas for Jones Lang LaSalle, a brokerage and real estate services company.
“What is likely to happen [as a result of the rate hike], and is happening already, is that lending rates are going to go up. They have to,” said Webb, who said higher rates have already slowed the pace at which commercial buildings are being bought and sold.
Fremont’s Whitesell said lending had slowed somewhat for his company before last week’s hike, but he blamed the slowdown as much on Y2K concerns late last year as on previous interest rate increases.
Fremont is on track to originate $275 million worth of loans in California and $723 million nationwide for the first six months of this year, down from $320 million in California and $800 million nationally for the first half of last year, Whitesell said.
However, he added, business began picking up in the first quarter after a fourth quarter that was inordinately slow because people were “sitting on the sidelines” waiting out Y2K.
Commercial mortgage lending is down to about $110 million so far this year at Southern Pacific Bank in Los Angeles, compared with about $135 million at this time last year, according to Greg Kelsey, a vice president at the bank.
Kelsey said Southern Pacific, which specializes in loans for apartment buyers, closed about $350 million in loans last year. Projections for this year have been revised downward to $300 million. “We’d prefer to do more like $500 million,” Kelsey said.
Kelsey attributed the slowdown in lending to declines in both sales and refinancings.
He said plenty of potential buyers are still in the market for apartment buildings, but many owners are not inclined to sell because the apartments are providing a steadily rising, stable cash flow that would be hard to match in another investment.
“Their problem is, if they sell, what do they invest in?” Kelsey said.
Refinancings were already slowing before last week and will probably slow further with this latest rate increase, Kelsey said.
According to a report by Century City-based George Smith Partners on the impact of higher interest rates, the increases so far have caused some shifts in the commercial lending world, but the impact has not been sudden or dramatic. For example, developers are not postponing construction projects.
“If anything, [developers] might have to come up with a few more dollars in equity,” Smith’s report said.
A Smith subsidiary that places private debt “has seen a significant increase in the number of loan requests” as a result of rising interest rates that have prompted banks to become more conservative in their lending criteria, the report said.
“Many of these are deals that we potentially would not have had a year ago because the borrowers would have been able to go to their banks, but the banks have tightened their underwriting standards,” the Smith report said.
Both Smith and Whitesell of Fremont Savings & Loan pointed out that prices of commercial properties typically decline when interest rates rise, but that hasn’t happened yet.
“There seems to be a lag in the market,” the Smith report said. “Many sellers are unwilling to lower their prices and are willing to wait and see what happens.”
Whitesell explained that, in general, commercial property prices decline when interest rates rise because buyers who pay the higher rates can’t afford to pay as much for a property. That’s because buyers need to pay the mortgage and other expenses from the rental income generated by a commercial building and, if interest rates rise without a corresponding drop in prices, some buildings don’t generate enough income to cover the mortgage.
Like Smith, Whitesell and Nancy Sulse, Fremont’s regional manager, both see a lag between what’s happening with interest rates and what’s happening with prices.
Sulse said it’s understandable, however, that sellers aren’t lowering their prices yet.
“If a seller has four or five people lined up to buy a property, which is often the case today, he doesn’t see any reason to lower his price,” Sulse said.
Webb, too, mentioned the gap between buyer and seller expectations.
“The market has to take a while to digest the higher rates,” Webb said. ‘Typically, there’s a gap between seller and buyer expectations in periods like this before the market has time to adjust.”
Rising interest rates ultimately could cut into the capacity of properties to service mortgages, Whitesell noted.
“Last year, it was very easy for people to put 25% down on deals and pay the debt service with no problem. But today, with interest rates higher, buyers might have to put more dollars into a deal to get the same debt coverage,” Whitesell said.
Despite their concern about rising rates, lenders and industry analysts make it clear that the commercial real estate markets remain healthy.
“Compared with historic levels, interest rates are still reasonable,” Whitesell said. “We all got spoiled by the lower rates.”
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Money for Space
Commercial real estate lenders lent a total of more than $163 billion on office, industrial, retail and apartment properties in 1999, continuing a trend in which total commercial mortgage lending has increased substantially every year since 1995.
Total commercial real estate lending in the U.S.
(in billions of dollars)
Note: Multifamly consists of investor-owned buildings of five units or more.
Source: Federal Reserve
