Interest Rate Increases, Inflation, and the Real Estate Cycle – JD Supra

In the nineteenth century, a musical genre known as the song cycle developed. Consisting of individually complete vocal songs, collectively, a song cycle

Composer Franz Schubert’s cycles of German lieder (musical compositions sung by a soloist with piano accompaniment) are among the best-known examples of this genre. However, Beethoven and Carl Maria von Weber wrote some of the earliest examples of the German song cycles.

Song cycles aren’t only seen among German romantic composers. French, English, and American composers also have written song cycles. In 2020, a song cycle in English and Yiddish by American composer Alex was a finalist for a Pulitzer Prize. And in popular music, many classify Pink Floyd’s rock opera, The Wall, as a song cycle.

In March 2021, I wrote about another type of cycle — the real estate cycle. I blamed the COVID-19 pandemic for bringing an abrupt, premature end to the last cycle and predicted we would see signs of recovery by mid-2022.

Recovery came by more quickly than I predicted. By October 2021, the National Association of Realtors (NAR) reported increased absorption/reduced vacancies in most commercial real estate sectors, with multifamily showing the most dramatic recovery. Only the office sector appeared to remain stagnant, and NAR’s economist forecast it could be at least 2024 before that sector shows recovery.

This article again discusses the real estate cycle, the current state of the market, and what the future might hold for commercial real estate.

The Relationship Between Supply, Demand, and Real Estate Prices.

Real estate finance isn’t complicated. Investors frequently use an income analysis to calculate the purchase price. First, investors decide what percentage return they want on their investment (ROI).

The market and perceived risk primarily determine ROI. The calculation uses a base return equal to that on a no- or low-risk interest rate, such as that on a US government bond or bank savings account, plus a risk premium. The risk premium may consider many factors, such as geographic location, property condition, and competing rents. But the risk premium is a function of supply and demand.

After deciding on their desired ROI, investors look at the property’s anticipated cash flow from a property to determine what investment amount would yield that ROI. For example, if an investor wants an eight percent ROI and the real estate generates $800,000 in cash per year in cash flow, the investor will likely value that real estate at $10,000,000.

A more sophisticated analysis will also look at additional factors, including tax benefits, depreciation expenses, and possibly, net operating income. I’m working with cash flow in this article to keep this simple.

Cash flow from an investment basically is the cash revenue minus the cash outlays. Many real estate expenses are fixed costs like taxes, insurance, and utilities, which the owner can’t change. For instance, mortgage loan payments affect cash flow – they may fluctuate with interest rates, but the owner can’t change them unless they refinance. And with an astronomical 41% year-over-year increase in energy costs, owners will likely experience significant utility cost increases, which they also can’t change.

Although the owner has more control over rental income, in the end, the rental market determines how much rent an owner can charge. For example, if a property owner charges significantly more rent than the competition, that property’s occupancy will go down.

Supply and demand affect rent prices. High demand without increased supply in Florida during the pandemic resulted in substantial rent increases in desired markets. Yet a decrease in market occupancy typically translates to lower rents. Since most expenses don’t go down proportionately with reduced revenue, the result is lower net cash flow for the property. With increased telecommuting, businesses don’t require as much office space. That reduced demand eventually increased vacancies and therefore, supply.

The Real Estate Cycle

Historical real estate cycle statistics show a predictable 18-year real estate cycle for 125 years from 1800 until 1925 – when there was no government intervention. Increased government regulation after the Great Depression altered the predictable cycle, as did government interest rate increases in the 1970s.

The real estate cycle has four main stages: Recovery, Expansion (or Growth), Hyper Supply (or Over Supply), and Recession. Each stage has characteristic elements:

Recovery: Low vacancy rates, new construction hasn’t yet increased, moderate absorption rate, gradual rent increases, seller’s market due to low supply

Expansion: Low vacancy rates, new construction is increasing to create more supply, the absorption rate is still moderate to high, rent increases are moderate to high, and it’s still a seller’s market.

Hyper Supply: Vacancy rates are increasing due to increased supply, new construction remains moderate to high (so additional supply is on the way), the absorption rate has slowed due to the increased supply, rent increases also have slowed, and it’s become a buyer’s market

Recession: Vacancy rates are high as supply outstrips demand, new construction is declining in response to excess supply, high supply also leads to low absorption, rental rates are static or even decreasing, and it’s a strong buyer’s market

Although the real estate cycle has been remarkably consistent, outside factors, such as changing demographics and the general economy, also affect real estate. But past disruptions have occurred when government policies and interest rate adjustments have interrupted the regular cycle—at least until the worldwide COVID-19 pandemic accelerated the real estate cycle.

Where are We Today?

I’m not an economist—just an attorney and real estate broker—but I believe we are experiencing a disruption in the real estate cycle. The disruption is partially due to Federal Reserve interest rate increases and government policies. Interest rate increases may well curb inflation, but as the economy reacts, so will the commercial real estate market.

Although the Federal Reserve and government policies may be the direct cause, general economic developments indirectly drive these changes. We’ve recently experienced a period of relatively low inflation marked by historically low interest rates.

Recently, the rate of inflation has increased markedly. When there’s significant inflation, a dollar’s buying power decreases noticeably from year over year. As a result, mortgage lenders will want to recoup their “buying power” and receive interest or profit.

The result is increased interest rates. And as interest rates increase, mortgage payments go up, and buyers can’t afford a loan as large as they might have been able to obtain when interest rates were lower. Since most real estate purchasers, whether commercial or residential, depend heavily on mortgage loans to purchase real estate, lower loans translate to lower purchase prices.

Interest rate uncertainty has led to changes in real estate purchase terms beyond lower purchase prices. Parties uncertain about interest rate fluctuations are seeking shorter periods between signing contracts and the closing dates to minimize the risk of unsupportable interest rates before closing. And sellers, concerned that buyers may back out of a purchase in a falling price environment, are requiring nonrefundable deposits earlier in the purchase process.

Interest rate increases and inflation may drive price fluctuations, but I think there’s more driving changes in the real estate market. The pandemic has changed how people use real estate. As people increasingly work at home, they seek different features in their homes, whether they buy or rent.

The work-at-home trend has disrupted the office market and significantly reduced demand for office space, causing rental rates for office space to plummet. Increased use of online shopping has created similar struggles for the retail sector. And a reduction in travel caused hotels and other hospitality real estate to struggle.

Yet, at the same time, the real estate market is experiencing housing shortages, which translate to rapid rent increases and increased demand for new multifamily properties. And increased online shopping has spurred demand for industrial space. So, although some real estate market sectors are struggling, other sectors are booming. The result is expansion in some sectors and hyper supply in others.

What Does the Future Hold?

Repurposing is becoming a common investment strategy to combat hyper supply in the current market. Severe housing shortages and an increasing rent environment are causing developers to evaluate how they can repurpose existing buildings to create affordable housing.

Obvious targets for repurposing are offices and hospitality assets, with hotels particularly well-suited for conversion to multifamily. However, reports that creative developers have also converted diverse assets, such as textile mills, schools, and even a funeral home and a parking garage to affordable housing.

Cost is one driver of this trend. It can be less expensive to repurpose a building that’s in good condition than to demolish it and rebuild. Shortages and rapid increases in price of construction supplies have made new construction expensive and sometimes unpredictable. .

Taxes also may be driving the trend. Building conversions sometimes are funded with tax incentives available to gentrify struggling neighborhoods, while preserving historic buildings.

Environmental concerns are another driver. Repurposing existing buildings, rather than demolishing them and constructing new buildings in their place, also aligns with investor focus on ESG– repurposing usually requires fewer natural resources and creates less environmental impact than demolition and reconstruction.

Congress has jumped on the ESG bandwagon with the newly-passed Inflation Reduction Act (IRA), which will be the subject of a future article. The IRA expands and adds incentives for green buildings and energy efficiency, which may appeal to owners repurposing their buildings.

So, the real estate cycle still appears to be in the Expansion stage – despite increased interest rates and inflation. However, the expansion might not involve as much new construction as occurred in previous Expansion stages. Instead, repurposing real estate to better meet market demand and adding “green” and energy-efficient features to better appeal to investors and tenants appears to be the focus of the real estate market in the immediate future.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.