As we near the end of 2019, the economic outlook is increasingly uncertain. A real estate downturn is eventually expected to follow this extended upswing that began after the financial crash a decade ago. Although several economic signs are ominous, there’s a silver lining. New opportunities could arise in commercial real estate.
Certain trends bear watching that could affect commercial real estate finance — and the affordable and distressed portions of the market, in particular — as we prepare to move into 2020. First, the nation’s affordable-housing stock is still failing to meet the overwhelming demand, which should continue to generate strong demand for commercial mortgage brokers and private lenders, regardless of how the economy fares next year.
During the recovery, the apartment market has told two different stories. Rents for luxury apartments have grown strongly for several years and developers have produced high numbers of new upper-scale apartment buildings. The affordable market is a different case, however, because there remains a considerable shortage of affordable rentals.
According to U.S. Census Bureau data cited in a 2018 report by Harvard University’s Joint Center for Housing Studies, the number of low-cost rental units with monthly rents below $800 — making them affordable to households earning less than $32,000 a year — declined by more than 2.5 million between 1990 and 2016. By contrast, the number of units with monthly rents of more than $2,000 increased by 2.6 million.
The National Low Income Housing Coalition (NLIHC) reported this year that only 4 million rental homes are affordable and available to the nation’s 11 million extremely low-income renter households whose incomes are less than the poverty rate, or 30% of their area’s median income. That leaves a shortage of 7 million rental homes, according to NLIHC. The median asking rent in 2017 for an apartment in an unsubsidized development was $1,550 per month, which is too costly for low-income borrowers, the advocacy organization reported.
Some market factors have held back the development of new affordable rentals. Construction costs generally are high. Federal, state and local governments also have failed to provide enough incentives for new affordable homes. Developers typically need these to attract investors and institutional capital. Institutional investors typically can’t get their required returns from unsubsidized, affordable developments. So, the new supply of affordable rentals over the past decade has been sparse.
The result has been a housing crisis that has priced out a growing proportion of lower-income individuals and families from decent homes. Despite the lack of new construction, however, there remains an opportunity to invest in the supply of existing affordable and workforce rental assets. Although these properties can’t address overall demand, they are still critical for housing a large population, particularly near major metro areas where employment centers are located. The point is that there should be considerable demand for commercial mortgages to purchase and refinance these properties, regardless of the state of the economy.
Private lenders also could do a greater share of the financing for multifamily assets. In the third quarter of this year, the government-sponsored enterprises (GSEs) Freddie Mac and Fannie Mae began to slow activity within their small-balance loan programs that target workforce and affordable rental properties.
Freddie Mac made specific efforts to remove some credit exceptions and to increase pricing. The agency also increased pricing for its Targeted Affordable Housing Express program, which provides faster and cheaper financing for the preservation of smaller affordable rental properties. Following suit, Fannie Mae also raised its prices.
More recently the prices have dropped again, but, the GSEs’ moves are not altogether surprising when reviewing their historic pauses in activity. The agencies are likely assessing the market. These program shifts, however, inevitably cause a pipeline slowdown and negatively affect the nationwide availability of debt for this vital and underserved housing category.
With this agency slowdown, which ultimately will affect the GSEs’ transaction volumes for 2019, private lenders and banks will be looked at to fill the debt-financing void. Nonbank lenders are more likely to play a greater role as banks face an array of challenges in financing affordable apartment deals. Unsurprisingly, lenders who offer nonagency financing programs for these asset categories are experiencing a dramatic influx of inquiries.
The movement of interest rates also bears close attention. U.S. Treasury yields decreased in third-quarter 2019, with loan rates following suit. With the scales tipping in favor of borrowers, commercial real estate loan demand will likely remain steady. But it’s hard to predict how long rates will remain this low. What we do know is that, at some point, the rates can’t go any lower as spreads will be negatively impacted. For your borrowers seeking debt, this is the best time lock in lower long-term rates.
Few in the industry dispute that the real estate cycle is mature. Although real estate fundamentals remain strong, the economy may suffer a downturn. The warning signs include the trade war with China; the recent yield-curve inversions that often foreshadow a recession; worsening global economic growth forecasts; and the increasing focus on corporate debt.
Although economists don’t agree on which individual shock will spark the next recession or when it will occur, these are causes for concern.
Downturns, however, bring opportunities in the distressed-property market. During the last downturn, for example, opportunity was found through purchases of nonperforming small commercial real estate loans from banks. The Federal Deposit Insurance Corp. established its structured transaction program, which packaged distressed mortgages from regional-bank balance sheets and disposed of them to private partners that had the ability to work out and resolve the issues.
Expect similar debt opportunities to arise and even flourish during the next downturn. While the viability of various investments shifts with a changing market, debt remains one of the best investments across the full economic cycle.
The bottom line is that mortgage brokers with diversified loan programs — both agency and non-agency — will be well-positioned to participate in high-demand financing opportunities, such as those for affordable rental housing. Likewise, those who are now nimble enough to pivot and take advantage of distressed opportunities will thrive even in the face of a market downturn.