By Doug Birrell
Commercial real estate owners in Utah are currently the beneficiaries of a lending environment that offers a plethora of loan alternatives, attractive rates and unprecedented interest from institutional lenders and buyers. The persistent strength of the local economy, healthy market fundamentals, and positive national press have combined to generate a significant appetite for lenders and investors to enter or expand their presence in the Utah market.
In many ways, Utah has finally been discovered and the universal conclusion seems to be the same: This is the place!
But how long can the current lending environment continue its course? Let’s look at some of the key components that have helped Utah stand out and discuss where the lending market may be headed in the future.
Where are we now?
Whether it is Salt Lake’s ranking as the 3rd-best market in the recently released “2018 Emerging Trends in Real Estate” report, Provo’s top spot on the “ACBJ Economic Index” or the state’s multi-year claim to the top spot on Forbes’ “Best States for Business” list, word about Utah is spreading. The Wasatch Front offers a young and growing population, features a diverse economy and benefits from a unique geographical layout and location, resulting in a dynamic market poised for continued growth and prosperity. Such accolades have motivated lenders and investors to pay more attention to the Beehive State.
Salt Lake is not alone among secondary markets experiencing this phenomenon. Investors are currently being driven to smaller markets in the pursuit of higher cap rates and yields than they can achieve in coastal and primary markets, such as Los Angeles, Chicago and Boston. Fueled by strong market fundamentals that drive demand for commercial real estate, Utah is considered an emerging market with exciting potential. One of the few limiting factors to Utah’s commercial real estate finance volume is the general lack of available product. Also, local investors have historically maintained longer hold periods for their investments, which correspondingly limits supply availability.
The property types most highly sought by lenders and investors are industrial and multifamily. Within these categories, Salt Lake is well-positioned to continue being a hot commodity for many reasons. As previously mentioned, Utah boasts fundamental strengths like a young population and strong job growth and is home to several local universities and a well-educated workforce, which help fuel multifamily demand. The state also boasts a strategic location as the “Crossroads of the West,” which drives industrial demand. The state has invested a great deal in infrastructure and has focused on expanding mass transportation.
In addition, Utah benefits from stable state and municipal credit ratings. Lenders have taken note of the growth and expansion in this area from market-leading companies such as Goldman Sachs, Adobe and Amazon, and now have a desire to actively participate in the state’s growth. This level of investor activity is expected to continue in the near term.
Where are we headed?
When pursuing commercial real estate opportunities, investors have benefitted from the historically low interest rate environment, which has translated into aggressive cap rates and spurred transaction volume in the commercial real estate finance industry. Property owners have achieved very attractive prices on sales and low interest rates on refinances. The only two limiting factors that have decelerated transaction volume over the past several years have been the relatively high prepayment penalties and seller uncertainty that available replacement properties can be found.
The commercial real estate finance industry has enjoyed an eight-year bull run following the global financial crisis that began in 2008. The previous cycle boom and subsequent crash were largely driven by loose regulations and underwriting standards, which led to highly leveraged loans. But the current cycle has been primarily defined by low interest rates. The low rates have helped the industry absorb and refinance the majority of rolling maturities, including the ultra-aggressive CMBS loans originated during the previous cycle from 2005-2007. The long-predicted impact of the “wall of maturities” — the accumulation of maturing loans from the previous cycle — has largely been muted due to the favorable lending conditions, allowing owners to escape relatively unscathed.
Given the length of the bull market (eight years), many market observers feel that the industry is mature in the current cycle. Unlike the last cycle, lenders have generally maintained better discipline relative to loan-to-value ratios and implemented underwriting techniques to help offset some of the exposure to interest rate movement and risk. However, borrowers have become highly accustomed — and almost addicted — to low interest rates, just like they were previously dependent upon leverage. Sellers have come to expect low cap rates that occur as a result of the current low cost of borrowing. As rates stay low, velocity will continue unimpeded. However, it is almost like a game of musical chairs. The music stops any time rates increase. This reality has been observable in two notable cases in recent years, where rates raised rapidly: the “taper tantrum” in the summer of 2013 (the surge in U.S. Treasury yields that resulted from the Federal Reserve’s use of tapering to gradually reduce the amount of money it was feeding into the economy) and the market following the 2016 presidential election. Whenever interest rates rapidly increase, borrowers tend to pull back and re-evaluate their strategies, which suggests that regardless of all the positive press and discussion of fundamentals, much of the recent market activity — within Utah and otherwise — has been driven by the low cost of capital and excessive market liquidity.
So, the longstanding question remains: How much longer will rates stay low and what will happen when they increase? The Federal Reserve (Fed) has already increased the federal funds rate three times in 2017 and rates are expected to increase once more in December. It is also likely that rates will increase two to three times (at 25 basis points each time) in 2018. If the Fed follows through with such a plan and long-term rates don’t increase at a comparable pace, there is the threat of an inverted yield curve, where short-term rates are higher than long-term rates. This occurrence has preceded each of the past seven recessions.
One key factor to keep an eye on is the Fed’s planned balance sheet roll-off during the coming years. The wind-down process will increase in earnest during the latter half of 2018. (This roll-off is the act of the Fed paring down its bloated balance sheet that occurred as a result of quantitative easing.) Redemptions are scheduled to total $1.14 trillion (46 percent of total Treasuries) between 2018 and 2022, which could result in a material impact to bond markets. When combined with the reduced volume of loan maturities from the previous cycle, rising interest rates will almost certainly lead to the first reduction in commercial real estate finance volume since the Great Recession began.
As we approach the end of the current cycle, many borrowers are opting for longer-term fixed rates in an effort to take advantage of the historically low interest environment while they can. For now, the lending market continues to be very favorable to borrowers. For lenders and borrowers looking at commercial real estate opportunities in Utah, this is the place and now is the time.
Doug Birrell is a first vice president of debt and structured finance in the Salt Lake City office of CBRE.