There’s a growing consensus that we need more housing and less office space as cities move forward with plans to transform themselves in a post-pandemic world.
The thought process is straightforward — in a world with more remote work, cities have too many offices, but in many cases not enough housing to accommodate everyone who wants to live there. Adding housing means residential density needs to increase, so it’s important that restrictions to development are reduced and that the “YIMBY” — yes in my backyard — movement notches policy wins. The problem is this planning vision clashes with the current financing environment. Cities and developers know what they want to build, but financing costs and lenders, for the most part, won’t accommodate it. Large-scale urban transformations will have to wait, perhaps for years.
The problem starts with higher interest rates. Policy tightening by the Federal Reserve has flowed right into the costs for commercial property developers. One Washington DC developer recently said that interest rates on construction loans are approaching 10% from closer to 4% in early 2021. The industry also faces a structural challenge in refinancing existing borrowing at higher rates as debt matures.
For developers, the slowing rental market is a problem as well since higher-density residential construction is most likely to focus on rentals. Nationally, asking rents for apartments are down from a year ago, vacancies are rising, and there are a lot of units being built that will be delivered over the next couple of years. That's good news for tenants looking for a deal on an apartment lease, but creates uncertainty for developers and lenders looking at potential new projects.
The banks and lenders who tend to finance real estate development are another challenge. While the high-profile bank failures in March may be a distant memory for financial markets, they've cast a pall over the property market that has yet to be resolved. Banks looking to offload property loans are struggling to find buyers. Blackstone Inc.’s $70 billion real estate trust has faced redemption pressure for months, and recently announced it is selling a minority stake in the Bellagio casino and resort in Las Vegas to raise liquidity. It’s generally not a great environment for new projects when huge funds are offloading high-quality assets.
This shows up in the Federal Reserve's quarterly Senior Loan Officer Survey. The July survey showed that a net 71.7% of domestic banks were tightening standards for commercial real estate loans with construction and land development purposes, with borrower demand for such debt showing extreme weakness.
Close to home here in Atlanta, we've felt the impact of this shift in the financing environment. The German real estate firm Newport invested at least $155 million over six years to revitalize multiple blocks of south downtown, and as recently as January was still adding buildings to its holdings. In July, it announced that its funding had dried up and it was selling the project. It remains unclear how much of a setback this will be.
Notably, these financing challenges don't apply to the same degree to single-family residential construction. Mortgage rates above 7% are sidelining some buyers, but homebuilders have found it profitable to buy those rates down to help with affordability. Building and selling a house is a faster, less complex proposition than building and financing a high-density commercial project that can cost tens or hundreds of millions of dollars.
Obvious questions for urbanists hoping to see more housing built and office buildings converted is what it will take to encourage this kind of development. A decade of low interest rates in the 2010s was a missed opportunity for cities like New York and San Francisco now trying to make the transition in a more challenging financing environment. Removing obstacles to development such as relaxing zoning restrictions helps, but the impact of those actions might not be seen until the next time market conditions are supportive of a construction cycle. A recent New York City plan to convert office space to add 20,000 residential units might well gather dust on a shelf for some time to come.
The option more likely to make an immediate impact is public money. Cities such as Boston have looked into or enacted programs that waive property taxes for office-to-residential conversions that meet certain conditions. Depending upon how that goes, municipalities could consider financing projects themselves with low-interest loans.
Without public money, those hoping for a shift in the financing environment need to practice patience. “Survive 'til ’25” has become something of a mantra this year in the commercial real estate industry, with participants thinking or hoping that by 2025 conditions will have improved. Even if that's the case, a new project that's begun in 2025 wouldn't be delivered until at least two or three years after that, bringing us into the late 2020s. Just as we appear to be in a “higher for longer” environment with interest rates, those hoping for a redevelopment boom in cities should expect to be waiting for a while.
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