Rising Interest Rates, GSP Commentary

$14,760,000 (80% LTV) Bridge Financing for 62,000 s.f. Mixed-Use Facility: GSP has obtained 80% LTV, floating-rate financing for a 62,000 s.f. mixed-use facility (health club and retail, plus parking structure) in Southern California. By refinancing the property and defeasing a pre-existing CMBS loan, the borrower was able to (1) gain access to substantial trapped equity, (2) take advantage of low floating-rate interest rates, effectively lowering the mortgage payment despite significantly higher leverage on the property and (3) fund re-entitlement and redevelopment initiatives facilitated by excess on-site parking in the densely-populated, infill area. Terms: (1) Pricing: 1-month LIBOR +2.35% for initial term; (2) Initial Term: 36 months; (3) Amort: I/O for initial term, 25 year schedule for extension; (4) LTV: 80%; (5) Prepayment: Locked for 12 months, 0.75% exit fee thereafter; (6) Top 20% recourse; (7) Lender Fee: 1%. (Gary Mozer, Lee Norman, Larry Wilemon)

We were recently asked to comment on the effect of rising interest rates on the real estate market, here are responses from George Smith and David R. Pascale, Jr.

“I have been in real estate since July 1964 and income property real estate financing since July 1968. Cap rates have never been lower. Southern California is the lowest in the country with possible exceptions of Washington DC and NY Metro areas. Our opinion is that cap rates have moved down with the lower mortgage rates. While the Fed has increased the Fed Fund’s Rates, the longer term Treasury rates have not moved (except for bounces, and they have recently moved downward) and pricing spreads over the Treasuries have narrowed, indicating the strength of the mortgage market. At some point, if the Fed continues raising rates as expected, the long term rates will have to start rising. When this happens there is the likelihood that spreads will also widen as cap rates rise and income property values start to decline because loans typically represent 75% of value. What has surprised me is that “the market’ usually anticipates the Fed’s movements. I would have expected long term rates to have increased and sales cap rates to have started increasing. Instead, everyone I know cannot find anything to buy, the supply of listings of quality product is down and sellers can’t find bargains and are holding on to the properties.” (George Smith)

Construction and Bridge/Reposition: Higher interest rates combined with rising prices for hard cost items (steel, lumber, concrete, etc) are driving total project costs up. If rates stay high, then the higher rates will negatively affect the eventual permanent loan proceeds and possibly the sales price, further "squeezing" the return on equity. Property owners in certain markets (and property type sectors within those markets) may have "pricing power" to raise rents on tenants. This depends on market dynamics such as vacancy, absorption, new construction, etc. Rising rents will also be more likely if the macro-economy goes into an inflationary period where consumer prices are rising. Owners that have to hold the line on rents due to high vacancy or other factors will see lower returns.

Permanent/Acquisition: Higher interest rates will negatively affect cash flow and investor returns as long as cap rates stay where they are. Sellers will not be flexible until they get resistance from buyers. With so many acquisitions being driven by 1031 exchanges, buyers are still hungry and willing to sacrifice some return in order to defer taxes. Eventually, if rates keep rising, there will be a point in each market and product type where buyers start to pull back and cap rates should rise.

Macro-Economic Issues: The question is "How high will rates go?" A dramatic rise in interest rates will negatively affect consumers as discretionary income will drop due to higher mortgage, car, credit card and other loan payments. This could affect retail, apartment and hotel rents and/or occupancy rates--also office and industrial if the high rate environment lingers for a substantial period (David R. Pascale, Jr.)

Correction: Last week we reported that Gary M. Tenzer judged the 1st Annual Real Estate Case Competition at USC Law School on April 8. It was actually at the USC Undergraduate Real Estate program at the Marshall School of Business. The winner of the competition was University of Texas, Austin. Congratulations!

The University of Southern California’s Lusk Center for Real Estate has named Gary M. Tenzer, Executive Vice President and Principal of GSP, to the leadership council of the board of directors. As a member of the leadership council, Mr. Tenzer will guide the Lusk Center’s efforts to produce relevant and timely real estate research, support educational programs for students and executives, and convene professional forums that bring together leaders in education, business and the community.

GSP Profiles - Gilda Rivera: (Part of our continuing series profiling GSP's "Next Generation" of Brokers) Ms. Rivera joined GSP full-time in January 2004 and has worked on placing and closing over $100,000,000 of financings. Prior to that, she worked at Washington Mutual Bank as an analyst in Commercial Real Estate originations. Ms. Rivera obtained her MBA from University of St. Thomas in Manila, Philippines. Gilda can be reached at ext. 139 or grivera@gspartners.com

Luncheon I – April 27th

George has an exciting line-up of speakers & panels scheduled. Sign up now!
Join the Series and attend 3 private luncheon briefings, as well as pre-reserve your Table of 10 for our Annual Luncheon this Fall.

For more information, log on to www.gspartners.com/at.