Unsurprising to many, the Federal Open Market Committee announced April 27 that it would not raise interest rates. While the housing and job markets continue to recover in 2016, the overall U.S. economy has experienced sluggish growth, with GDP increasing by an annualized rate of just 0.5 percent in the first quarter, lower than the 1.4 percent GDP increase in fourth-quarter 2015. The Fed’s decision largely reflects this sluggish economic growth, as well as inflation being below the FOMC’s 2 percent objective, and has led many to question whether the committee will follow through on the two interest rate rises it’s projecting for the rest of 2016 (revised down in March from the four rises it said would take place in 2016).
There is also some question of how the low interest-rate environment is impacting the real estate industry. While this scenario can attract an influx of capital into the industry, there’s the possibility that too much capital into an asset class can result in overbuilding or overpricing—especially for multifamily. MHN had the chance to speak with Warren Higgins, head of mortgage banking for commercial real estate giant Berkadia, to discuss the Fed’s decision and how low interest rates are affecting multifamily and commercial real estate financing.
MHN: Why do you think the Fed decided against raising interest rates?
Higgins: I think what they’re seeing, and we’re seeing, is continued weakness in not only the U.S. economy but probably the global economy even more so. The idea of raising interest rates based on an accelerating economy and potential rise in inflation doesn’t seem to be bearing fruit, so they need to pause in order to allow the economy to get its feet moving a little bit.
MHN: How does this decision impact the real estate industry? Are there certain sectors you think will be more impacted than others?
Higgins: In general, I would say low interest rates are continuing to attract investment capital into real estate. Real estate is an investment class that generally offers higher yields than fixed-income securities, and to a certain extent, the stock market, which is variable. As long as interest rates are relatively low, money will continue to flow into real estate both from U.S. internal investment dollars as well as foreign capital moving into the U.S. So low interest rates are a boon to commercial real estate in the U.S. as far as attracting investment dollars.
As far as different investment classes, we still see multifamily as being particularly attractive. As of yet, we’ve not seen any softening in the multifamily market, whereas places like office, industrial and retail tend to be sluggish if the economy is sluggish. Multifamily has not suffered from that same sluggishness and continues to be robust. Multifamily continues to attract a lot of investment dollars, to the point where investment yields in multifamily are pretty low, and we’re probably at an equilibrium where there’s not an excess of dollars going into multifamily but there’s more than enough. The issue going forward would be when does that influx of money into multifamily cause overbuilding and over-investment? We’re getting close to being concerned about that.
MHN: Why do you think multifamily hasn’t been as affected by the volatility in the U.S. or global economy?
Higgins: People always need to live somewhere. If they’re out of work, they don’t need an office, there’s a limit to how much shopping needs to be built for them and the demand in a sluggish economy for office, industrial and retail space declines. But most people still need to live somewhere and we’re still growing additional households. So the pressure on multifamily is a little less. We’re also seeing households shift around, so we have a lot of urban multifamily, which is being built to address trends for Millennials and Empty Nesters.
MHN: Are there any challenges that come with the low interest-rate environment for the real estate industry?
Higgins: I think one challenge is if you have a lot of capital flowing into an asset class, you can have overbuilding. I’ve seen that over time in my career. The good news is, I think some of the bank regulation out there discourages construction loan investment, and we’re not seeing a lot of capital flowing into construction lending, so the odds of overbuilding are diminished. But the other risk is even if you don’t have overbuilding, you have overpricing or the asset class becomes a bubble. There are legitimate concerns about whether commercial real estate is overpriced now.
Multifamily would be the asset class you’d be most concerned about with overbuilding because it has the greatest demand and amount of capital flowing into it. There’s a significant amount of multifamily being built, but not at levels that most people are concerned constitute overbuilding. But that bears watching, and in some markets they might be temporarily overbuilt.
The places where there’s concern about overbuilding would be in higher-priced, Class A urban multifamily. That’s where you’re seeing the highest concentration of development and where you’re most likely to see either overbuilding or the pricing is getting out of hand in terms of what the projected rents will be.
MHN: What do you think is the probability of the Fed raising interest rates this year?
Higgins: I personally am pretty skeptical about further interest rate rises this year. I would be very surprised to see two. I don’t see anything in the marketplace domestically that indicates the economy is gaining steam, which I think is a precondition to interest rate rises. I’m certainly not an international economist, but I don’t necessarily see anything happening elsewhere in the world that would say the world economy is going to pick up steam as well. So I would not predict that they’ll actually follow through on two interest rate bumps this year. I think the general sentiment in the real estate business is that long-term interest rates will stay relatively low throughout 2016.
MHN: What are other trends or challenges you see coming up in the real estate finance realm this year?
Higgins:When you look at the different financing sources, the first quarter did see a tremendous stress in the CMBS market with the effects of regulation as well as investor appetite. Volumes were way off and the market was almost shut down at points during the first quarter. After a bit of struggle trying to figure out how to deal with the various regulations that either have gone into effect or will be coming into effect by year-end, it seems like the CMBS market is stabilizing and deals are getting done now. They’re getting done in ways that are probably a little more restrictive from an underwriting standpoint and a little higher from a pricing standpoint, so the market seems to have stabilized. That’s a good thing, because there was a fear that the CMBS market could potentially collapse.
Because of the dearth of CMBS lenders in the first quarter, the life insurance companies had kind of free rein and went wild, and most life companies are well ahead of their production goals. We may see them slow down a little bit for the remainder of the year.
The agencies had a lot of carryover and they started out a little slow, but they have plenty of capacity and we are seeing a pickup, albeit with more disciplined credit underwriting standards because they don’t have the pressure from the CMBS lenders.
The banks seem to be active in the first quarter but may be slowing down a little as they start to feel some regulatory pressures and pressures from having so much of their capital tied up in real estate lending, particularly multifamily real estate lending.
MHN: Speaking of lending, do you think the trend of lenders becoming more selective will continue?
Higgins: Yes, and I think that’s largely a good thing. At various points in the last couple of years, underwriting standards have deteriorated to the point of being a little too aggressive. We’re seeing lenders reel in their underwriting standards a bit. In the CMBS market, it’s being imposed on them by regulations and investor demand for their paper. On the life company side, it’s being driven by lack of competition from the CMBS side. On the agency side, it would be driven in part by their regulator putting an upward limit on how much they can lend. And the same thing with the banks: It’s largely being driven by regulatory pressures.
I think, again, low interest rates are making real estate an attractive investment vehicle, regulatory pressures are maybe keeping an upward limit on how much money will flow in from the debt side, and that’s probably a good thing.
MHN: What do you think prompted this trend of lenders becoming more selective?
Higgins: I think in the first quarter, it came from the CMBS market pretty much shutting down. That’s a huge hole and that was a withdrawal of enough capital from the marketplace that the remaining lenders could be more selective.
MHN: Are there any other trends that you think are emerging in the multifamily industry?
Higgins: I don’t think 2016 feels a lot different to me than 2015, with the possible exception that it seems to me like underwriting standards in 2016 are a little more disciplined. I think if you look at what happened in 2015, CMBS lenders and perhaps the agencies got very aggressive at various points of time, and that turned out to be not a profitable exercise for them. So in 2016, it feels like people have learned their lessons, and while they’re trying to get their money out, they’re trying to do it in a little more disciplined fashion so they don’t lose money. Some of the lending done in 2015, particularly in the second half of the year, turned out to be not very profitable, and lenders don’t want to make that mistake.
For the commercial real estate industry and for Berkadia in particular, 2016 looks to be a very strong year. For those of us that have a crystal ball, we’re still hopeful that the trends we saw in 2015 and are experiencing and project through 2016 will continue into 2017 because there continues to be that wave of maturities that started in loans made in 2007. So the next 18 months look to be very strong for the industry, but beyond that the picture becomes a little murkier as you see a falloff of loan maturities, which could affect overall volumes.