Experts from Hunt, NKF, George Smith, Marcus & Millichap Weigh the Chances of a Recession

By Dennis Kaiser

The Federal Reserve’s decision to suspend rate hikes this year and end the runoff of its balance sheet were closely watched across the commercial real estate sector for good reason. Not only do these moves coincide with a period of significant financial market volatility, they’ve come at a time when there’s robust demand for Treasuries. In turn, that’s pushed the 10-year Treasury below the 2.5% range and ushered in a condition economists refer to as an inverted yield curve, which has proven to be a fairly accurate predicator of past recessionary times.

To gain a better understanding of what these actions mean for CRE, Connect Media asked a group of experts across the spectrum of the industry to share their insights. We asked them two questions:

1.   How do you expect the current commercial real estate landscape to be affected by the Fed’s decision to hold interest rates steady?

2.   What advice are you giving to clients as a result of this decision?

Here’s what they told us:

Q: The Fed elected to hold rates steady last week, how do you expect the current commercial real estate landscape to be affected by that decision?

George Smith Partners’ Gary Tenzer: With last week’s pronouncements, the Federal Reserve modified its 2019 GDP growth projections for 2019 lower than prior forecasts. Rather than the two Fed Funds increases that were promised this year, the Fed is now signaling that there will be no further increases in 2019. In fact, the futures markets now predict that there will be a rate cut before any future rate increases.

Last week, there were several short-term Treasury rates that were slightly higher than long-term rates; the inverse of normal conditions. This condition is called an “inverted yield curve,” and is a typical harbinger of an impending recession. In fact, the last 10 recessions have been preceded by inverted yield curves, nine times.

The 10-Year Treasury rates have also continued to drop almost 80 basis points from its peak in Mid-October of 3.2%

NKF’s Kevin Shannon: The Fed’s announcement plays into two current commercial real estate trends for office product. There is more capital migrating to secondary markets in search of yield late cycle, and more suburban sales late cycle, since much of the CBD office product type has already traded to more permanent capital sources like REITS, core and sovereign funds. The resulting lower interest rate environment as a result of the Fed announcement helps lubricate secondary markets and all suburban product types. These food groups always have a debt component unlike CBD deals which frequently are all cash. The improved lending environment helps augment yields on both secondary market and suburban product.

Hunt Real Estate Capital’s David Casden: The announcement that the Fed will hold rates steady and are likely done with further rate hikes for 2019, has had a profound impact on the markets. The news from the Fed comes on the heels of the weakest jobs report in months and a slowdown in global growth, and has had a profound impact on the markets as a flight to quality has ensued with investors scooping up long-term Treasury securities.

The result? Yields are down to levels not seen in nearly two years. Furthermore, the yield curve officially inverted late last week, as the delta between three-month and 10-year Treasury yields is now sitting in negative territory. This inversion has historically forecast that an economic recession is on the horizon anywhere between 12 to 24 months down the road. 

With Treasury yields rallying, the effects on commercial real estate mortgages is undoubtedly a positive one. While concern will prevail regarding loan spreads widening on the heels of the yield rally, the gain in rates is a positive one for borrowers and should only continue to help drive business for lenders. This is particularly true for longer-term loans, where borrowers will be looking to lock in cheap long-term financing and take advantage of the current dip in yields.

CRE lenders are sure to take an aggressive approach in advertising these low rates. However, the expectation is that lenders – particularly securitized lenders – will look to unload assets being held on warehouse facilities as soon as possible, as the inverted yield curve will place a tremendous amount of pressure on the short-term financing economics, placing many lenders in a negative arbitrage situation.

Marcus & Millichap’s overview following the Fed’s decision predicts that the drop in interest rates is likely to invigorate investors and re-open opportunities. The Marcus & Millichap Research Brief notes: As borrowing costs have fallen, buyers are revisiting previous opportunities that didn’t pencil last fall. The sharp drop in Treasury rates rewidened the spread between cap rates and lending rates, which had previously proved to be an impediment for select acquisitions, particularly in primary markets. As a result, sales activity could be invigorated by the more attractive yield spread.

Q: What advice are you giving to clients as a result of this decision so they can chart savvy strategies?

George Smith Partners’ Tenzer: With upwards pressure on interest rates in the past few years, I have been recommending to clients that they finance stabilized assets with long-term fixed rate debt. On assets that were not stabilized or were in transition, I recommended variable rate bridge debt. Once the property was stabilized, I would then refinance the bridge financing with a fixed rate loan. My sense is rates may stay down for a while, and short-term rate pressure is off. It may even make sense on stabilized property for a borrower to take a variable rate loan now, as floating rates are typically lower than fixed rates. I would have not recommended that in the past few years in an upward-trending interest rate market.

At George Smith Partners, we’ve had strong loan volume both in terms of refinancing of existing debt and acquisition financing. We’re seeing a tremendous amount of structured financing being done, such as debt equity, preferred equity, and mezzanine equity, the whole panacea of the capital structure. There’s a tremendous amount of capital in market. The important thing is to know who is real and who’s not. Borrowers must know what’s effective capital and where it is sourced, to determine if they can really close or execute. They must really know the landscape.

I am seeing a lot of bridge or construction loans that have now either matured or need more time for the project to be completed or stabilized, as they’ve run out of interest reserve or money to finish the project. I’m recapitalizing some of those deals by bringing in fresh equity to help the developer get the project to the next phase, whether that be for lease-up, interest reserves, etc. I closed a $30-million loan few weeks ago for debt fund that was for paper lots being sold to public home builders, which was a hard deal to complete. I’m seeing a lot of variety in financings that are getting done right now.

NKF’s Shannon: This is a great time to refinance properties that aren’t ready to be sold. It’s also a great time to sell stabilized assets. Low 6% cap deals on stabilized product can produce double-digit cash returns in this current debt environment. Also, it’s a great time to sell single tenant assets with term. These assets are bond-like instruments that can be monetized at higher prices in the current low-interest rate environment.

For comments, questions or concerns, please contact Dennis Kaiser