Welcome to the magnificent autumn in Southern California!
As the days grow shorter, leaves crunch beneath our feet, and temperatures begin to cool, the commercial real estate market in our area faces a number of challenges.
The recent blatant attack on Israel by Hamas, the removal of our House speaker, and 10-year bond yields reaching 20-year highs are just some of the obstacles we are currently encountering.
Both the attack on Israel and the political turmoil in the House of Representatives create a sense of uncertainty. As I have emphasized before, in the face of uncertainty, long-term decisions are often delayed or abandoned altogether until the situation stabilizes.
Additionally, mortgage rates are reaching highs not seen since the financial crisis of the previous decade, which is causing stagnation in the housing market. As residential transactions decrease, we also feel the impact in the commercial sector.
You may be wondering how this is connected. Allow me to elaborate on a few scenarios.
The Ripple Effect of Turnover
I am reminded of the flurry of activity in our small neighborhood of East Orange before the pandemic.
On our street, my wife and I have owned our home for the second longest time among our neighbors. Diagonally across from us live the original owners who have been there since 1984, although now with a new generation.
However, in recent times, a few of our neighbors have either moved to assisted living or passed away, resulting in four homes changing hands. Additionally, one rental property has been converted into an ownership.
In every case, a significant interior renovation took place, followed by improvements to the exterior.
So let’s break it down. First, a transaction occurred, involving real estate agents for both the buyer and seller. Prior to the sale, staging, signage, glossy brochures, and touch-up repairs were done. There may have also been legal involvement in reviewing the contract.
Then, various professionals such as escrow officers, title representatives, and lenders became involved. Home inspectors, termite companies, and moving services were hired. Insurance for the new property was also part of the closing process.
And let’s not forget the increase in property taxes, which support our government. Once the deed is recorded and the title is transferred, a multitude of contractors descend upon the structure from the early 1980s. Painting, flooring, kitchen and bathroom upgrades, wall removal, and additional square footage are added, all with great enthusiasm.
The old furniture is replaced with new pieces to match the pristine interior. Trips to Living Spaces, Daniels, or Mathis Brothers are made.
Now, an elderly couple with limited consumption has been replaced by a family of four or five. The new residents fuel the local economy through groceries, gas, dry cleaning, sports equipment, school clothes, orthodontics, urgent care, pets and pet supplies, and Amazon home deliveries.
As you can see, the sale of houses actively supports commercial real estate activity!
Please take a moment to consider the steps outlined above. In each case, the office, industrial, and retail sectors benefit. Residential real estate agents, escrow and title services, lawyers, physicians, and insurance brokers, for the most part, utilize office spaces. Moving and storage services, contractors, and landscape companies operate from industrial buildings.
Finally, the act of purchasing items, whether through retail storefronts or online portals, stimulates the economy.
However, in the absence of turnover in the housing market, these businesses are forced to downsize, close their doors, or seek opportunities elsewhere.
The Impact of Rising Interest Rates
Last week, 10-year Treasuries exceeded 4.8% for the first time since 2007!
While this may be good news for savers, it poses a problem for those looking to buy homes, refinance mortgages, expand businesses, or invest in commercial real estate.
Two years ago, the same yield was at 1.61%, meaning yields today are approximately three times higher than they were two years ago.
Passive investors can now earn a risk-free return on their money backed by the full faith and credit of the United States government. They can avoid the unpredictable fluctuations of the stock market or the downsides of owning real estate, such as dealing with tenant issues.
However, this significant rise in interest rates makes borrowing more expensive, thus reducing affordability in the housing market.
If you are one of the unfortunate few with maturing loan balances to refinance, prepare yourself for the impact. Expanding businesses also become more costly.
For example, banks determine loan pricing based on their cost of funds and the strength of the collateral. As we discussed, savers can make 4.8% on Treasuries, prompting banks to increase rates on Certificate of Deposits to attract new funds.
Expanding a business in an uncertain economy could be seen as risky by lenders. To hedge against default, higher interest rates must be charged. And the cycle continues.
For those looking to secure a property for their business, many will find the debt service to be too expensive compared to renting. Rental agreements will become a more affordable option.
This year, I have been optimistic about our economy and the resilience of consumers. While others predicted a slowdown, I took a contrarian view. However, with the increasing repayment of student debt after the pandemic, declining home savings balances, the end of government stimulus, rising interest rates, and global unrest, I am afraid a recession is inevitable. The timing, depth, and duration of such a recession remain uncertain.
Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. You can reach him at [email protected] or 714.564.7104.
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