Two weeks ago we welcomed the spring equinox despite enduring another atmospheric river (see the link HERE to a video of Chichén Itzá in Mexico where on the first day of spring the setting sun depicts a snake crawling down the side of the temple). Santa Cruz is now approaching 50 inches for the season, doubling the season average. I'm ready for more sunshine and dry fairways, this past weekend was a nice change of pace. Here is what we’d like to discuss as we reflect on the first quarter of the year:
- Interest Rates
- Current Supply
- Dream FHA Loan program
- SVB Bank Collapse
- Commercial Real Estate
- How are they related?
We continue to see the second and third order effects of the COVID-19 pandemic and the implications of shutting down the largest economy in the world. The Federal Open Market Committee (FOMC) has moved forward with their anticipated interest rate hikes to combat inflation, deeming the issue their number one priority. We have seen nine consecutive rate hikes since March of 2021 and the effective funds rate is now at 5%. The FED does not set mortgage rates, however how mortgage providers interpret FED actions does impact the costs of borrowing. Despite the increase in mortgage rates over the last year, the market has remained active with sales prices steadily increasing since what is now being perceived as the “bottom” of the cycle, November 2022. This price stabilization is largely due to the inventory constraints outlined in our 2022 Year End Letter.
Inventory has increased ever so slightly since welcoming the New Year. However, this remains on average 450 fewer new listings per month than last year when inventory was also a concern in Santa Clara County (FRED Economic Data).
The consolidation of buyers to the active inventory in the marketplace is creating multiple offer situations and over asking price sales in desired neighborhoods. However, inventory that is mispriced or in areas that are deemed less desirable are experiencing longer days on market (DOM). As of February the average DOM is 38 days which is +16 days compared to this time last year. We do expect active inventory to continue the upward trend as we enter spring, where historically we see the highest number of new listings.
California’s housing shortage continues to be at the forefront of many conversations with local and state legislatures. According to a report by the California Department of Housing and Community Development, the state needs to build an estimated 1.8 million new homes by 2025 to keep up with demand. Governor Newsom campaigned on 350,000 new units per year in 2017. However, the state has been falling significantly short of this goal, with an average of less than 100,000 new units built each year between 2011 and 2020. Future development figures would have to exceed previous peaks from 2005 in order to meet demand. The most anemic growth occurs where zoning remains restrictive for housing, including San Francisco, San Jose and Los Angeles.
Despite recent building incentives and a decreasing population at the state level, the housing shortage is not going anywhere anytime soon. As a result the effects of higher borrowing costs have not impacted the demand market (buyers) enough to make significant changes to market conditions or median sales price.
California Dream HFA Loan Program
The California Dream For All Shared Appreciation Loan is an exciting new program designed to help more Californians achieve homeownership. The program is offered by the California Housing Finance Agency (CalHFA), which is a state agency that provides financing and programs to assist low- and moderate-income Californians in purchasing their first homes.
The Shared Appreciation Loan (SAL) is a type of loan where the borrower receives a loan from CalHFA to purchase a home, and in return, CalHFA shares in the future appreciation of the home's value. When the borrower sells or refinances the home, CalHFA receives a portion of the appreciation based on the initial loan amount and the percentage of shared appreciation agreed upon in the loan terms. They are offering up to 20% in downpayment assistance which would equate to a 20% share in future appreciation.
The program is designed to be an alternative to traditional down payment assistance programs, which can require borrowers to pay back the assistance with interest or make regular payments. With the SAL program, borrowers only pay back the initial loan amount and do not need to make any payments on the shared appreciation until they sell or refinance the home.
The California Dream For All Shared Appreciation Loan is available to first-time homebuyers and those who have not owned a home in the past three years. To qualify, borrowers must meet certain income and credit requirements, and the home being purchased must meet certain eligibility criteria, such as being located in California and meeting certain price limits. There is $300,000,000 in available funds for this program and we’re being told it will be gone in 3-4 months. If you or any family members are thinking of purchasing your first home this may be a great opportunity to alleviate the down payment burden. Please reach out to us for more information so we can put you in touch with a mortgage professional.
Collapse of Silicon Valley Bank
On March 10 we saw the second largest bank failure in history when Silicon Valley Bank (SVB) collapsed and the United States Federal Deposit Insurance Commission (FDIC) stepped in and took possession of the remaining assets. This was a result of a steady decrease in deposits and the investment in longer-term, higher-yielding bonds. When interest rates spiked, SVB was not well positioned to mitigate the risks and as a result was forced to sell those bonds for a large discount to meet reserve levels and scheduled withdrawals. Concerns travel quickly in today’s intertwined network of investors, executives and deposit holders and it didn't take long before the run began.
Keep in mind the real estate market moves notoriously slow. With that said it is hard to know the immediate implications. A bank collapse could potentially have a negative impact on the residential real estate market, as it may lead to a decrease in available credit and a decrease in overall economic stability. Additionally, a bank collapse can lead to a loss of confidence in the overall economy, which can cause potential buyers and investors to be more cautious and hesitant about entering the real estate market. This can ultimately result in a decrease in demand for properties, which can lead to a decrease in prices.
However, in contrast we may see an increase in demand for tangible assets: During times of financial insecurity, investors may lose confidence in traditional financial instruments such as stocks, bonds, and currencies. As a result, they may turn to tangible assets such as real estate as a safe haven investment. This can lead to an increase in demand for real estate, which can in turn lead to an increase in property values. We now know that FDIC has stepped in and guaranteed all of SVB’s depositors. This greatly reduces the direct impact on the businesses that dealt directly with the bank. However, we still have questions about overall consumer sentiment and trust in the financial system and what will be the next second or third order effect of the pandemic to shock the world. As of now signs are pointing to the Commercial Real Estate sector.
The Commercial Real Estate Market
Commercial real estate (CRE) refers to any real estate property that is used for business purposes. This can include properties such as office buildings, retail spaces, warehouses, hotels, apartment buildings, and industrial properties. Commercial real estate is typically owned and operated by businesses or investors who lease the property to tenants. The value of commercial real estate is often based on the income generated from rent, as well as the location, condition, and potential for future development.
In order to accurately explain the current market turbulence, it is important to point out the differences between commercial lending and residential lending that most of you are with. When applying for a commercial loan the bank looks far more closely on the asset being acquired. Whereas in a residential application the focus is primarily on the borrowers creditworthiness, assets and liabilities. In commercial lending they use what is referred to as Debt Service Coverage Ratio (DSCR). This is essentially the assets ability to cover the requested debt with cash flow. A DSCR of 1.0 equates to the asset barely being able to cover the debt obligation, lenders typically look for at least a DSCR of 1.25.
Secondly the length of these commercial loans are much shorter than most residential loan structures. Commercial loans are typically either 5, 7, or 10 years in duration and in some cases interest only payments. Meaning every 5, 7 or 10 years the property owner needs to refinance the outstanding debt. When this refinance occurs the lender revisits the properties current performance and current market conditions. An emphasis is needed on the second point as today's climate is drastically different than it was 5, 7 or 10 years ago. This can be easily seen in asset classes like office space where our post-covid era has led businesses to rethink their existing office footprint. As a result we’ll see higher vacancy rates and lower price per square foot lease rates on new leases, renewals and subleases. All of these factors affect the properties ability to cover its debt obligation. Combine these hurdles in the demand market with the macroeconomic events taking place in the financial system, we may be looking at a credit crisis. Meaning we could see a large number of distress sales and defaults in the CRE sector as property owners will have limited options when it's time to refinance.
How are they all related?
How does this affect you, especially if you don’t own CRE? At least 68% of CRE loans are held by Regional Banks and some say that number is closer to 80%. Banks are on the defensive, tightening credit requirements and likely unwilling to modify loans as they deal with other liabilities. With office vacancy rates below 50% in a lot of cases and rents on a downward trend for many CRE asset classes, the question is not if this will come to a head but when…So what happens when this occurs? It’s likely we will see similar federal intervention as we saw with SVB. The federal government will step in and provide X number of billions in relief resulting in an acceleration between the rate hike pause and the first rate hike cut. For context there is an estimated $1.5 trillion in CRE loans coming to maturity in the next 3 years. Loans maturing in the next 24 months that have a debt service coverage ratio below 1.25 total roughly $70 billion (Trepp). Analysts from JP Morgan predict that without intervention the losses recorded will be far greater than those during the 2008 Financial Crisis, where the recovery timeline was rather short whereas the current work from home trend doesn’t appear to be going anywhere.
When facing a dire commercial sector and a need for an increase in housing units, I would imagine it is only a matter of time before government officials at both the state and local levels revisit their general and master plans, specifically zoning. We are already seeing some of these projects play out in the retail sector where once thriving malls, in areas like Orange County, are being converted into large scale housing projects. I would assume office space is next in line.
Thank you for reading, feel free to reach out to Josh Pulpan or myself if you have any questions. In addition if you would like to be referred to other industry professionals like CPA’s, Attorney’s or even Commercial Real Estate professionals please let us know.