As economic conditions continue to improve, the Federal Reserve is expected to tighten monetary policy further in 2017, naturally leading to higher interest rates. While a rise in borrowing costs could hinder loan origination, commercial real estate financing should remain robust in 2017, bolstered by a fresh crop of lenders and an optimal climate for activity.

​(From left to right) Paul McCormick, SVP - Investment Sales & Capital Services and Brett Campbell, Senior Analyst

The Fed now appears confident that the economy is sturdy enough to withstand the impact of higher rates. The Fed's policy-making arm raised short-term interest rates by a quarter of a percentage point in December, pushing the fed funds target rate up to around 0.50 percent. That movement was the Fed's sole increase in 2016 and only the second increase in the last 10 years.

Evidence of the improving economy, namely a strengthened labor market, acted as a catalyst in the decision-making process of the central bank. The December jobs report showed the unemployment rate sliding from 4.9 percent to 4.6 percent, the lowest it has been since August 2007. Additionally, the GDP growth rate was 3.5 percent in the third quarter of 2016, sharply above the 1.2 percent registered in the second quarter.

Long-term Treasury yields have been on an upward trajectory since November, due largely to the Fed's hawkish stance and expectations that President Donald Trump will embark on an array of stimulus measures. If the Trump administration's initiatives, which includes lowering taxes and $1 trillion in infrastructure spending, are successful, Fed Chairwoman Janet Yellen has advised that she is open to raising rates up to three more times in 2017. Higher rates should “normalize“ market conditions, with sellers possibly lowering price.

To understand what may occur as a result of these projected changes, it is useful to engage in a look back. For most of the past decade, historically low interest rates fostered rabid demand for New York City real estate. Large-sized transactions drove dollar volume to record levels in 2015, while in 2016, small to mid-size transactions played a more dominant role, causing NYC total dollar volume to drop markedly compared to the prior year, according to Ariel Property Advisors' research.

In 2016, prices across the city held steady or appreciated in the third quarter, although Brooklyn showed modest softening. The six-month trailing averages of capitalization rates, a metric used to gauge the value of a property relative to its income stream, edged higher in the borough, according to Ariel Property Advisors' Multifamily Month in Review, October 2016. While there is no direct correlation, cap rates historically adjust upward to compensate for the higher cost of capital brought on by rising rates.

New Lending Landscape

As property values appreciated over the past decade, investors avoided locking themselves into expensive long-term debt with sizable prepayment penalties. They opted for short-term fixed-rate mortgages of five years or more and creative and flexible financing structures, such as interest-only loans. With interest rates on the rise and cap rates nudging higher, investors are shifting to more “traditional“ capital, such as 10-year fixed-rate loans, to maximize cash flow and minimize exposure to rate and market volatility.

The market for commercial mortgages is starkly different from a few years ago when banks binged on multifamily commercial loans. Banks have dramatically pulled back on lending, due primarily to concerns of overleverage and government regulation. The institutions have tried to mitigate the threat of overleveraging through more stringent client and credit vetting processes. Various government agencies have passed legislation that addresses overall lending risk and related exposure. Starting this year, issuers of commercial mortgage-backed securities, will be required to hold more capital on their books as a buffer against possible loan losses.

Alternative lenders, both individual and institutional, have been actively stepping in to fill the void left by banks. Some of these entities already own and develop real estate, such as the institutional debt fund that provided financing to Emerald Equity Group on their $357.5 million purchase of a multi-family portfolio in East Harlem and Manhattan, a sale arranged by Ariel Property Advisors. The 47-building package was the largest transaction in 2016 for Northern Manhattan.

Institutions like Blackstone and Starwood Capital have been active lenders in the last 12 to 18 months, and commercial real estate firms such as RXR Realty, Kushner Cos and SL Green have hopped onboard the lending train. Private lenders can offer more creative loan products than traditional banks, offering a mix of bridge, mezzanine and preferred equity financing to get higher up on the capital stack. While the rates charged by private lenders are usually higher, borrowers are often willing to pay a premium in exchange for a shorter, more streamlined loan underwriting process. While interest rates are poised to rise in 2017, Fed tightening indicates a healthy economy. We expect capital markets to remain strong in 2017, allowing investors unfettered access to attractive and reliable financing.