Bracing for rising interest rates in all corners of real estate

From residential to commercial </br>to construction, a look at where loan prices stand

From left: Julie Clapp, Brian Rehling and Melissa Cohn
From left: Julie Clapp, Brian Rehling and Melissa Cohn

Most observers last year predicted that interest rates would rise in 2014 as the Federal Reserve removed its stimulus, but the exact opposite happened. Rates are lower now than they were at the beginning of last year, offering borrowers even cheaper capital.

But 2015 may be the year when rates do gradually march upward from near historic lows. Many expect the central bank will incrementally increase the federal funds rate, a benchmark rate for business and consumer loans. Last month, the Fed indicated it could start tinkering with rates as early as May, though most pundits are eyeing the latter half of the year. A slow rise will help those investing in real estate to appropriately adjust to the changing landscape. Here is a look at how things may play out across different real estate sectors.

Residential loans

While it’s true that nearly half of all residential purchases in the NYC market are made without a mortgage, that still leaves a good chunk of buyers who need a bank’s help to close a sale. Yet rather than suppress demand, “rising rates may coax buyers off the sidelines,” said Juliet Clapp, managing director of Town Fifth Avenue.

Adjustable-rate conforming mortgages — those up to $625,000 — may offer the lowest rate of all purchase mortgages, but they are still more sensitive to changes in the fed funds rate than longer-term fixed mortgages, said Brian Rehling, chief fixed income strategist at Wells Fargo Advisors. That’s because ARMs are tied to the yield on either the 1-year Treasury note or LIBOR, the London Interbank Offer Rate, both of which correlate closely with the fed funds rate.

The most commonly used mortgage, the 30-year fixed-rate, tends to track the yield on the 10-year Treasury note, which follows the federal funds rate, but isn’t as highly correlated as shorter-term treasuries. Additionally, if investors take money out of the 10-year Treasury (typically considered a safe-haven investment), the yield will rise, pushing mortgage rates up as well. This scenario may unfold if the world economy stabilizes and investors feel comfortable with riskier assets.

Still, “if the 30-year fixed went from 4 percent to 5 percent or even 6 percent, that’s still historically low,” said Melissa Cohn, president of GuardHill Financial.

Expect jumbo rates to also rise, but not as much as the 30-year fixed, said Cohn. That’s because jumbo loans — those for $625,000 and more — exist in a different secondary market than conforming loans, which are primarily bought by Fannie Mae and Freddie Mac. Jumbo loans are sold to REITs and hedge funds. Lately, large lenders have also been keeping these loans in their portfolios or selling them to national or regional banks. This competition has helped to keep rates low. Cohn also noted that jumbo ARMs, which are more rate-sensitive, will continue to draw homebuyers with higher purchase prices. “

After $1 million, homeowners lose the tax deductibility on mortgage interest,” said Cohn. “So, those buyers want the lowest rate possible.”

Commercial loans

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There are two conflicting views of the effect of rate hikes on the commercial real estate market,said Jonathan Aghravi, senior director of Eastern Consolidated’s capital advisory division. One side worries that rate increases may set off a wave of defaults, because highly-leveraged investors won’t be able to refinance, much like in 2007 and 2008.

The other side believes that rates will first rise gradually, and only after the central bank determines that the economy is healthy enough to absorb them. If the economy is strong, that translates to higher rents for property owners, Aghravi said.

“Again, the speed at which rates go up is very critical,” he said.

“We’ve been telling our clients to take advantage of the low rates now, with increases to come some time,” this year, said Michael Korine, director of capital markets for Berko & Associates. “Our clients are trending toward longer-term financing, with a 10-year at 4.25 percent.”

Korine has also noticed that more banks are offering 10-year products, when historically they tended toward 5-year or 7-year marks. There is also a direct correlation between interest rates and capitalization rates, said Jerry Swartz, one of the founders at HKS Capital, “in that they rise and fall together.” He explained as rates increase, the cost of capital rises for borrowers, which eventually leads to lower pricing of real estate. When values fall, appraisers use higher cap rates based on comparability.

The good news, though, is that there is still a lot of equity looking to fund deals now. (See related story, page 60.)

“We’re doing a lot more equity transactions,” Swartz said. “We’re seeing a lot of private wealth managers for foreign investors putting money in New York. Rates have come down on that, too.”

Construction loans aren’t as sensitive to rate hikes as investment loans, said Swartz. Their rates are not as competitive as purchase or refinance commercial loans either, because they are riskier, especially as the cost of construction continues to rise, said Korine.

Banks still don’t have a very strong appetite for the construction market, sources noted, although it’s getting better. Lenders also require more post-closing liquidity to make deals.