NYU’s Sam Chandan on the Changing Real Estate Capital Markets
- May 16, 2018
In a year of changing federal regulations and policies, as well as rising interest rates, the impact of these factors on the commercial real estate capital markets is still unclear. Sam Chandan, associate dean of the NYU Schack Institute of Real Estate & founder of Chandan Economics, explained why the effects will be specific to each market and asset type, and outlined how tightening lending conditions and growing crowdfunding platforms will factor into the capital markets picture going forward.
The past year we have seen various changes in tax legislation, the new tariffs for imported steel, rising interest rates, etc. How do you think these adjustments will impact capital markets going forward?
Chandan: Probably the most significant development over the course of the last several months, which will carry over to 2018 and impact capital markets, is the changing interest rate environment. The timing of increases in interest rates has been a topic of great discussion and debate in the real estate industry for most of this expansion. At this point in time, we have very clear signals from the Federal Reserve and the Federal Open Market Committee that they will pursue a relatively more aggressive path of short-term interest rate increases over the course of 2018 and 2019. In an environment where the economy is growing, long-term interest rates will be higher than short-term interest rates. So, I think that with some modest slope on the yield curve, we will see both short-term and long-term interest rates begin to increase.
There’s a great deal of discussion in our industry around how property prices and cap rates respond to interest rate increases or tightening of monetary policy. What that misses is that the different types of property, depending on their location, the degree of competition for the asset, matter for how valuations and cap rates respond to changes in interest rates. What we will ultimately see is that there are some properties in the higher interest rate environment where a lot of those increases are absorbed into spreads and there are going to be other properties where the value comes under pressure as sellers have to offer higher yields to entice buyers to the market.
So the impact will be different for each property or each market?
Chandan: Yes, we will see differences in the impact. Certainly, the market is going to matter. One of the real basic drivers is the extent of competition for the property—how many potential buyers are there for a property, how many lenders are there that want to provide the financing for the deal—but also size, location and property type. Where there is more intensive competition for an asset, in an environment of rising rates, it’s more likely that the interest rate increase will be absorbed into spreads. All things being equal, we see that rising interest rates do exert more pressure on the property value.
What other factors are influencing the real estate financing environment?
Chandan: There are a couple of factors here. As we have seen on a year-over-year basis, the transaction volume growth has moderated. Also, the rates of appreciation in the market have slowed and we’re in a different phase of the real estate investment cycle than we have been for most of this expansion. That means we can expect to see that both investors and lenders will, in some cases, take a more reserved or judicious approach to the market. We begin to see this in metrics such as how long a property is on the market before it transacts, the difference in the assessments of value on the part of buyers and sellers. That’s where we see some differences emerging that signal a more modest pace of improvement in the market over the course of 2018 and 2019.
Apart from that, we see that lenders have pushed yields to very low levels, while leverages increased. A survey we conducted with the Real Estate Lenders Association is telling us that, on average, standards will tighten up a bit this year, but there are differences across property types. For example, lenders have indicated that they see the greatest potential for tightening of standards in the retail sector, whereas in the industrial sector, they see that there is still some room to make credit relatively more easily available.
Many say we are at a late stage in the real estate cycle, while others claim there is still room for growth in the U.S. What is your view?
Chandan: Whether we are looking at the macroeconomic cycle or the real estate cycle, I think, compared to historic trends, this has been a longer cycle. Certainly, if the economic expansion proceeds another year or surpasses another year, it will be the longest expansion in the modern U.S. economic history. There is no fixed time frame or timeline for an economic expansion, so it becomes difficult to predict. We would not say simply because the cycle is long, it must come to an end. What we need to do is look at what are some of the risks being taken in the economy and the debt markets, what are some of the potential proximate causes for an inflection.
The underlying performance of the economy does not point to an impending recession and there are good arguments for why this current expansion will continue. On the real estate side, in an environment of rising interest rates, we will see more modest improvements over the course of the next couple of years, but those improvements can continue.
What risks should investors consider going forward?
Chandan: Where we do have to be cautious is on two fronts. One is the result of a potential deterioration in U.S. trade relationships—a destabilization of the geopolitical environment that could upset the economic balance. But also, if we are an investor or a lender in the market today, our time horizon is not three, six or 12 months. We are making an investment that will sit on our balance sheet for maybe three, five or seven years. It would be prudent to assess how will the investment perform in an environment where the economy is weak.
If I am holding this asset for three, five or seven years, in all likelihood, I will hold that asset and have exposure during a period when the economy is not performing well. It’s not so much about when exactly will that inflection occur, we know that it will occur. It’s more about “am I testing and stressing the resilience of the investments I am making today against their performance in an environment where the economic conditions are less favorable?” We don’t see that test being done with sufficient rigor, but there’s an opportunity there for investors to be thinking more carefully how their assets will perform if market conditions change.
What do you think the next recession will look like? Will we see something similar to what happened in 2008?
Chandan: Based on what we see happening in the financial services sector and in the single-family housing market, the underlying conditions that could precipitate another great financial crisis are limited. We do see significant risk taking in other areas of the market. I don’t believe that commercial real estate and the deterioration of real estate performance would be the trigger or the proximate cause for the next recession.
There are other candidates out there that are not real estate related. Even if real estate isn’t the cause or is not causally related to the next recession, when that next recession does occur, we will feel pain in our sector. Our sector will be impacted whether or not we are the driver.
Do you think the next recession will be linked to the digital world, the online aspect of the business?
Chandan: No, I don’t. We need to look for evidence of significant risk taking and that risk taking often involves excessive debt levels. We need to look at segments of the economy where debt levels are rising in a way that will be unsupportable by the underlying fundamentals.
Could you give us an example?
Chandan: Corporate debt, student debt, unfunded pension obligations at the state and local level.
In 2018, we are seeing new sources of capital, such as crowdfunding, gaining popularity. What are the prospects for these alternative sources of capital going forward?
Chandan: I think that it’s been exciting to see the emergence of new platforms that are taking advantage of people’s interest in real estate, but also leveraging new and emerging technologies in combination with changes in the regulatory environment.
While there is potential for growth and it’s an exciting opportunity, real estate crowdfunding will remain a relatively small share of the overall market. In our view, on the long-term, banks, agency lenders, life insurance companies will remain the dominant sources of financing into the market.
Image courtesy of NYU’s Schack Institute of Real Estate