By Dennis Kaiser

Connect Westside Los Angeles’ annual gathering on Nov. 27^th at the Luxe Sunset drew more than 300 commercial real estate professionals, and included a panel entitled “Climate Change: Spotlight on Rising Construction Costs, Interest Rates and Inflation.

Front-line CRE leaders shared how the industry is addressing concerns such as rising construction rates, higher interest rates and general inflation, as it enters the latter-end of the current cycle. The conversation focused on how the issues have been offset to a degree by strong demand for housing, rising wages, and low employment.

Moderator George Smith Partners’ Gary M. Tenzer framed the robust conversation by noting over the past year short-term interest rates have shot up 75 basis points, and another 25 basis point bump is expected this month. He also points out treasuries were up nearly 100 basis points. That’s caused some adjustments on the deal flow, and is impacting cap rates, a bit, as they adjust to match interest rates.

Parkview Financial’s Paul Rahimian says the private lender for ground-up projects isn’t seeing a slowdown as a result of interest rate increases because the demand is there. The rate bumps may have actually “accelerated” deals, as developers move quickly to get project financing locked in before rates rose more. He says there is some concern, but they are still doing deals amidst the higher interest rate environment. Though, he notes, their rates to borrowers haven’t risen, despite the cost of funds going up, which is compressing their margins.

Another concern is the cost of construction that’s steadily risen the past 36 to 48 months. Rahimian says in L.A. costs have rise higher than in any other city in the nation this year, which is causing them to examine loan to cost on deals. Eventually, he predicts, it will become a decision to determine at what point the budget does not make sense. He also pointed out property valuations are at an all-time high.

“Combined, those three things give everyone a second to pause and consider where we are now and where we are going to be in 2019 in terms of climate change,” he says. It is getting tighter and tighter, Rahimian points out. He says cap rates are slowly inching up mainly because people are not buying at the velocity they were six months or a year ago, but developers are still looking at low exit rates. “The reality is cap rates have to move up as interest rates go up,” he says. “I can’t believe they can be any more compressed than they are. They (developers) have to be building to at least a 6.5% cap to make sense.”

Madison Realty Capital’s Bradley Ross agreed the bridge construction lender hasn’t seen a deal slowdown in West L.A., especially since rates remain at historic lows. “Proformas still work, the models are still working, people are not stopping projects due to 100 basis points or less change in the proforma for the average real estate deal today in L.A.” He notes they are not trending rents now, but looking what has to “go right” versus what “could go wrong.” They examine if business plans make unrealized assumptions, or does the project still make sense in the path of progress. Ross pointed out they believe the market is closer to end of cycle and they take that into consideration, and try not get “over their skis” on the basis as a result. They are “somewhat more conservative” from a year ago, though it’s more of a “stay the course” approach, he says. Though he admits they have to remain disciplined today because there’s just more deals that don’t work due to factors such as construction costs, materials, labor, cap rates, or interest rates, all of which may now work against a deal that previously looked good.

Ross says, the outlook for the Westside is “very good from a supply and demand basis,” which is being driven by tech and entertainment. Demand is strong, supply is constrained and there’s job growth, he says.

Deutsche Bank’s Mark Fluent says on the permanent debt side, there’s a sense that rates are going up the next few months, so a few more refinancing’s are getting done earlier than expected. Borrowers may feel they need to get it done before they planned to, out of a fear that the rate will not be there later, he notes.

On the bridge or construction side, Fluent says, they look at project differently, whether that be selling a market, deals that are asset class driven or is borrower driven. He says that results in them not looking too hard at interest rates. Because they are following macro trends in California’s economic shift of tech companies moving into the media business, it is leading them to capitalize on that change in the tenant base and those developments. The types of projects they are lending on involve occupants such Apple, Facebook, Google or Microsoft, which carry balance sheets and cash that “we’ve never seen in our lifetimes,” he says. “The ability to pay rent, we’ve never seen before and we’re not so concerned about it.”

Fluent has a positive view of the SoCal market because it offers something tech giants want. That being the ability to “stream and show media in a new way that its never been shown before,” he says. They are attracted to the well-established content creation and production system in the entertainment industry. “I feel like we’re in early innings of that change,” he says. That’s why they have gone “so deep” in Culver City, and are about to do the same in the Grove area.

As far as predictions, Rahimian says it depends on what you do and your viewpoint. For construction lenders, he believes it will be a strong year ahead with plenty of “projects in the pipeline that still make sense, that still pencil out, will get closed and will be built in 2019.”

Ross says it is a good time to be a borrower, though it is a tight market. That means buyers of market-rate deals are required to bring a full arsenal of asset management skills to the table.

Fluent forecasts it will be “sunny with slight chance of showers” in 2019. He says, individual deals may make sense, but he advises being careful and to “pick your shots.” He says, there will be certain types of buildings that will be in demand next year, and there will be a need for them.

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