The Domino Effect of Surging Interest Rates on Multifamily Housing Starts
The ripple effects of interest rate hikes are destabilizing the commercial real estate market; will the multi-family housing starts be next to bear the brunt
The commercial real estate world is currently in the grip of an intensifying storm, spurred by the relentless upsurge of interest rates. This emerging financial tempest is beginning to unveil disconcerting cracks in the once robust edifice of the commercial real estate market. This burgeoning concern echoes patterns we've seen in previous decades, creating an eerie sense of déjà vu among industry veterans.
During the 1970s and 80s, the Federal Reserve employed a monetary policy instrument to combat inflation by raising interest rates. The federal funds rate skyrocketed, peaking at a jaw-dropping 20% in 1981. This action dramatically altered the commercial real estate industry's landscape. Sky-high borrowing costs made real estate investments less alluring, slowing down the industry's pace and triggering substantial financial distress for both developers and investors.
This period of distress culminated in the infamous Savings and Loan crisis in the late 80s, where over a thousand savings and loan institutions in the U.S. collapsed under the weight of bad real estate loans. But from this financial rubble arose the Real Estate Investment Trusts (REITs), providing a beacon of hope in an otherwise gloomy financial landscape. REITs offered an innovative solution to the liquidity crunch faced by the real estate market, allowing investors to invest in income-generating real estate much like stocks, thereby providing the industry with a new lifeline for raising capital.
Today's circumstances eerily mirror the past, as we see companies like Brookfield defaulting on substantial office building mortgages. These instances are not isolated incidents but rather red flags signaling potential distress in the market. The next sector that could feel the ripple effects of these rising interest rates is the multi-family housing starts. As the cost of capital becomes increasingly expensive, new development projects lose their financial appeal, pushing developers to delay or even cancel projects due to the escalating financial strain.
This predicament is underscored by recent data. In March 2023, U.S. housing starts dipped by 0.8%, largely driven by a sharp 5.9% decline in multi-family projects. This trend in multi-family housing starts presents a stark contrast to the pickup in single-family homes' construction, which experienced a 2.7% boost. Although single-family home construction can potentially help meet demand in the face of limited inventory, multi-family projects are, unfortunately, left in the lurch.
Adding to the industry's mounting challenges are the tighter loan standards for borrowers and mortgage rates, which have doubled since the end of 2021. Applications to build, a key indicator of future construction, slipped by 8.8%, primarily due to fewer permits being issued for multi-family projects.
However, amidst these intimidating challenges lies a silver lining. As we've seen in the past, during the interest rate hikes of the 70s and 80s, adversity often triggers innovation. Today's rising interest rates and tightening capital markets could incentivize industry players to reassess their strategies, pushing them to explore new frontiers. The creation of REITs during a period of financial tumult in the past stands as a testament to the industry's resilience and capacity for innovation.
While the current market outlook may seem grim, we must remember that the history of commercial real estate is a testament to the sector's ability to bounce back from downturns. Such challenging periods have often served as catalysts for innovation and adaptation. As the industry navigates these turbulent waters, the critical question is, how will the players respond to this challenge? With foresight, flexibility, and a dash of creativity, the current obstacles could potentially pave the way for a new era of growth and resilience in commercial real estate.