LOS ANGELES—A moment that financial markets have anticipated is finally upon real estate investors and owners: The cost of borrowing may finally be rising significantly as the Federal Reserve takes measures to reduce the money supply, and interest rates respond, Eastdil Secured President Michael Van Konynenburg told an audience of 800 real estate professionals in Los Angeles on Sept. 9.
The markets remain flush with liquidity, with banks, life insurance companies and even the commercial mortgage-backed securities market fully engaged in real estate lending. But financing costs are 0.5 percent to a full 1 percent higher than they were six months ago, he said.
His customers have peppered him with versions of the same three queries as rates have taken “a pretty material move” upward in the last 60 days, Konynenburg said. They want to know how fast he believes the central bank will “taper” its $85 billion a month in purchases in the bond and mortgage-backed-securities markets and how capital markets will change as a result, he said. They want to know if current capitalization rates are sustainable, particularly in light of rising borrowing costs. And, they want to understand if the rate increases will be offset by economic and rental growth.
Van Konynenburg was lead keynote speaker for the half-day annual Allen Matkins real estate convocation at The Beverly Hilton. Eastdil is a capital markets and real estate company that does business from 11 U.S. offices including San Francisco and L.A. as well as Hong Kong and London. Its services include traditional investment property sales coupled with expertise in debt placement, investment banking, private equity and structured joint ventures, mortgage loan sales and structured finance. The company manages some of the Bay Area’s most high profile and valuable property sales.
The Federal Reserve has been explicit about its intent to keep the money supply expansive as long as the unemployment rate remains above 6.5 percent and inflation remains below 2.5 percent, Van Konynenburg said. Based on the current labor participation rate of just more than 63 percent and a current job creation rate of about 150,000 jobs a month, Eastdil projects it will be two-and-a-half years before the unemployment rate reaches 6.5 percent.
Other scenarios premised on a rising labor-participation rate and 200,000 new jobs a month produce outcomes from three years to as long as seven-and-a-half years. “The Fed has a long way before it meets this target,” he said, and inflation appears to remain very tame.
Based on measures such as loan-to-deposit ratios, banks also have lots of money still to lend. In 2007, banks had lent 93 percent of their deposits. Today that ratio is closer to 70 percent, and there are $10.8 trillion in deposits. “We view this as very bullish to the system,” he said.
Eastdil projects $85 billion in commercial mortgage-backed securities lending this year, about the same as 2004. Life insurance companies are expected to originate an estimated $60 billion in mortgages in 2013. Insurers have begun to step back from instruments with longer-term maturities and have adopted “a growing willingness to lend on transitional assets,” he said. With little demand from corporations and consumers to borrow, banks should be turning to real estate.
“We are starting to see some growing interest out of Asian banks and from some European banks,” he said. “In our view, the rate volatility starts to trickle out of the system. We will see financing costs coming down in the next couple of months.”
One bearish signal has been the decline in stock values of public real estate investment trusts by about 15 percent, a decline that has put “public-market values below private-market values,” he said. That “could be a bad prediction.”
Yet, Eastdil believes REIT prices have overcorrected. Hotel REITS have been the least impacted by the decline with industrial and office REITS affected somewhat more. Retail REITS have seen stock values drop by close to 20 percent, he said. “Retail has longer-term leases, so they are more interest-rate sensitive and more penalized by the sell off.”
Real estate on the thriving American coasts has benefitted tremendously from the low interest-rate regime maintained by the Federal Reserve, largely to help locations far from the Bay Area. In 1994 and 2004, the last times the Federal Reserve began to tighten money supply, real estate suffered in the short term and then did well as the larger economy recovered, improving rents and occupancies, he said. “Think 2005 to 2007. It wasn’t the end of the world that some people seem to view it as right now.”