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'Real Estate Is Not Going To Be The Reason The Market Goes Upside Down,' Expert Says

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'Real Estate Is Not Going To Be The Reason The Market Goes Upside Down,' Expert Says

In 2006, real estate played a significant role in the financial crisis. A combination of low interest rates, readily available mortgages and the unfulfilled promise of rising property values fueled unsustainable borrowing.

Across commercial real estate assets, properties were underwritten on the expectation of increased rent growth. When the Federal Reserve raised interest rates, the high cost to refinance forced borrowers to put their assets back on the market. Home values fell, owners were unable to reach expected rents, mortgage balances exceeded values and property owners went into default. 

The loss of wealth prompted consumers to tighten their belts, and U.S. gross domestic product contracted 8.2%

Twelve years and over $1 trillion in direct fiscal stimulus later, the U.S. economy is on track to experience the third-longest recovery period in the nation’s history. But as interest rates again start to rise, and after the stock market's 1,500-point drop last month, the possibility of a downturn has re-entered the conversation. Unlike 2006, conservative lending put in place after the last bear market and a strong GDP will bolster commercial real estate activity, Marcus & Millichap broker Rick Lechtman said. 

“This time around, deals are being underwritten based on historical trends and with the understanding that tomorrow isn’t always better, so people are not overleveraged,” Lechtman said. “Real estate is not going to be the reason the market goes upside down.”

The Fed announced plans to raise rates three times this year, and Federal Reserve Chairman Jerome H. Powell suggested in February that the central bank could hike its key interest rate faster than anticipated due to strong economic growth. Inflation in the short term yields higher values for commercial properties as tenants can pay more and businesses expand. 

'Real Estate Is Not Going To Be The Reason The Market Goes Upside Down,' Expert Says

Rising rates have also encouraged property owners to refinance sooner rather than later while rates are still low. While the eventual rise in inflation will lead to higher cap rates, it is not a basis-point-for-basis-point correlation, Marcus & Millichap broker Dan Lisser said. Market fundamentals and the popularity of a particular area also play a role in determining cap rates. 

"Liquidity in the commercial real estate marketplace is still strong," Lisser said. "There is still significant debt chasing deals and a tremendous amount of equity to be deployed."

Traditional lenders have remained conservative when underwriting loans. After the Great Recession, banks became reluctant to issue loans with loan-to-value ratios over 65%. Regulations like Dodd-Frank increased the amount of capital banks must hold in reserve, and lenders more stringently vet bridge loans and construction financing based on the current market outlook and how that asset will perform in a particular submarket.

To fill that gap, nontraditional debt sources have proliferated within the lending market. “Pop-up” lenders, ranging from major real estate families and REITs to private equity and debt funds, have launched lending services within their businesses. Unlike traditional lenders, debt funds can offer borrower higher LTV ratios with competitive rates that fall between a traditional bank loan and mezzanine debt. 

Banks, life companies and pension funds are now competing with these debt funds for bridge and construction loans. Interest rate spreads have compressed as a result, a positive for borrowers looking for more affordable debt. Several banks have also been willing to shorten loan terms. While the growing competition creates a riskier environment where lenders might overextend themselves to borrowers, real estate owners are warier of the risk of overleveraging their debt position during this most recent cycle. 

Cracks in the veneer have started to emerge in luxury multifamily, which has seen a glut of development across gateway markets, Lisser said. Class-A apartment construction hit a seven-year high last year, leading some real estate investors to question whether it might be in a bubble

As with stocks, real estate portfolio diversification and investing in commodities like agriculture, energy sources or building materials can provide stability and protect against losses should the market head south. Workforce housing and Class-B and C assets act as real estate’s version of the commodities market.

“The firemen, the teachers, the doctors, the office workers, they all go to work daily and would continue to do that through a recession,” Lechtman said. “Those people are still going to need places to live, and while Class-A, luxury apartments would be affected, Class-B product will remain competitive. In top markets, vacancy does not get too high within Class-B and C properties. Tenants don’t disappear the moment the stock market tanks.”

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