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August 18, 2023 Written By Clear Investment Group, LLC

Market Insights: 2023 Q2

Interest Rate Hikes, Commercial Lending, and Impacts for Short-Term Holders

Last month, the FOMC announced its latest rate hike, bringing the Fed Funds target to 5.25 – 5.5%. Chairman Powell noted that the Committee will continue relying on economic data in determining any future rate hikes, and left the door open for an additional increase at the September meeting. 

While largely anticipated, this latest increase brings the benchmark for borrowing to its highest point in over 22 years, prompting many business leaders to push back. “It is time for the Fed to give the economy time to absorb the impact of past rate hikes,” argued Joe Brusuelas, U.S. chief economist at RSM. “With the Fed’s latest rate increase of 25 basis points now in the books, we think that improvement in the underlying pace of inflation, cooler job creation and modest growth are creating the conditions where the Fed can effectively end its rate hike campaign.”

In the interim, it is imperative for CRE managers to reevaluate their financing options. Historically, Clear Investment Group has opted for floating rate loans, as fixed positions typically penalize pre-pay – and as short-term holders, we rarely carry mortgages through their full term. Furthermore, we have previously preferred to finance capital expenditures in conjunction with first position loans. Most recently, our Shreveport acquisition was financed at 70% LTC, 250bps over SOFR. 

In the current rate environment, we are increasingly executing loan assumptions on fixed rate debt, that on average is 250-350bps below market.  In some cases, even if a prepayment penalty is likely, given the projected sale date, this cost is less than that of securing new debt at current market terms. Such was the case with recent acquisitions in Syracuse, NY, where assumptions provided nearly 86% LTV on first position debt with a blended interest rate of approximately 450bps, fixed.

We also continue to explore options in preferred equity or mezzanine debt, specifically to finance construction costs. For some recent acquisitions, including the Syracuse portfolio, we are assuming agency paper which precludes us from piggybacking second position debt efficiently. With future portfolios, however, we are carefully looking into the feasibility of adding pref / mezz  to our capital stack. There appears to be some appetite from both HNW investors and debt funds. This capital, while more expensive than a traditional mortgage, at even 15%+, would lend to a more efficient use of member capital, and overall, higher returns.

Given the current environment, preferred equity and mezzanine debt are increasingly attractive, especially when it comes to financing construction and capital improvements.

Multifamily Demand Remains Steady, Workforce Boasts Strong Fundamentals

Interest rates are also affecting the renter base. With 30-year fixed mortgages inching closer to 7%, more single-family buyers are remaining in their current homes. The result: a 13.5% year-over-year drop in single-family listings. Delivery is also down >3% YOY. 

As a result, the comparative affordability of renting is increasingly attractive, especially for young Americans. This trend is driving multifamily demand and keeping occupancy high. The national average for multifamily in June was 95%. The asset class also sported strong rental growth, the bulk of which is being enjoyed by workforce housing. Year-over-year rents are up 3.8% nationally for the ‘renter-by-necessity’ asset class, versus 1.8% among luxury rentals. 

Sale Trends & Projected Exits

Rising rates have also benefitted our position as a buyer. In our deal flow, we are seeing sellers return to previous offers, counter LOIs submitted months ago, and revert to the mean in terms of pricing. The impact of rising rates is such that already over-extended, cash-strapped operators become more eager to off-load distressed assets.

It goes without saying, rates only further exacerbate deteriorating conditions for owner-operators asleep at the wheel. Rising cost of debt can be the proverbial “straw” in already precarious circumstances — low-rate environments won’t ameliorate managerial inefficiencies, deteriorating NOI, poor lease-up strategies, nor mounting deferred maintenance and repairs.

Our experience is echoed in the data: Freddie Mac reports a 70-80bps increase in cap rates from September 2022 to January 2023. RCA’s Commercial Property Price Index reported a 4.9% decline in pricing at the end of 2022, and the agency forecasted up to a 10% decrease in overall sales volume. As a buyer, the result is acquiring assets at a low-basis from which to add value. 

Of course, we remain cognizant of what this means for our latest Fund, and the exit of its assets. Where will interest rates be when we look to sell, and what impact will that have on cap rates? This is one of the many reasons we are conservative with modeling exits, and stress test well above market cap rates.

Sources: Marcus & Millichap; Yardi Matrix; CNBC; Freddie Mac Viewpoints; Real Capital Analytics.