Although the Federal Reserve voted to raise rates another .25% at its second meeting of the year, there was a silver lining in the announcement.
In his opening statement, Fed Chair Jerome Powell indicated significant rate hikes may not be needed going forward, which will bring much needed relief and stability to the commercial real estate market.
Investors were bracing for a .50% bump following Powell’s congressional testimony several weeks earlier during which he implied a larger rate increase might be warranted in response to stronger than expected economic indicators, especially in the labor market. Additionally, the annual inflation rate for February was 6%, still higher than the Fed’s 2% target, but below the peak of 9.1% in June.
Cause and Effect
The Fed’s revised Summary of Economic Projections released in tandem with the rate announcement left the projected median fed funds rate at 5.1% at the end of 2023, meaning the central bank is close to reaching its terminal rate since the new fed funds target range is between 4.75% and 5.00%. If this holds, only modest increases may be on the horizon.
Addressing the banking crisis, Powell stressed that all deposits are safe and that the banking system is sound and resilient with strong capital and liquidity. Silicon Valley Bank was an “outlier” in which management exposed the bank to significant liquidity and interest-rate risk without hedging it. As a result, the bank was vulnerable to a rapid and massive bank run by a large, concentrated group of connected depositors.
Mortgage Resets and Mortgage Maturities: Why Real Estate Type Matters
Fortunately, the economic fundamentals of New York City have been on the rise despite inflation, interest rate hikes and bank closures. However, mortgage maturities and mortgage resets in this environment will affect each asset class differently.
As outlined below, stronger asset classes should be able to withstand the headwinds facing the industry, while owners of weaker asset classes may need to make harder decisions moving forward.
Stronger Asset Classes
- Predominantly residential rental free market properties, small and large, are usually considered an inflation hedge, so we expect the top line to grow somewhat with or higher than inflation in the long run. In addition the perpetual supply constraint in New York City almost guarantees long-term growth in this sub-segment of multifamily.
- Affordable housing, specifically Project Based Section 8 properties and buildings that can lend themselves to affordable preservation execution will remain in demand. These assets are attractive because they offer allowable budget based increases, or OCAF (operating costs for Project Based Section 8), coupled with the ability to receive a tax abatement and/or subsidies. In addition, private equity, Mission Driven Capital has moved into this space in the past decade with interest accelerating since the start of the Covid-19 pandemic.
Weaker Asset Classes
- Office buildings, primarily Class B and C office buildings in transition, which may be partially vacant, will be challenged. We examined options for these assets in a previous Forbes article. However, some Class A office assets are now beginning to suffer from the short-term effects of mortgage resets and maturities combined with higher vacancy rates and lower values as well. The New York City Metro area (New York, New Jersey and Pennsylvania), will see approximately $15.7 billion of loan maturities on office buildings by year end 2024, according to a Goldman Sachs analysis based on data from Trepp.
- Condominium projects in the middle of construction may be at risk. The spike in interest rates has led to much slower sellouts and lower pricing. As a result, construction loans, which are usually floating rate, increase the immediate carrying costs in addition to the challenge to pay them down (through the sale of units) or refinance out of them. In Brooklyn, a New York City borough with a population of 2.6 million, condo sales in 4Q22 fell 19.2% year-over-year to 846, according to Douglas Elliman. During the same period, listing inventory fell 12.5% to 977 units, which is only a 3.5 month supply, compared to a 12 month supply in 4Q18.
- Predominantly rent stabilized property valuations have suffered as a result of higher borrowing costs as well as the Housing Stability and Tenant Protection Act (HSTPA) of 2019, which prevents adequate rent increases for stabilized units. Therefore, mortgage resets and maturities will strongly affect this sub-segment of the multifamily market, a topic we explored in detail in a previous Forbes article. Most vulnerable are the approximately 795 rent stabilized buildings with 41,000 units acquired between 2016 to 2019 before HSTPA was passed, according to an Ariel’s analysis of sales of buildings with over 10 units. The fundamentals for these assets have changed drastically not only because of market conditions but because of HSTPA.
Near Term vs. Long Term
Our Capital Services team has been fielding calls from clients concerned about the bank closures and reaching out to lenders. It’s reassuring that the recent turmoil in the banking sector isn’t the result of sour commercial real estate loans or questionable underwriting, but macro issues that are working their way through the economy.
What we have seen is a few select banks stepping up and filling the void left by Signature Bank. “Long-term, we believe other lenders will take market share, mostly in the safer multifamily asset class (regulated or not),” said Matt Dzbanek, Senior Director of Ariel’s Capital Services Group. “However, in the short-term, valuations and cost will suffer. We remain very bullish on New York City’s fundamentals and always have different financing options even in this tougher environment.”
Dzbanek said he remains optimistic, noting that most lenders he’s working with are moving through deals at a diligent pace. “We’re getting deals done,” he said. “We’re in the middle of a closing as we speak and signing multiple term sheets every week. So, as of now, the biggest thing we’re seeing is maybe proceeds pulled back a little bit or maybe a higher rate. But so far, lenders still have a good appetite for New York City real estate.”
Dzbanek’s pipeline is a healthy balance between both acquisition and refinance opportunities. In this climate he is advising clients to run a process and identify multiple lenders for each project to mitigate risk. “When there is uncertainty in the market, it’s even more important for borrowers to be exposed to as many options and banking relationships as possible,” he said.
While there will be volatility in the short-term, this crisis will firm up a new bedrock for New York City commercial real estate lending. We believe that this period will be an opportunity for new lenders to step up and gain market share and increase their presence in New York City.