Staving off the interest rate heebie jeebies

Alternative sources of financing could grow more popular as interest rates rise

Last year, the Related Companies got $475 million in construction funding for its behemoth 13 million-square-foot Hudson Yards project from an unlikely group of investors.

Starwood Property Group provided $350 million, while Related’s joint venture partner Oxford Properties Group, the trade union United Brotherhood of Carpenters and Joiners, and luxury retailer Coach, a future tenant, put up the balance. The package also included a rare mezzanine construction loan.

This sort of alternative financing could become more common as interest rates rise, according to Dan Fasulo, managing director at Real Capital Analytics. That’s because commercial developers will likely feel the biggest impact from rising rates, making it necessary to look outside the traditional avenues for funding.

Interest rates remain low, although they have risen slightly. Late last month, 30-year fixed rate mortgages, the type most often used by middle-class homeowners, were at 4.4 percent, up about a percent in the past year, according to Freddie Mac. Meanwhile, five-year adjustable rate mortgages were at 3.1 percent, up about a half percent from a year ago.

On the commercial side, loans over the past six months have increased to a range of 3.75 to 5.45 percent, from 2.75 to 4 percent, for trophy and Class A office transactions, according to Jones Lang LaSalle. The exact rate is determined by the length and size of a loan and the source of the capital.

Higher rates will most definitely have at least some negative effect on the real estate industry. The stock market’s reaction to comments last month from Federal Reserve Chair Janet Yellen predicting faster increases than previously expected showed that real estate investment trusts are likely to feel the brunt. Investors, both in REITs and those who buy real property, will also feel a pinch. But despite stock traders’ heebie-jeebies, experts are predicting limited damage, barring a sudden rate spike.

And there may be a plus side for some. New York landlords, for instance, could benefit as higher rates restrict first-time and middle-income buyers and push more tenants to continue renting in their buildings. And observers say New York’s residential market overall should stay stable, since cash buyers are still king for many deals.

Here’s a breakdown of how interest rate hikes will be felt across the real estate industry:

No wiggle room

Residential developers don’t have the luxury or the room in their construction loans — which typically last between two and three years — to use the sort of adjustable-rate loans available to individual homebuyers that can provide some cushion from rate increases. So they will need to look for ways to temper the cost or seek other funding sources.

“[Rental] developers, for example, will have to either figure out how to pass costs on through higher rent or [find] other ways to finance, through mezzanine financing or additional equity,” said Fasulo. “In any case, if rents go up and vacancies stay low, that will soften the blow of the debt costs.”

One option may come from overseas.

“There is a lot of foreign money willing to take lower returns,” said Andrew Gerringer, managing director of the Marketing Directors, which handles sales for new developments and provides market research for developers. “Now we’re seeing an influx of Chinese investors. There is always somebody who is willing to take that risk.”

In one high-profile example, the Bank of China stepped in with a $600 million loan for Vornado Realty Trust in late January for the REIT’s long-delayed luxury condominium at 220 Central Park South. The loan covers four lots on West 58th Street in Midtown.

Similarly, a consortium of Asian banks gave Hines Development an $860 million loan for its planned 1,050-foot-tall tower that will house the Museum of Modern Art’s gallery expansion, along with 145 luxury condos. The billionaire Kwee family of Singapore is also putting up $300 million, in return for an equity interest in the project.

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Some developers may look to get into different sectors of the market altogether. Higher rates could encourage more affordable-housing projects, said Heidi Burkhart, president of Dane Professional Consulting Group. And she predicted that builders will turn to city and state agencies to fund development.

Conventional construction loans will bear interest rates that are too high to make the developments make sense for builders, Burkhart said. “Either agencies will need to support development, or construction will come to a halt.”

Investment, undeterred

After Yellen’s unexpected comment regarding the pace of rate hikes, REIT stocks slid by 1.3 percent, a bigger drop than the 0.7-percent decline for the Standard & Poor’s 500. REIT shares were seeing a strong turnaround through the middle of last month after stumbling out of the gate for the year (see “A REIT rundown for 2014”), but at the end of the month struggled to regain those rate-related losses, while the broader market quickly recovered.

But the irony is that, despite investor jitters, a gradual rate increase along with a strengthening economy largely won’t deter most real estate investment. Only an unforeseen spike could derail deals and send companies into trouble.

“As long as the overall economic environment is favorable,” said Ryan Severino, senior economist at real estate investment advisory firm Reis Inc., “then I don’t see any deleterious impact due to rates alone.”

As for hotel sales, higher interest rates may hurt investment activity and lower values somewhat, but only in the short term as long as the economy is improving, said Sean Hennessey, founder and CEO of Lodging Advisors. Hoteliers are also more nimble when it comes to adjusting to changes in the cost of capital, because they can change room rates to match the environment.

“It cuts both ways,” Hennessey said. After Lehman Brothers collapsed in September 2008, “hotels were one of the first to go into the tank,” he said. “But during the recovery, it was the first asset class to start showing improvement.”

Hennessey expects operating fundamentals to continue to improve as business travel and corporate group meetings finally follow leisure travel in rebounding, he said. And that will keep investment demand and prices up.

Residential reaction

Rising rates will likely mean good news for apartment landlords, because higher rates make it harder for people to afford buying. That could send more people back into the rental market, which is already tight due to strict lending standards, said Jonathan Miller, president and CEO of Miller Samuel Inc. Rents will stay strong with the increased demand.

On the residential sales side, Miller believes the luxury market will largely be insulated to the rise in interest rates, since many buyers come with pockets full of cash, such as international buyers and Wall Street types with big bonuses. But the entry- and middle-home markets will start to feel the squeeze because their buyers typically depend on financing.

“Still, I think there is a lot more upside to rates before it really dampens the housing market in New York City,” Miller said. “We have to go another point, well into the 5s, before we see a significant impact on transaction volume.”

Homebuyers also may consider adjustable-rate loans instead of fixed-rate mortgages if interest rates rise, said Gerringer of the Marketing Directors. “There are many ways to skin a cat for these things,” he said.