Rates and the Real Estate Recovery
Real estate has had some difficult times in the last few years in Southern California. After years of unbridled growth and a steady and virtually unrelenting rise in the prices of homes and income producing residential and commercial property in the mid- to late 80's, real estate prices leveled off or fell in the early '90s as the economy in Southern California ground to a halt.
For the past several years, job growth in high-paying positions and commercial space has declined. The restructuring of the military, the virtual obliteration of the defense industry, the lethargic construction industry, the lackluster results in the in the tourism industry, and the overall sobering effect felt by all businesses of record tax increases in the early '90s at the state and federal levels, have combined to create very low demand for many types of real estate.
The number of foreclosures and loan modifications have reached record levels in the last three years. Real estate prices that were reaching new highs in the late '80s were suddenly available from desperate lenders for 30-50 percent discounts from the last acquisition price.
Savvy real estate investors have been quick to take advantage of these last opportunities. In the past few years, Real Estate Investment Trusts (REITs) have formed at record levels to take advantage of the unique opportunity to acquire real estate at prices that had not been seen since the '70s. They have also taken advantage of the historical lows in the cost of raising capital.
Wall Street even found a new investment vehicle to replace the mutual fund as the darling of the investment community. Almost every major Wall Street investment firm formed their own real estate "vulture fund" that acquired large pools of delinquent or non-performing real estate loans from lenders anxious to dispose of unwanted real estate assets at significant discounts. These funds received significant publicity, positive and negative, as they would then sell of certain select real estate assets for quick, and sometimes obscene, profits.
Real estate investing has never been quite the same since the fundamental shift caused by the elimination of many of the tax advantages for real estate owners in the mid-'80s tax reform. However, combine these amazing low prices with historically low interest rates, and real estate began to make sense again as investors could actually buy property that would generate competitive cash-on-cash returns. Money began to flow rapidly from the overbought mutual fund market and other investments into the REIT and Wall Street real estate funds at record levels. Major Fortune 500 firms, like GE Capital, have also been significant players.
However, after reaching 20-plus year lows, interest rates have rapidly increased as Alan Greenspan and the Federal Reserve have increased the federal discount rate seven times in the last 14 months in their almost single-minded effort to keep the economy from overheating and to achieve their stated goal of a "soft landing."
While the Federal Open Market Committee, comprising the seven Federal Reserve Board Governors and five of the 12 Federal Reserve regional bank presidents, voted in late March to hold the federal discount rate level, the committee is very divided. One Federal Reserve Board Governor even allegedly resigned due to the failure to raise interest rates even higher.
The most recent increase was February 1 and that additional .5 percent increase brought the federal discount rate to 5.25 percent. The stated goal of the Federal Reserve Board is to ensure that the economy has a slower, yet sustained growth of 2.5 percent per year without inflation and they believe that heir strong action is justified.
Not everyone shares this opinion, particularly the owners of real estate with adjustable rate home loans. Both home owners and commercial income property owners have seen the low teaser or start rates rise dramatically on their adjustable rate loans over the last 12 months. Of course, the negative impact on their monthly cash flow has been significant.
Ironically, many economists had based their predictions of a strong national economic recovery, at least in part, to the broad refinancing boom over the past 36 months that provided most owners of real estate with hundreds of dollars of monthly savings in interest costs that could be used to address the pent-up consumer demand for durable goods.
The broad resurgence in spending for vehicles, airplanes, major appliances, and other big ticket items seems to ratify this correlation theory. However, recent reports of durable goods are showing signs of dropping as the tighter credit markets are beginning to have an impact.
With the "cost of money pendulum" swinging back the other way, there has been an equally dramatic impact on real estate, namely the costs of financing and owner's cash flow. Bank officials indicate that they have already seen a noticeable decrease in real estate loan application. Real estate appraisers and mortgage brokers can also testify to the effect of rising interest rates on the fledgling recovery of real estate in California.
New owners of properties have been hit hard and an illustrative example is the purchaser of a large commercial office building who financed their acquisition early in 1994 with an adjustable rate loan indexed to the prime rate. With the prime rate indexed at six percent, the state rate for this $1 million lean was a modest eight percent. However, a series of almost monthly loan rate increases have pushed the owner's interest rate to its current level if 11.5 percent, with further increases looming if the Federal Reserve increases the discount rate when they meet again on May 23.
What effect does this 3.5 percent rate increase have on the annual cash flow to the owner of this commercial building? Well, their annual interest costs have risen from $80,000 to $115,000, or an increase of over $2,900 per month. This amounts to a 43.75 percent increase in the interest expense for this building in just over one year!
In the mid-80s, the owner would most likely be able to pass this cost increase along in the form of higher rent, but not in today's competitive rental market. Commercial office rental rates that were $1.50-$2 per square foot just four to five years ago are now at effective rates 50-60 percent lower. There is also the negative impact of tighter credit and higher financing costs when commercial building owners (or even their tenants) have to borrow finds to complete extensive tenant work. To make matters worse, owners are also seeing an increase in tenant delinquencies and defaults.
Clearly the rise in interest rates is having a significant impact on the real estate recovery in Southern California which was already tentative at best. Sales in the next 12-18 months will better show the effect that rising interest rates have had on real estate values. Surprisingly, there are still many buyers for distressed real estate, but the lack of reasonable financing us already chasing some of the buyers out of the marked and causing others to limit their acquisitions.
Despite what many real estate industry observers claim that Southern California's income-producing real estate has hit bottom and the market will continue to improve, I believe that due to rising interest rates and continued stagnant job growth, we are truly facing the possibility of a second wave of real estate foreclosures.
Many of the properties that were acquired from lenders within the past two years may be able to survive, if they were purchased at tremendous discounts or if the buyer used minimal debt financing. However those few commercial property owners have been "survivors" and have been able to avoid foreclosure or loan modifications for far, may be pushed over the edge with the recent interest rate increases.
Of course, those long-term owners of properties are being hammered by the new competition with much lower debt obligations as well. For example, a purchaser of a large commercial building in the mid-80s will find it increasingly difficult to match the rates and terms being offered by a similar building across the street that was purchased from the RTC for 50 cents on the dollar and minimal financing. Thus, I believe that we witness "a second wave" of foreclosures and loan modifications as the price wars take their toll.
Just ask the owners of commercial property on adjustable rate loans what effect rising interest rate loans have had on their real estate holdings!
From the June 1995 Issue of the San Diego Commercial Association of Realtors®'s Commercial Reporter, pages 1-3
Robert Griswold and the Real Estate Today! radio show strongly support the intent and the letter of all federal and state fair housing laws. As a reminder to all owners and managers of real estate, note that all real estate advertised is subject to the Federal Fair Housing Act, which makes it illegal to advertise "any preference, limitation, discrimination because of race, color, national origin or ancestry, religion, sex, physical disability, or familial status, or intention to make any such preference, limitation or discrimination." Additional state and/or local fair housing laws may also apply. Be sure to inform all persons that all dwellings offered or advertised are on an equal opportunity basis.
Revised and Updated - Wednesday, April 26, 2006
Robert S. Griswold, CRE, CPM, CCIM,
PCAM, GRI, ARM
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