We have a new economic reality as a result of the virus. More than 40 million people became jobless in the span of three months earlier this year. Additional layoffs are inevitable. The government has spent trillions of dollars trying to avoid an outright depression.
Consumer spending represents roughly 70% of our entire gross national product. When millions of people are suddenly jobless the impact is felt in every corner of the marketplace, including current real estate interest rates.
In mid-May Fannie Mae explained that “the sharp decline in payroll employment supports our expectation of a significant contraction of approximately 40 percent annualized in consumer spending this quarter. Early evidence of this can be seen in the historic drop of light vehicle sales in April, which posted the second straight month of double-digit declines and fell to the lowest level since the series began in 1980.”
The marketplace upheaval created by the coronavirus means real estate financing must be re-thought. What may be different for investors and borrowers? Wall Street tells us that “past performance is no guarantee of future results” yet in this case there’s no recent pandemic experience to provide guidance.
“The scope and speed of this downturn are without modern precedent and are significantly worse than any recession since World War II,” said Federal Reserve Chairman Jerome Powell, speaking before the Congress in May.
“In addition to the economic disruptions,” Powell said, “the virus has created tremendous strains in some essential financial markets and impaired the flow of credit in the economy.”
How do interest rates affect commercial real estate?
Whether one is a commercial property owner, lender, or operator the goal is to preserve buying power, increase real wealth, and avoid excess risk. Financing at the right interest rate is crucial.
The definition of the “right” interest rate is not so clear. For lenders it might be to get the highest possible rate but not if such financing involves excess risk. Borrowers might want the lowest rate but even that cannot justify the purchase of a property with insufficient revenue. The key is to balance objectives.
Today’s interest rates are very attractive for commercial property owners and managers. Seven-year insurance financing is available at less than 2% – but not for everyone. Lenders are looking for the right property in the right location with the right ownership. They also want a solid equity commitment from borrowers.
Rates are constantly in flux, but the theme is very clear: Borrowing costs within the US are at or near historic lows as this is written. And they may go lower.
Borrowers love lower rates because as interest costs fall affordability goes up. Project economics change. In some cases, properties that would have been unappealing suddenly take on an attractive gleam.
As real estate interest rates decline the pool of potential borrowers grows. There can be increased competition – and more demand — for a limited supply of properties. Sellers also love lower rates because property prices tend to go up.
With lower rates the debt service coverage ratio (DSCR) becomes more attractive. The DSCR, according toInvestopedia, is “a measurement of the cash flow available to pay current debt obligations. The ratio states net operating income as a multiple of debt obligations due within one year, including interest, principal, sinking-fund and lease payments.”
How do negative interest rates work?
In March the US federal funds rate – the cost banks pay for overnight borrowing – was suddenly reduced 1.5% to essentially zero. Meanwhile, in May, the Bank of Japan had short-term interest rates pegged at -.01%, the European Central Bank made $3.3 trillion available to banks for as little as -1.0%, and the UK sold bonds worth $4.6 billion at -0.003%.
The idea of negative interest seems illogical on its face. Why would investors provide funds guaranteed to lose value? Several answers stand out.
- Securing capital with a known loss is a better option in some cases than free-range investing and the probability of far greater losses.
- For nation-states the attraction of negative rates is that they may jump-start consumer spending and increase employment in lagging economies.
- It might be better to move funds from areas with significant political and economic turmoil to markets with stronger legal systems and better protections for investors.
The negative interest debate
Negative interest rates have become the subject of serious conversation. They are no longer unthinkable.
In an interview with 60 Minutes, Powell explained that “I continue to think, and my colleagues on the Federal Open Market Committee continue to think that negative interest rates is probably not an appropriate or useful policy for us here in the United States.”
Powell added that “the evidence on whether it helps is quite mixed. And the issue is people would be depositing money in the bank and that money would be shrinking. They’d be paying interest to put their money in the bank. So, it’s not a particularly popular policy, as you can imagine.
“But in addition, it can also tend to depress the profitability of banks, which makes them likely to lend less, which weighs on economic growth. So, I would just say it’s not at all settled in, you know, in economic analysis that negative rates really add much value.”
Narayana Kocherlakota, former president of the Federal Reserve Bank of Minnesota, explains “Sure, negative interest rates would help lower the unemployment rate from what is likely to be its highest level since World War II. But officials worry that they will also weigh on banks’ profitability, pushing down share prices and making the financial system more vulnerable to distress. Put crudely, the Fed is giving up on unemployment reductions to help keep banks and their shareholders safer.”
Current real estate interest rates & the future
We are at an early stage of understanding the impact of the coronavirus pandemic. With the addition of this new factor economic models worldwide are being deleted, tired relics of past assumptions and old ideas.
What lies ahead is not clear. But one thing is certain: Commerce will not stop.
The need for commercial property will continue. Given options worldwide, capital will continue to be available at low rates for commercial owners, developers, and operators in the US.
Right now, the imbalance of capital supply and demand remains in place. There’s just too much supply and too little demand. As Warren Buffet explains, “interest rates are to asset prices what gravity is to the apple. When there are low interest rates, there is a very low gravitational pull on asset prices.”
Learn more about the potential impact of negative interest rates on commercial real estate here or by visiting https://kbs.com/news.