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  • Writer's pictureRealFacts Editorial Team

RealFacts Weekly Real Estate Report

Updated: Apr 18

This Week's Topics

Navigating Commercial Real Estate Debt: Assessing the Impact of Maturing Loans

In the world of commercial real estate (CRE), Federal Reserve Chair Jerome Powell recently highlighted some big problems for investors and banks. Powell spoke to the House Financial Services Committee on March 6 and talked about how small and medium-sized banks could be hit hard by upcoming losses in CRE. With loans coming due soon, the industry is in a tough spot and needs careful attention.

The impending maturity of CRE debt looms large as a pressing concern. Federal Reserve Chair Jerome Powell's acknowledgment of anticipated losses underscores the urgency of addressing maturing loans. With a significant portion of CRE debt set to mature in the coming years, large balloon structured loans are due for payment. The sector braces for a period of heightened volatility and uncertainty.

The evolving landscape of CRE debt poses multifaceted challenges for investors and financial institutions alike. The tightening of lending standards, coupled with the specter of rising interest rates, exacerbates the risk landscape. As borrowers grapple with the need to refinance maturing loans, the potential for cash flow constraints and default risks is large, necessitating proactive risk management strategies.

In response to these challenges, investors must adopt adaptive strategies to navigate the evolving CRE debt landscape. Vigilance and foresight are paramount, with a keen focus on monitoring interest rate movements, refinancing trends, and sector-specific dynamics. By staying informed and agile, investors can position themselves to capitalize on emerging opportunities while mitigating downside risks.

Source: CFODive

Construction Cost Challenges Shift from Materials to Labor

In the realm of real estate development, a careful eye on construction costs is paramount for investors seeking profitable ventures. However, recent trends in the industry paint a complex picture, challenging conventional assumptions about inflation's impact on project budgets.

Amidst the decline in consumer-level inflation, some developers may have anticipated a similar trajectory for construction costs. Yet, a deeper examination reveals a different reality. While material prices, including steel and lumber, have retreated from their record highs, other crucial factors continue to drive construction expenses upward.

Direct labor costs and subcontractor prices remain on a relentless ascent, exerting significant pressure on project budgets. This is particularly pronounced in projects with heavy remodeling endeavors, where labor costs represent a larger proportion of total inputs compared to new construction projects.

The Bureau of Labor Statistics (BLS) provides a comprehensive gauge of these dynamics through the producer price index (PPI) for inputs to new nonresidential construction. They say, “Following Russia's invasion of Ukraine in late February 2022, prices surged for petroleum products, steel, and various other inputs, compounding pandemic-induced shortages and price escalations.”

While supply chain disruptions ease for materials, the labor market remains tight for construction workers. Average hourly earnings for construction employees have shown only a marginal slowdown compared to the broader private sector, with wage growth at 5.7% as of June 2023.

Despite broader economic indicators suggesting a moderation in wage growth, the unique dynamics of the construction sector point towards sustained upward pressure on labor costs. With job openings in construction reaching near-record levels and a dwindling pool of experienced workers, construction firms are compelled to raise wages to attract talent.

In conclusion, for investors in commercial real estate, particularly those embarking on labor-intensive projects, the trajectory of construction costs presents a formidable challenge.

Expectations of cost stabilization may prove elusive, especially in projects involving union labor. As such, a nuanced understanding of these dynamics is crucial for informed decision-making and effective risk management in real estate investments.

Source: Naiop

US Home Sales Report Blows Projections Out of the Water, Will it Last?

Existing home sales for February were reported this week and instead of coming in at a decline of 1.3% as analysts predicted, the reported number was an increase of 9.5% to an annual number of 4.38 million (3.95 million predicted). This was the biggest increase since February of 2023. Bloomberg’s Michael Mckee reported, “With mortgage rates coming down a little, not a lot, this is really good news.” What Mckee is getting at is that although mortgage rates did come down a little bit, they are still higher than past years. This is why these sales numbers are so great, because they show that people are willing to pay higher mortgage rates for prices.

Although these numbers look good for February, many analysts don’t believe that this recovery can last. Thomas Ryan, property economist at Capital Economics wrote, “Existing home sales rose in February which we think largely reflects the sharp fall in mortgage rates at the end of last year, but borrowing costs have been rising so far in 2024, which in the near term suggests this isn’t a recovery with legs,” Lisa Sturtevant of Bright MLS added that home prices climbed in February and “are now more than 40% higher than they were before the pandemic,” And with interest rates nearly double what they were then, the typical monthly payment for a homebuyer has increased by nearly 90%” The boost in sales stems from the sharp cut in mortgage rates near the end of last year and the fact that people are getting adjusted to higher mortgage rates being normal, but with house prices still rapidly increasing, along with average house payments, this recovery may be short lived and fleeting.

Source: Bloomberg Markets, MarketWatch

US Homebuilder Index Reaches Eight Months Highs

The US Homebuilder Index (NAHB) has risen for the last four months and just hit its highest level since July 2023 this week. This rise was driven by the limited number of houses for sale, falling mortgage rates, and positive growth in the homebuilding sector. Tawan Davis, CEO of The Steinbridge Group, joined Bloomberg to discuss this rise and the importance of the homebuilding sector in the nation’s economy. He began by explaining that housing and gasoline represent about “60% of all the nation’s inflation” with house prices rising 5.2% and rent rising 6% in the same time as general inflation being about 3.2% currently. Seeing as house prices play such a monumental role in the country’s inflation, it's important to follow the housing market and its own inflation percentages.

The bullish sentiment in the housing sector has been from the increase in new builds the past few months, Greg Robb of MarkWatch wrote, “Construction of new U.S. homes rebounded 10.7% in February to an annual pace of 1.52 million units, the Commerce Department said Tuesday. That is the biggest gain in nine months. Despite the increase, starts are still below December’s level.” These numbers came in well above analyst expectations of 7.4% and 1.43 million. Building permits also rose 1.9% in February which indicates future construction growth. The numbers are showing that the housing market is healing and cycling back into a growth trend. This growth in the sector is much needed, Aarthi Swaminathan of MarketWatch writes, “A low level of resale home listings and expectations of a drop in mortgage rates in the back half of this year are expected to boost demand further for newly built homes, builders indicated.” With low supply and demand increasing due to the prospect of lower interest rates, the sector desperately needs to begin increasing its supply.

While with Bloomberg Tawan Davis also talked about the undersupply of houses, “That's the problem, thankfully housing starts and housing finishes were up last month but in general there is still a chronic undersupply in houses in the US. That is why 50% of Americans currently pay 30% of their income in housing.” The challenge, Tawan says, “is to find ways in the market to create more housing and to encourage supply.” The relationship between supply and demand is what causes the housing market to move the most, with new builds and finishes showing positive growth, analysts are hoping that levels of supply can reach up with the demand for houses.

Source: Bloomberg Markets, MarketWatch, Marketwatch

Biden’s First-Time Home Buyer Tax Credit Proposal, Plan to Strengthen LIHTC

President Biden's recent unveiling of a comprehensive housing plan has garnered support from the National Association of Home Builders (NAHB), signaling potential shifts in the real estate landscape. NAHB Chairman Carl Harris praised the plan's focus on addressing housing affordability through measures such as a $10,000 tax credit for first-time homebuyers and bolstering the Low-Income Housing Tax Credit to a $25,000 down payment. Moreover, NAHB advocates for transforming the mortgage interest deduction into a targeted tax credit aimed at the middle class, emphasizing the critical role of boosting housing supply alongside demand-side incentives.

However, while NAHB supports many aspects of the plan, it has expressed reservations regarding a provision concerning rental housing fees, cautioning against a one-size-fits-all approach that could hinder state-specific regulations. Additionally, NAHB has outlined a set of policy recommendations aimed at streamlining regulations, promoting skilled trades, and reducing housing costs, emphasizing the importance of collaborative efforts with policymakers at all levels.

For investors, understanding the implications of Biden's housing plan and NAHB's stance is crucial. The plan's potential to stimulate demand and alleviate housing inflation, coupled with NAHB's advocacy for increased housing supply, may present opportunities and challenges for investors in the real estate market. As policymakers and industry stakeholders work towards implementing key measures, investors must stay informed and adapt their strategies accordingly to navigate the evolving landscape of housing affordability and homeownership opportunities.

Source: NAHB

Why Private Developers Are Rejecting Government Money for Affordable Housing

In the dynamic urban environment of Los Angeles, a fresh approach to tackling the affordable housing crisis is emerging. Private developers are forging new paths by sidestepping traditional reliance on government funding and regulations, thus reshaping the development landscape.

SDS Capital Group takes center stage in this disruption of the low-income housing market, spearheading the development of a 49-unit apartment complex in South Los Angeles without governmental subsidies. By navigating regulatory obstacles and leveraging private financing, SDS achieves significant cost efficiency, with each unit costing approximately $291,000, remarkably lower than government-funded projects, which average out to be $600,000 a unit.

The prevailing narrative of affordable housing development undergoes a profound transformation as SDS Chief Executive, Deborah La Franchi, advocates for reduced dependence on government funds. With a $190 million fundraising for constructing 2,000 units catering to the formerly homeless, SDS demonstrates the viability of private investment in addressing societal needs while ensuring financial viability.

Privately funded projects offer a more efficient solution to the housing affordability crisis than government-backed initiatives. Government regulations accompanying the construction of buildings in such projects often include stringent environmental and labor standards imposed by unions. This sluggish and costly process needs to be more efficient to address the urgent housing crisis facing many metropolitan areas.

While privately funded projects present promising opportunities, concerns linger regarding their scalability and sustainability. Questions arise regarding residents' long-term maintenance and welfare amidst profit-driven motives, as well as the reliance on federal housing vouchers. These challenges underscore the complex interplay between public and private sectors in the affordable housing ecosystem.

Investors are presented with an enticing proposition as the private equity model disrupts conventional norms. "The potential for attractive returns, coupled with the opportunity to address housing insecurity, positions privately funded affordable housing as a compelling investment avenue." However, the sustainability of such endeavors hinges on collaborative efforts to address systemic challenges and foster an enabling regulatory environment.

Source: Wall Street Journal

NAIOP Industrial Space Demand Forecast: Cooling Market Signifies Return to Normal

In the wake of the COVID-19 pandemic, the industrial real estate market experienced an unprecedented surge in demand driven by shifts in consumer behavior and the rapid expansion of e-commerce. However, as the economy transitions into a new phase, characterized by slower growth and evolving market dynamics, the industrial sector is undergoing a period of adjustment.

Following two years of robust absorption that far exceeded long-term averages, the industrial sector is now experiencing a relative cooling trend. The extraordinary demand for distribution space, fueled by consumers' increasing preference for home delivery during the pandemic, led to a surge in net absorption. However, “in 2023, industrial net absorption totaled 93.7 million square feet, significantly lower than the record-high completions of 486.6 million square feet.” This imbalance between supply and demand has brought balance back to the industrial market, which had been substantially undersupplied since 2020.

The economic landscape plays a crucial role in shaping the trajectory of the industrial real estate market. Despite initial fears of a recession, the U.S. economy grew by 2.5% in 2023, with inflation showing signs of slowing down to approximately 3%. Optimism surrounds the potential for interest rates to fall in 2024 and 2025, contributing to a "soft landing" for the economy. However, economic conditions in 2024 are expected to remain uncertain until inflation reaches the Federal Reserve's target range and interest rates decline.

Source: NAIOP

Forecasting the industrial market involves analyzing various drivers, including lagged net absorption, GDP growth, inflation, and monetary policy. The current forecast reflects a downward revision to account for cooling demand for industrial space and a slowdown in macroeconomic growth. For 2024, industrial absorption is projected to reach 62.8 million square feet, with a range of 39.6 to 86.0 million square feet. Absorption is expected to bottom out in the first half of 2025 before rebounding later in the year, with a projected net absorption of 49.1 million square feet for the full year.

As the industrial real estate market navigates through a period of transition, stakeholders must adapt to evolving market conditions and adjust their strategies accordingly. While the slowdown in demand may signal a "return to normal" after the pandemic-induced surge, it also presents opportunities for investors and occupiers alike. By closely monitoring economic trends and market dynamics, stakeholders can position themselves to capitalize on emerging opportunities and navigate the shifting landscape of the industrial real estate market with confidence.

Source: NAIOP

How High-Interest Rates Affect CRE Investments

When the Fed began hiking interest rates in March 2022, the CRE investing landscape fundamentally changed. The cost of capital became higher, cap rates rose driving down property values, and debt service coverage ratios were squeezed. We’ll explore these issues in more detail below.

When the Federal Reserve increases interest rates to combat inflation and cool down an overheating economy, it does so by increasing the Fed Funds Rate. This increases the rate at which lenders borrow their money. In turn, these institutions pass on these costs to their customers through higher interest rates on loans. This increases the cost of debt for developers and investors which makes investing in many projects less appealing. For the projects that are picked up, their bottom line will be significantly affected by higher debt service.

Cap rates are another victim of interest rate hikes. As a refresher, a project’s cap rate is found by taking the net operating income (NOI) and dividing it by the property's value or purchase price. When capital becomes more expensive, properties become less affordable to investors. This drives property values down. When the denominator in our equation shrinks but NOI stays about the same, this increases the cap rate. Typically, a seller wants a lower cap rate when trying to offload a property. Because interest rates decrease value, this contributes to the next issue.

If you don’t plan on selling your investment any time soon, taking a hit on value is pretty insignificant. However, rising interest rates can also force unprepared investors into a sale or worse, foreclosure. This is because many commercial real estate loans are structured with floating interest rates. What’s more, many developers use bridge loans or other short-term debt obligations that mature in a few short years. The issue is obvious; When an investor takes out a short-term loan with a floating rate and then interest rates begin to climb, it becomes harder to cover the debt service on the loan. If margins were tight to begin with, this could even put the investor or developer underwater. As the loan matures, there is typically a balloon payment which creates a sticky situation.

If the investment is still profitable with the higher interest rates, the borrower can try to renegotiate the loan terms with the lender. However, this isn’t always possible. Another option would be to refinance, but the debt service coverage ratio has likely changed so significantly that many borrowers wouldn’t want to take on the risk. This could force the investor into selling the property at a discount to hopefully cover the remaining loan balance or worse, they may have to foreclose.

We can clearly see that interest rate hikes can cause some serious problems for real estate investors who haven’t priced in such a risk to their investments. With a mix of higher capital costs, decreasing property values, and tighter bottom lines, investors will have to make some difficult decisions. Professionals should always price in these risks in the due diligence phase to make sure the project would still pencil. Doing this can save a lot of time, money, and headache.

For First Time Rents in the West Lag Other Regions

According to data from RealPage, apartment rent growth in the Western United States has lagged behind the rest of the nation post-pandemic. In this same period, the South, Midwest, and Northeast have all seen above-average rent growth. This is the first time that average effective rents in the West have trailed those of the Northeast since 2015.

In the last 4 years, rent growth in the West has been about 20% which is well under the other three regions' growth at 29% and below the national average of 25.5%. Despite the slowing growth, there shouldn’t be too much cause for alarm. “As of February 2024, average rents in the Northeast ($2,221) outpaced the West ($2,204) by about $17,” the article said. The two regions typically track pretty closely.

Despite the West falling into second place in terms of average effective rent growth, it still holds the top spot in rent per square foot while also having the smallest average unit size at 871 square feet.

We will likely continue to see more shifting trends as the rental market continues to rebalance after the pandemic era price hikes.

Source: RealPage

Rents on the Rise: The Markets Leading a Long-Awaited Increase in Rents

After a six-month streak of decline from August 2023 to January 2024, median rents in the United States are showing signs of rebound, edging up by 0.2% to reach $1,377 in March 2024. This uptick aligns with a seasonal pattern of rents typically increasing during the spring and summer months, signaling a potential shift in market dynamics.

Despite this recent uptick, rents remain down by 1% compared to the previous year, underscoring the lingering impact of recent economic and societal disruptions. Moreover, vacancy rates have climbed to their highest level since September 2020, reaching 6.6%, indicative of ongoing challenges in tenant retention and occupancy.

Among metropolitan areas, Milwaukee, Memphis, Cleveland, Tulsa, and Honolulu have emerged as the fastest-growing markets in recent months, with rents holding steady. Milwaukee, in particular, has witnessed significant growth, notching a 4% increase in median rents over the past 12 months, alongside Grand Rapids, Michigan, which shares the same growth rate. Grand Rapids has experienced a staggering 29% growth over the past three years, positioning it as a standout performer in the rental market landscape, second only to Miami.

Conversely, Sun Belt markets have exhibited slower growth trajectories in the current cycle. Austin, Texas, stands out as the slowest mover over both the past six and 12 months, reflecting unique market dynamics and potentially shifting preferences among renters. San Francisco, while posting a positive growth rate of 9%, ranks as the slowest metro over the past three years, signaling a notable departure from its previous growth trajectory.

Source: NAAHQ

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