In spite of rising interest rates and global economic turmoil, U.S. capital markets have proven resilient. Last year has been a record year for the real estate community. Investment activity and the velocity of transactions reached record highs, and fundamentals in many markets across the U.S remained strong.
This late cycle success has many wondering if we will experience a softening or market correction in the new year, and what this means for investors, especially in terms of financing.
As a mortgage banking firm with more than 30 years of expertise in financing commercial properties across the nation, we’ve seen three significant events where the availability of real estate capital was dramatically interrupted:
1980’s increase in interest rates; long-term rates reached 16 percent
1990’s erosion of values
2007 collapse of capital markets
We understand the cyclical nature of our business and it is crucial that investors keep a pulse on the market and factors that may impact their investments in the new year. Below are the top items investors should be mindful of when financing properties in 2019:
Cost of capital
As we move into the new year, we have certainly seen some changes in the cost of capital over the last year and the last several years.
From 2014 to 2017, the 10-year Treasury bill, the index primarily used to set pricing for real estate, came off its historic lows and hovered around 2.0 percent. Since June of 2017, we have seen the 10-year Treasury rise to its current level of around 2.90 percent. Most of the capital provided for commercial real estate is priced at 1.70 percent to 2.10 percent over the Treasuries.
Therefore, all-in rates to owners have moved from around 4.0 percent to 5.0 percent for 10-year fixed-rate loans. As in the past, if higher rates slow volume and alternative investment yields aren’t attractive for the larger institutions, we have seen the spreads on real estate lower so the net cost to the borrower in a higher rate environment could be softened.
That said, most of the institutions we work with have met their 2018 allocations or expected volumes, which demonstrates that this slight rise in the cost of capital has yet to slow velocity or volume. This is something that will likely remain true throughout 2019.
Increase in mezzanine Debt
Another major trend impacting financing in 2019 is the increase in the mezzanine market. This is the result of compressed cap rates and rising prices in major metros that have impacted leverage in the CMBS market.
Traditionally, CMBS underwriting and sizing was still able to achieve maximum leverage at 75 percent loan-to-value. Today in the CMBS market, we are seeing maximum leverage of 65 percent to 67 percent, which is driving more high leverage buyers to the mezzanine market. Some CMBS lenders are even aligning themselves with mezzanine lenders to provide a transparent one-stop option.
The Fed and rising interest rates
In response to the capital market collapse in 2008, the Fed lowered the federal funds rate to almost zero. Since then, the Fed has been slowly raising rates.
This is a trend that will continue in 2019. With the GDP rate of increase at 3.1 percent, unemployment rate at 3.7 percent, 250,000 jobs added across the nation in October and the rate of inflation at 2.9 percent, we expect the Fed to increase rates at least two more times in 2019.
This does not necessarily mean the cost of real estate capital will increase directly at the same level. That said, we may see the beginning of cap rate movement. As interest rates remain at elevated levels, it directly affects cash flow and therefore values.
Overall, the U.S. capital markets are resilient. We’ve seen a slight uptick in the cost of capital, as well as changes in the CMBS market and short-term interest rates. We have also seen a great deal of socioeconomic worldwide events. In the last several years, we have seen unrest in the Middle East, Brexit, European counties facing economic failure, North Korean threat, tumultuous national elections and the imposition of tariffs, all while the U.S. capital markets were modestly affected.
We believe that unless there is a dramatic worldwide event, the capital markets have proven their resiliency, and there will continue to be ample amounts of capital available for financing in 2019, and at rates that still remain attractive to investors.
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