Zain Jaffer is the founder and president of Zain Ventures, a family office that invests in real estate and proptech.
We have seen widespread coverage to various issues with both commercial and residential real estate recently. The problem varies depending on the geography and the type of property. However, as a partner at an investment firm that invests mostly in real estate and property technology startups, I’ve noticed that in general, real estate financing is now more complicated these days as opposed to the pre-Fed-hike low interest years.
The short-term outlook for commercial real estate is not good in many major cities.
For commercial real estate, the problem is in office properties, especially the older generation office buildings that are not ESG compliant. Companies that are doing well and want to attract their workers back to the office often want to do so with slick modern offices, not with older ones. Other commercial real estate projects like warehouses are doing well because of the growth of online retail.
There are many empty office buildings in major cities like San Francisco, Los Angeles, Chicago, New York and other areas. The advent of work-from-home (WFH) technologies resulted in less demand for office space, which also resulted in a drop in downtown retail store sales, which combined to see a lot of shuttered downtown commercial real estate.
Thus expensive developments, such as the 61-story Salesforce Tower in San Francisco, have a lot of vacant spaces. Similarly, the Transbay Transit Center should serve millions of commuters but now sits almost empty.
Property values for office commercial real estate are depressed because supply outstrips demand right now, and projected cash flows at least for the near future are low. It can be argued that eventually the economy will recover in the future, but those cash flows are several years down the road and their present values for the valuations are lower.
The risk-free yield on the U.S. 10-year bond is now just slightly less than the average cap rate (the annual net income divided by property cash price) of most U.S. office real estate projects.
U.S. real estate is in big trouble. No one wants to lend to developers. High vacancy rates, no one wants to buy because of high mortgage rates, etc. Why would investors want to risk their capital these days on real estate projects, especially commercial real estate, if the yields on risk-free 10-year U.S. Treasury bonds are just slightly less than what they would get from risking their money?
For residential real estate, the situation is just as bad.
Because the Fed rate is now around 5.5%, the actual mortgage being released to the public is around 7%-8% depending on the bank and area. Very few homeowners want to sell their houses that are still being financed at the old 3% rate to trade up to a more expensive 7.5%-8% mortgage rate. Hence even if there is demand, there are few houses for sale on the market unless the seller really wants to move out. So the housing market is now frozen.
Banks also have to contend with the fact that if a recession does kick in, many more people may lose jobs—including those currently paying mortgages. Already personal savings are extremely low, and the use of credit card debt is flying through the roof.
Real estate developers even have it worse. Instead of the Fed overnight rate, for real estate developers, banks use the 10-year Treasury rate that is higher now at the time of writing in October. Hence real estate development loans may even reach up to 15% or higher, and it may not be for the full loan amount of the development—if they can actually get the funding. Many banks are already distressed holding older lower yielding Treasurys and foreclosed real estate. Thus the developer may need to increase the ratio of equity to the full value, if there will be investors.
Loan-to-value ratios are affected by the depressed prices. As interest rates rise, the present value of cash flow generating assets decrease. Before you could take out a loan with a little equity because cash flows on office properties, for example, were really good. These days, with depressed cash flows due to vacancy, you can only take out a small loan. The rest, you need to look for other ways to finance. Many banks may already have too many foreclosed properties turned over to them that will force them to deny more project development loans.
There are, of course, shadow banks that may issue a development or construction loan, but the terms may be so high for the developer, such as requiring an overcollateralization of the loan and even higher rates to compensate for the risk, that it becomes financially unattractive to proceed.
What can business leaders do to set themselves up for success?
For business leaders, one thing you can do is to clarify your position internally on how you view office work. Does your company feel that work-from-home as a benefit is already part of your identity, or do you feel that eventually everyone will need to get back to the office? If analysts and real estate planners are simply guessing as to the future plans of corporate America, that information asymmetry just leads either to an overabundance or a shortage of office space.
Right now it is a renter’s market out there for the less sophisticated office space, if that is what business leaders are looking for. Terms are negotiable, especially for landlords desperate not to miss their loan payments. But again, it depends on your position on WFH and reporting back to the office.
Real estate is a major engine of economic growth for America, but it is also a sector that is heavily impacted by the Fed decisions on future interest rates and the future plans of businesses. Until we see some changes on the horizon, I think this sector will be extremely challenging for the next few years, with the possibility of a lot of bankruptcies, foreclosures and more unstarted projects in the future.
The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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