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How sky high mortgage rates rates slow commercial real estate

October 14, 2023

Welcome to our glorious SoCal fall!

As days shorten, leaves crunch underfoot, and temperatures cool – our commercial real estate market faces several headwinds.

Hamas’ blatant attack on Israel, the ouster of our House speaker, and the 10-year bond yields at 20-year highs headline the obstacles.

The first two – Israel being attacked and a certain game of pattycake in the House of Representatives each create uncertainty. As I’ve said here many times: In the face of uncertainty, long-term decisions are postponed or scrapped entirely until things level.

Headlines in my frame of reference target mortgage rates and highs not seen since the financial meltdown of last decade. Such high rates create gridlock in the housing market. As residential transactions ebb, we also feel it in the commercial sector.

How, you may be wondering? Allow me to expand on a few scenarios.

Turnover generates commerce

My mind is drawn to the pre-pandemic spate of deals in our small enclave of houses in East Orange.

On our street, my wife and I have owned our home the second-longest among neighbors. Kitty-corner to us are original owners since 1984. Their multi-generational setup remains today – only with a new generation.

But lately, several of our neighbors tapped out for assisted living or passed away, leading to four homes changing hands. Also, one rental converted into an ownership.

In every instance, a dramatic interior redo occurred followed by a freshening of the outside as well.

So let’s break this down. First, a transaction happened. In the process, real estate agents were deployed for the buyer and seller. Staging, signage, glossy brochures and touchup repairs preceded the sale. Maybe a lawyer or two got a look at the contract.

Then escrow officers, title representatives and lenders were engaged. Home inspectors, termite companies and moving vans were hired. Insurance for the new digs was a closing component.

And let’s not forget the bump in property taxes, which funds our governments. Once the deed records and title transfers, an army of contractors descends on the early 1980’s structure. Paint, flooring, kitchen upgrades, bathroom remodeling, wall removal, and additional square footage is added, all in earnest.

The old furniture surely can’t be set inside this pristine interior. So a trip to Living Spaces, Daniels, or Mathis Brothers follows.

Now an elderly couple – with limited consumption – is replaced by a family of four or five. Groceries, gasoline, dry cleaning, sports equipment, school clothes, orthodontics, urgent care, pets and pet supplies and Amazon home deliveries are all fueled by the new residents.

You see, commercial real estate activity is bolstered by the sale of houses!

Please take a moment to review the steps above. In every case, office, industrial and retail are enhanced. Residential real estate agents, escrow and title plants, lawyers, physicians, and insurance brokers all use office spaces, for the most part. Moving and storage, contractors and landscape companies ply their trades from industrial buildings.

Finally, buying stuff. Yes! Retail storefronts or online portals.

But absent such turnover in houses, these businesses are forced to downsize, close their doors or look elsewhere for new work.

Rate shock

The 10-year Treasuries eclipsed 4.8% last week for the first time since 2007!

It’s great news for savers but lousy for those looking to buy a house, refinance a mortgage, expand a business or purchase commercial real estate.

Two years ago today, that same yield was 1.61%. Yes, yields today are roughly three times where they were two years ago.

Now, backed by the full faith and credit of the United States government, passive investors can make a nice risk-free return on their money. Avoided are the gyrations of the stock market or the downside of real estate ownership – such as losing a tenant.

However, this astronomic rise in rates makes borrowing more expensive. Therefore, affordability in house purchases becomes less so.

If you’re among the unfortunate few who have maturing loan balances to refinance, brace yourselves. Finally, expanding a business becomes richer.

Here’s what I mean. Banks price loans based on their cost of funds and the strength of the collateral. As we just discussed, a saver can make 4.8% in Treasuries so banks must raise Certificate of Deposit rates to attract new money into their bank.

Expanding an enterprise into an uncertain economy could be viewed by some lenders as risky. Therefore, to hedge against default, the rates charged must compensate. And the circle continues.

For those hoping to secure ownership in a location to house their operation, many will encounter a debt service too expensive compared with a rental. More will find leasing to be more affordable.

This year, I’ve been quite bullish on our economy and the resilience of the consumer. When others predicted a slowdown, I took the contrarian position. Now, with student debt repayment ramping up after pandemic hibernation, home savings balances declining, the government money spigot ending, high interest rates ramping plus some new global unrest, I’m afraid a recession is inevitable. When, how deep and how long remain questionable.

Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at [email protected] or 714.564.7104.

Orange County Register

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How sky high mortgage rates rates slow commercial real estate

Turnover generates commerce

Rate shock

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