Will rising interest rates slow down the market? In a word, no. At least, not in the short term.
Interest rates that continue to creep up have not had a major impact on Front Range lending activity. While interest rates are on the rise, this is still a low-rate environment. The rise in interest rates and associated uncertainty has compelled many commercial real estate players to act now, believing that favorable conditions today may not be available tomorrow. Those choosing to refinance early into fixed-rate, long-term debt are rate locking as quickly as possible in a well-published anticipation of a rise in interest rates.
Not everyone holds this view. With an unprecedented $1.8 trillion in long dated agency paper on the Federal Reserve Bank’s balance sheet, the impact on the marketplace of trickling out this $1.8 trillion remains uncertain. They’re going to take it slow, remembering the impact of the rapid rise in rates under Fed Chairman Paul Volcker. Today’s federal funds are at 2 percent, unlike in 1979, when federal funds were 11 percent before Volcker hiked rates all the way to 20 percent in 1981. That’s unlikely to happen again, at least not like that. Then again, we’ve never had $1.8 trillion on the federal balance sheet before, so it’s hard to say exactly how it’s going to play out. Safe to say, they’ll take reasonable steps to avoid a sudden shock to the system like the Lehman Cliff. They’re going to avoid volatility by focusing on stability and take it slow.
With an unprecedented amount of money on the sidelines, there remains too much money chasing too few deals. The paucity of high-quality investments, extending beyond real estate to include all asset classes, creates a seller’s market. Nowhere is this more evident than in the disparity between interest rates and cap rates. To the casual observer, they appear disconnected, if not unhinged. Factoring in too much money chasing too few deals handily reconciles the difference. Simply put, there are more buyers than sellers.
Many have observed that financing from banks appears to have fallen a bit, with many construction lenders having left the scene entirely, save for their best customers. But this doesn’t mean that overall lending activity is down. In fact, the introduction of new programs and lending sources in order to adapt to changing conditions provide more options that result in more expansive deal coverage. Financing volume has remained robust. As volume from bank financing has fallen off from 2017, agency, life company and commercial mortgage backed securities underwriting has not changed from 2017, with agency and life company lenders offering new programs in 2018 to support the volume demands in the marketplace. Most lenders believe that deal volume for 2018 should be consistent with 2017.
Rising interest rates have impacted the investment sales market for stabilized assets where properties already were selling at historically low cap rates. Rising interest rates have created a compression of lender spreads for stabilized, lower-leverage loan requests across the board. For Class A and B properties with permanent loan requests below 65 percent loan to value, this is still a borrower’s market with highly competitive interest rates, extended interest only and overall accommodative terms.
Underwriting terms remain steady. Many view the unchanged underwriting terms as a positive market attribute mitigating the risk of adverse consequences in a recessionary environment. Real estate leverage among insured institutions has remained relatively conservative during this cycle. There appears to be no material decline in credit structures with most banks lending no more than 65 to 70 percent loan to value. Five years ago, 80 percent LTV loans were de rigueur. Disciplined credit and strong capital ratios leave banks well positioned to weather any economic downturn.
Despite the back and forth, most lenders remain bullish on multifamily. No doubt, the threat of higher interest rates has impacted the single-family housing industry; mortgage application volume was down 4.5 percent compared to a year ago, according to the Mortgage Bankers Association. Zillow observed that the share of median income required for a monthly mortgage payment on a median U.S. home increased to 17.1 percent in June, outpacing June wage rate gains of 1.6 percent by a factor of 10. By the way, fully half of the U.S. metros noted for spending the largest percentage of the area’s median income on housing are based in the West, Denver included.
While multifamily remains popular, the ratio of income to housing costs creates an intuitive nervousness: How long residents can spend more than 50 percent of their income on rent or mortgages? Traditionally, rents could not exceed 30 percent of a tenant’s income. Now it is closer to 50 percent. None of this is lost on bank regulators, some of whom are privately expressing concerns about today’s renter being no different than the overleveraged 2006 sub-prime homeowner.
The loosening of these lending standards may not bode well for multifamily landlords in softer markets. A slowdown in construction for pricey, Class A multifamily products may prevent this problem from spiraling out of control in some submarkets, particularly ones that already are saturated with elite housing options where affordability is experiencing various forms of obsolescence from rent concessions to outright vacancy.
Apartment rental demand remains quite strong, albeit with fewer Class A construction loan opportunities in 2018, perhaps given moderating rent growth assumptions and the spike in construction and labor costs making new projects harder to pencil.
Many hold that Denver is a market at risk of oversupply, but this risk appears mitigated by a strong, well diversified economy. The economic strength and diversity supports a positive outlook for Denver and the Front Range, despite rising interesting rates – at least, in the short term.