Survive Until ‘25…The Interest Rate Story

The real estate market has gone through a major shift over the past 2 years. 2012 through 2022 was a series of continuous upward market trends with moments where many thought it was unsustainable and would recede. It was a 10 year stretch fueled by low interest rates and high liquidity.

As economic fears set in around inflation and a potential recession, the market turned downward. The Fed raised their Fed Funds Rate at an unprecedented rate, causing many fearful investors to turn to Treasuries that offered a fair return with minimal risk (so long as you believe in the integrity of the United States).

Rising interest rates affect investors who borrow money as it increases their borrowing costs. The Fed Funds Rate directly impacts shorter term construction loans. Treasuries, on the other hand, 5-yr/10-yr/30-yr affect longer term conventional loans.

The higher Fed rate meant higher rates for bridge and construction loans as these are tied to indexes like WSJ Prime or SOFR, which trend on a 2-3% spread above the Fed Funds Rate. When the Fed raised its rate to 5.25-5.5% from their 0% level, many investors with bridge/construction loans began borrowing at 7.5-9% interest instead of at the 4.5-5% level where they were for years prior.

If we look at conventional debt, Treasuries across the board rose 3.5-4%, raising traditional bank rates to between 7-8%. This affected people buying both single family homes and commercial real estate, such as office buildings, retail shops or apartment buildings.

What’s the impact of higher rates?

1. As rates go up, prices come down. Investors want the same return on their money, if not more when market risk is higher, so to offset the higher borrowing costs they will pay a lower price.

2. Loan sizes drop. As rates go up, banks decrease the size of loans they give to a particular asset to keep the net loan payments the same. A 3% loan may get a $1,000,000 loan whereas a 6% loan may secure a $600,000 loan.

The significance of the rise of interest rates starting in 2022 was the decrease in value of commercial real estate. It came at a time when we were beginning to normalize post pandemic. Office buildings had high vacancy, apartment buildings had delinquent tenants and brick-and-mortar retail was sluggish.

The motto became “Survive until ‘25” because many owners had loans that were set to mature in 2025, both temporary bridge loans and conventional loans that had been originated when rates were in the 3-4% range. The hope has been that rates would come down and give owners of struggling properties, where the existing loan is higher than a loan they would be able to refinance into today, a chance to stabilize their assets. Today, many owners would need to put cash in to secure a new loan, where the standard is to get cash out upon a refinance. If these owners choose to sell instead of refinance, they would take a loss as values have dropped significantly.

We started to see hope back in September 2024 as the Fed began to cut rates and Treasuries dropped as a result. Since then, something strange has happened.

The Fed has continued to cut rates through the end of 2024, which has tremendously helped owners with bridge loans. We have seen a 1% drop over the past 4 months on construction loans. At the same time, Treasuries have gone up 0.60%, keeping bank loans at 6-6.5%. Owners who have been waiting 2 years to refinance at lower rates may have to continue waiting because their building won’t support a loan at this higher rate.

The Survive until ‘25 may turn out to be Survive through ‘25, unless we see Treasuries cool down to a manageable level for real estate. Real estate should rebound with borrowing costs below 5.5% and sustaining at that lower level. Confidence would ensue, both from owners needing to refinance and buyers returning to the transaction market. It is anybody's guess as to when this will occur.

As for TGG, 2024 was a year where our investment strategy heavily focused on strengthening our current portfolio while adding to it where and when we saw fit. We renovated units that were previously occupied by long-term tenants, built ADUs to add units to existing properties and improved building operations to maximize cash flow. We have maintained distributions to our investors and continue to increase our equity positions by increasing property values. We have several potential refinances pending where we will be able to return a large percentage of the original capital, but these will occur once rates drop to levels where it makes sense to refinance. We have put ourselves in a position of strength to be able to act as we choose to, in order to protects our business and our investors.