Pay attention to what may come

Beginning in March 2022, the Fed started raising interest rates. These rate increases ended a 14-year era of cheap money.

But quickly raising interest rates from essentially zero to current levels causes problems such as bank failures, commercial properties being returned to lenders, and slowdowns in some sectors of the economy. The real estate market will face these challenges and at least four others.

First, real estate is an accessible business to enter. The aspiring developer needs only the ability to borrow money (more below) or have cash. Over the past few years, with money (relatively) free, the carrying costs of a real estate purchase were modest, and the resale of the property at a higher price was almost inevitable. The tax code (Section 1031) even allows sellers to defer real estate profits if they buy another asset and comply with other rules.

But as interest rates increase, resales slow, and values decrease, will these new entrants exercise the emotional discipline necessary to weather the storm? Or will anxiety lead to bad decisions and cause further damage to the market?

Next, buying any asset, particularly real estate, in a low-interest-rate environment does not mean one is astute. Unfortunately, over the past few years, some people confused luck with intelligence. Soon the consequences of excessive hubris may begin to play out. Higher interest rates require property owners to consider real estate an operating business rather than a source of easy profits. Suppose business conditions slow down and interest rates hold at current or higher levels. Can real estate owners/investors train themselves to become long-term owners and adopt a hold strategy?

Third, in an easy-to-enter business, borrowers need to understand the risks of leverage. When money was cheap, lenders were eager to loan money on investment real estate but usually for no more than a three-to-five-year term. Today, debt is not the real estate owner’s friend. Real estate values are determined by the present value of the underlying property’s income stream or comparable sales. With interest rates increasing, the value of the real estate declines — higher interest rates cause the asset’s value to go down.

When the loan matures, as a condition to extend it, lenders may either reduce the new loan amount (the value of the real estate asset has decreased or overall business conditions threaten future cash flows) or requires additional collateral, preferably cash. Suddenly, what was easy to enter (see above) becomes painful. What happens as bank lending standards tighten? Does the real estate owner or its investors feel comfortable contributing more cash to a questionable deal?

Finally, many people working in the real estate business — borrowers, loan officers, lawyers, brokers, appraisers — have not fully experienced a bad real estate cycle. Even if they have, the future never plays out exactly as it has in the past. Debt and its stresses — interest rate increases or lender demands for more collateral — cause the borrower to become anxious. Panic and emotion take over, and clear thinking is ignored. If the current property was acquired with 1031 proceeds from the sale of other properties, it is hard to see any good choices. Where does the owner get good advice in a falling market?

The point? A business with inexperienced entrants, hubris, too much leverage, and a lack of overall industry experience may aggravate the situation. Couple these factors with tighter overall bank lending standards, and it is time to pay attention and be careful.

Alan Lewis is a retired transaction lawyer in Bentonville and the managing member of 207 Consultants, LLC. The opinions expressed are those of the author.