The Commercial Real Estate Forecast

                          

Interest rate decrease – Not Happening

We were expecting a decrease in interest rates to bail out the commercial real estate community by mid-year, but that’s not happening. Now, we suspect there will probably be one rate cut before the election in November, but that won’t be much help. Here’s what we know now.

 

Banks Mitigate Risk

We know that banks have tightened their lending and here is why. Banks have a certain amount of capital in the form of deposits they can lend out. Their regulators determine what percent of deposits can be safely put into loans so the bank’s liquidity is not endangered. They like making construction loans because they are the most profitable, albeit the riskiest. They mitigate their risk by vetting their developer-borrowers very carefully. They also want the borrowers to put up a sizable amount of equity which is fully at risk if there is a loss, and probably personal guarantee to make up any losses should the equity not be enough to cover the losses. Think about my March-April report where Joe Equity is shot dead by Bad Bart, and the first Debt brother is injured.

 

Development Slows, A Lot

Well, these days, the problem arises when the banks’ loans don’t get paid back as fast as the banks would like, usually within a three-to-four-year period for construction loans. So, then they can’t roll out that money into new loans and make new fees. For many local banks, who are the most active in construction loans, that first-tier bucket is pretty full and there is little room for any more lending for construction. The only ones that need apply are triple A credit developers and then they may only be able to borrow 55% of the project’s construction cost, rather than the 75% they could a few years ago. Ouch. So, development slows down, a lot. The developers who have completed their projects can’t sell or don’t want to, because they can’t make the profits they promised to their investors. Interest rates are too high for their prospective buyers, which mean they have to pay less for the project so they can make the returns they need for their investors. And their investors want a higher return, cause, shoot, I can get a 4.6% or better risk-free return in 10-year Treasuries, so why should I risk my money on a construction deal that won’t make me a return triple that, or so.

 

Tax Relief

Oh, and then there is the tax man. Properties have escalated in price 5% or more annually over the past ten years, that is, up until 2022 when the music stopped. It is estimated that overall property values have now declined 20% in the past two years, with values bottoming out this year. Guidance is now that you should expect a 30% reduction in tax assessments in office properties, due to Work-From-Home plus obsolesce issues; probably 10% in retail and 15% in multifamily. But the Tax Assessor will fight you to get the 20% annual increase he thinks he is entitled to get every year. The State Legislature just passed a cap on increases in assessed value at 20% per year for commercial properties under $5-million. But the assessments will still be raised despite the evidence that values are actually declining, not increasing. This will lead to a massive number of lawsuits for the Appraisal Districts, but that is just how we have to roll these days, if you want tax relief.

 

This all-combined means new commercial development will be slow for the next year and probably well into 2025. Values have bottomed, but will not increase for some time. Once rates start to come down, and we hope that will not be because we got ourselves into a recession, it will take 6 months to a year for the backload of buyers and sellers to clear the market place to the Next New Normal.

 

Uncertainty is our constant companion, now.