The first half of 2022 has been a difficult one for the US commercial real estate debt markets, with record inflation, four Federal Reserve rate hikes, and global geopolitical and economic instability. But there is largely a sense the commercial real estate debt markets are in a better position today to weather a possible storm than in the run-up to the global financial crisis – and a significant component of this is the discipline seen in the single-family residential market.
Here are three things to know about why a stronger residential market bodes well for the broader commercial real estate market.
1. Single-family stability means less volatility
Billy Procida, founder and CEO of Englewood Cliffs, New Jersey-based debt manager Procida Funding & Advisors, believes relative strength of the single-family residential market and more stringent lending standards bodes well for the broader commercial real estate market.
In a white paper published last month, Procida makes the case that while investors are understandably nervous about the US housing market, more underwriting discipline and checks on supply mean there will not be the same kind of housing-fueled recession that was seen in 2007.
“At first glance, there are some eerie similarities between the current environment and the one preceding the last housing-fueled recession. Home prices have increased at a faster rate than at any other time in post-war history, including the period preceding the last housing crisis,” Procida said. “But the housing market of today appears to be starkly different from the bubble that burst in 2008.”
The takeaway is there is less chance of turmoil in the single-family residential market derailing an already volatile commercial real estate debt market.
2. Overbuilding is less of an issue
Procida cited a potentially significant shortage of housing units in the US, per data from the National Association of Realtors. Moreover, borrowers have stronger balance sheets than in 2008. Mortgage rates and affordability are in line with historic norms.
According to NAR, since 2000 the number of existing homes available for sale has averaged 2.3 million units. This number peaked at more than 3.7 million housing units before home prices began to fall steeply in 2008.
“Since then, the number of existing homes available for sale has steadily declined and reached an all-time low in May 2022 of 1.1 million units,” Procida said. “Even after three interest rate hikes this year, the current WSJ Prime Rate of 4.75 percent remains significantly below its 50-year average of 7.35 percent. The 30-year mortgage rate, which as of June 16 had risen to 5.78 percent, likewise remains well below its 50-year average of 7.77 percent.”
This metric also means that there continues to be strong demand for multifamily product, with less of a danger of overbuilding, he added.
3. Homebuyers have many options for financing – as do commercial real estate borrowers
“Although 30-year fixed-rate mortgages are the most popular mortgage product, it is worth noting that other less costly financing options are available to prospective home purchasers. Despite their stigma, adjustable-rate products are not necessarily bad options for large cohorts of homebuyers, and their availability may continue to support the housing market as 30-year mortgage rates increase,” Procida said.
The firm found the average interest rate for a five-year adjustable-rate mortgage was 4.2 percent as of early July, a level that is more than a full percentage point lower than the interest rate for a 30-year fixed rate mortgage.
“Notably, home sellers’ homeownership tenure averaged only six years as of late 2021, and adjustable-rate products lock in a lower interest rate for at least 5-10 years and afford some protection in the form of interest rate caps,” Procida added. “As a result, adjustable-rate mortgages are a smart option for many buyers, especially given their improved underwriting standards.”
While some of the debt funds which rely on warehouse financing have pulled back, and lenders across the board are more cautious, there continues to be liquidity in the markets for strong sponsors and strong deals.
Looking ahead
In Procida’s opinion, today’s investment landscape is undoubtedly littered with land mines.
“Inflation is now at a 40-year high, and we’ve yet to see any clear signs that it is abating, or even decelerating. Interest rate increases have been rapid, and rates may continue to climb steeply for a long time yet. Even after its recent 20 percent decline, the stock market remains nearly 12 percent above its pre-pandemic level as of June 30 despite a laundry list of economic risks that have accumulated since then,” Procida said.
Real estate, unlike stocks, will always have a basic intrinsic value.
“You can sleep in it, eat in it, shop in it, and have medical procedures performed in it; you can feel it, kick it, and smell it,” he continued. “Moreover, its supply is constrained, and its versatile – you can reposition it and breathe new life into it if need be.”
Corporate boards can dilute common shareholders, and the Federal Reserve can unilaterally lower prices for paper securities by ceasing to provide liquidity for them. “But nobody is creating more land. It’s only becoming scarcer and more valuable,” Procida said.