By Jon Meyers
September 28 — When the Federal Reserve announces a rate adjustment, multiple market sectors take notice — especially lenders and developers in commercial real estate. Since 2015, the Federal Reserve has raised interest rates nine times, the most recent in September. Slowly increasing from almost zero percent, one more rate increase is expected before the end of this year.
So how can these rising rates be good? In my day-to-day work helping commercial real estate clients at the closing table, I am often asked what I think of the rising rates. Many are somewhat surprised when I tell them it actually can be a positive for the market. Historically, the Fed adjusts rates to correct and or stimulate the market. In my opinion, the rate increases we are seeing this year focus on market correction. This is forcing many lenders and developers to change their focus and strategy — all in a good way.
Rising rates make market players cautious. Lenders tend to reduce or even eliminate commercial real estate lending. At the same time, developers and investors are forced to closely evaluate their pipeline of projects. At the end of the day, gently rising rates provide a healthy market purge, ensuring that developers with viable capital stacks and liquidity move forward with projects that are actually meeting supply, and are not inherently unnecessarily speculative in nature.
On the other hand, developers that are pursuing “risky” developments in a frothy market that have expensive costs of capital will be weeded out. Yes, this can be painful for some investors, yet healthy for the market. I like to give the analogy of maintaining a forest. If the underbrush is not removed or allowed to burn naturally, it simply aggregates too much and becomes kindling for what is ultimately a massive, devastating fire. I think the parallel applies here. In order for the market to continue to grow and be healthy, funding for risky portfolios needs to be eliminated or indefinitely postponed.
The increases in interest rates are also causing commercial real estate developers to look at adding new investors other than banks. With large amounts of cash reserves, investors such as life insurance companies, are being targeted as likely partners. At the same time, prudent developers are seeking to recapitalize any assets with impending maturity dates while market trends take place in a macro sense. In some instances, developers are also choosing to increase debt service coverage ratios simply by reducing their loan-to-value ratio — meaning they are putting more equity into their deals. This strategy inherently lowers the risk of a deal, and will allow developers to better handle future corrections in the market.
In underperforming markets, I see that developers are simply waiting to see what the next two quarters hold, especially in the multi-family asset class.
Lenders and title companies are also proceeding but with added caution. Lenders are certainly tightening their lending standards and signaling to the marketplace that their appetite for some asset classes is waning. To date, most title companies are “business as usual.” However, I strongly recommend to colleagues in the title industry to diversify their client base. If a downturn in one market or asset class declines, it would not put their entire business in jeopardy.
Finally, I’m asked where we stand in the real estate cycle. Of course, knowing that exact answer would make anyone instantly wealthy. In real estate, the mantra is it’s an industry of 10-year cycles and nine-year memories. However, I see our current trend as a healthy market correction. In markets like Dallas and Denver, where real estate values have appreciated at higher than normal levels over the past few years, you will start to see a natural correction, but I see no reason for an imminent downturn when it comes to the economic evaluation of GDP growth, unemployment rates, corporate expansion, increases in productivity and more. Even with the repeal of certain safeguards put into place following the 2008 financial crisis, the economy still has necessary protections in place to avoid a massive downturn.
There’s definitely no need to panic. The focus should be on making smart adjustments to the market and taking the right risks. So for the vast majority of us in commercial real estate, we move forward with an added optimism that the recent interest rate upticks by the Federal Reserve will only make our industry and our economy stronger.
Jon Meyers is the co-founder and president of MBL Title company headquartered in Dallas, Texas. Prior to co-founding MBL Title, he led the Acquisition Team at Suntex Ventures, a Dallas-based private equity real estate fund that invests in resort destination markets with a focus on mixed-use waterfront properties. For direct inquiries, contact Jon at firstname.lastname@example.org.