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Fed Update
The Federal Reserve announced on Wednesday it will not raise its benchmark interest rates and expects to raise rates more slowly in the coming years. The Fed has decided to stick with its cautious approach to adjusting monetary policy, as recent economic indicators have continued to be mixed. With only 38,000 jobs added in May, job growth has declined, yet economic growth has shown signs of improvement. As such, 15 of 17 policymakers project no more than two rate hikes this year, and six of those officials expect just one rate hike for the remainder of 2016. The Fed will meet again in July and September.
Global economic uncertainty and the recent Fed announcement have promoted a flight to safety that has caused the 10-year treasury yield to close at 1.594 percent, its lowest closing level since December 2012. The negative yielding bonds from Asia and Europe have also played a part, as these investors continue to purchase U.S. Treasury Bonds and, in turn, drive yields lower.
Regulatory Impact on Housing Affordability
New banking regulations that are coming into effect are restraining construction lending and the delivery of supply. In turn, these restrictions, combined with increasing demand for multifamily housing, are further impacting housing affordability issues prevalent in core urban markets. In a time when home ownership is at already historic lows, people are increasingly relying on multifamily rentals for housing. With this evolving development, existing project owners are benefiting, while renters and developers are being heavily burdened.
Housing Overview
In the first quarter of 2016, non-seasonally-adjusted U.S. home ownership rates dropped to 63.5 percent both on a quarterly and yearly basis, down from 63.8 percent at the end of 2015 and 63.7 percent in the first quarter of 2016, according to St. Louis Fed data and generally falling in line with the U.S. Census estimate. Currently, home ownership rates are at their lowest since 1967, with similar rates last seen in 1985. The current sustainable dynamics indicate a faltering market, reflecting the overall weakness in economic growth and inefficiency of monetary policy.
Amidst declining home ownership, the multifamily segment of the market looks relatively bright and fundamentals remain relatively strong. The National Association of Home Builders’ Multifamily Production Index (MPI) shows a reading of 58 in the first quarter of 2016 compared to a reading of 59 in 2015, still above the long-term average of 49 since the index was started in 2003. The MPI is a weighted average of current production indexes for low-rent, market-rent and for-sale units, and can vary from 0 to 100, where any number over 50 indicates more builders report stronger rather than weaker conditions. In May, REIS reported the nationwide occupancy rate was 96 percent in April, down 10 basis points from March, but flat with the first quarter average.
Regulations Overview
In an effort to make banking safer after the 2008 market crash, we are now seeing the effects of financial rules taking shape, specifically in the form of the Basel III banking regulations and HVCRE rules, which went into effect at the beginning of 2015. As mentioned in our April article, banks have become increasingly concerned with their risk exposure to CRE loans, in particular construction loans, and are tightening their underwriting standards. In certain cases, they are reserving capacity solely for long-standing relationships. Their balance sheets are even more constrained, further limiting the amount of money going into new development deals, impacting availability and pricing, as they become more conservative in terms of leverage and, in some cases, ask for partial recourse.
While these regulations work to make banking a safer practice as a whole, they are making it more difficult for developers to obtain the financing necessary to move forward with development projects and deliver supply amidst declining vacancy rates, rising rents and pent-up demand. Many core urban markets already face significant supply constraints in the form of a lack of developable land and community opposition. These constraints have a tendency to increase as new projects consume land and developers build resistance. Market participants can now expect the added burden of banking regulation to result in the slowing of multi-housing construction and exacerbating of affordability problems.
Certainly, financial regulators and the rules they enforce are intended to look out for the safety of depositors and their funds. The institutions they regulate are regional, national and international in nature and not designed to respond to local market conditions. However, there are ways to recognize local conditions. For example, Fannie Mae and Freddie Mac determine conforming home mortgage size limits based on zip code, signaling a willingness and capacity to accommodate for local conditions.
Benefit and Burden
While the housing shortage and affordability component is widely seen as a burden, it directly benefits owners and developers who are ahead of the game. Those who own rental housing or already have projects under construction have less future supply competition to worry about. As the supply of affordable housing is outpaced by demand, more would-be home buyers are turning to rentals, allowing landlords to raise rents accordingly. Additionally, developers who already have loan commitments or projects under construction have a distinct advantage and can capitalize on the shortage, with higher rents and ease of lease-up due to lack of new product.
Developers seeking financing for projects in their pipeline are now having to expand beyond their known lending sources, find other banks and consider alternative financing in the form of debt funds. With tighter construction lending conditions becoming the new reality, we are seeing higher borrowing costs, which are passed on to the end-consumer in the form of higher rents and greater delays in bringing new product to market. Additionally, developers might not meet anticipated project returns due to higher costs of borrowing and may even decide to postpone projects altogether.
As a group, renters might be households that cannot afford to buy, cannot qualify for a home mortgage or simply choose to rent by lifestyle choice. In high-rent markets, finding housing is difficult enough for many of them, as they sometimes pay over 50 percent of annual income on housing alone. As such, many renters fall into the category of severely cost-burdened households according to the Department of Housing and Urban Developments’ (HUD) rule which uses a maximum of 30 percent of annual income to determine if housing is affordable, which is not realistic in supply constrained markets. Collectively, these households ultimately suffer when additional impediments to supply are added to their list of challenges.
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If you have a pending transaction in need of financing, contact a member of the Dekel Capital executive team to discuss how we can assist in getting your project over this hurdle and finding the best capital source for your needs.