With strong consumer confidence, ongoing economic growth, and low unemployment, there are few signs of an imminent recession in recent U.S. economic data—but real estate experts speaking at a recent industry event in New York City said they want to be prepared.

“I know in my heart that there will be a correction, though I can’t tell where it’s going to come,” said John Jacobsson, executive vice president of capital markets for the Related Companies.

Jacobsson was one of several speakers at the Schack Institute of Real Estate’s 51st Annual Conference on Capital Markets, held by New York University in November in New York City. Speakers discussed their plans to manage shrinking investment yields and the risk of investing late in the real estate cycle.

“It is increasingly difficult to deploy capital at the risk profile that we want,” said Gary Phillips, managing director and head of acquisitions for Allianz Real Estate of America, and a ULI product council member.

Watching for a Downturn

“We are positioning as if there is going to be a recession,” said Alisa Mall, director of investments for the Carnegie Foundation. Her team is allocating its investments so that if prices fall rapidly on the Dow Jones Industrial Average, its funds will not suddenly be overallocated to real estate. That means trimming real estate in favor of keeping more cash on hand. “We want to have dry powder.”

Private-equity funds also have to work harder to make investments that provide a good return relative to the risk of the investment. Some investors are accepting lower yields to make deals. Others are taking more time to find deals that offer a solid return.

“You can toggle pace or toggle return,” says William (Billy) Rahm, partner and senior managing director of Centerbridge Partners. “We have been very choosy. . . . In the last 12 months, it’s taken much longer to make deals.”

When it does buy property, investors like Carnegie are focusing more on niche property types like student or senior housing. “What kinds of properties are likely to be recession resistant?” asked Mall. “We are looking for the kind of investments where we are likely to get that income.”

Alternative investments ranging from data centers to cellphone towers also are attracting capital, becoming almost mainstream as more investors become aware of their history of steady income. “Everyone keeps calling these properties niche, but everyone keeps talking about them,” said Phillips.

Even if the U.S. economy continues to grow, real estate investors can no longer count on rapid appreciation in property prices or quickly rising rents. Prices and rents are already very high, compared with those seen a few years ago. “Rents everywhere are now 20 percent to 30 percent above prior peaks,” said Khaled W. Kudsi, senior managing director of Northwood Investors.

At the same time, the cost of investing in real property continues to rise. “Anyone underwriting real estate has to assume the cost to operate and the cost to finance properties is going to accelerate,” said Rahm.

Interest Rates Finally Begin to Rise

Rising interest rates are also likely to put pressure on all types of real estate investors. Officials at the Federal Reserve have already raised their benchmark, with several overnight interest rate increases, and experts expect several more increases over the next year.

“It’s going to be very hard for the Fed to keep rates low if they see signs of rising inflation,” said Centerbridge’s Rahm.

So far, the borrowers who take out permanent loans have been spared, even though the yield on 10-year Treasury bonds—the benchmark for many permanent loans—has risen more than 100 basis points in 2018. Lenders have been cutting into their own profits to keep originating loans without substantially increasing the interest rates they offer. But they cannot keep cutting the “spread” that they add to interest rate that they charge to borrowers forever.

“Spreads can’t go to zero,” said Related’s Jacobsson. 

Lenders Compete to Make Deals

The competition is intense between lenders to make deals. “Volume is low, the margins are very thin, and it is very competitive,” said Brian J. Baker, managing director and global head of commercial mortgages and real estate special opportunities for JP Morgan Chase.

Lenders have fewer potential borrowers who need their loan products because fewer investors are buying and selling real estate properties compared with a few years ago. At the same time, some investors have been eager to put their money into somewhat safer vehicles like loan funds—and that has increased the competition between lenders to make deals.

“Are we really getting paid enough to take the risks that we are being asked to take? It is late in the real estate cycle and competition is really intense,” said Kara McShane, managing director, head of commercial real estate capital markets and finance for Wells Fargo Securities.

Still, lenders have resisted the urge to make larger and larger loans. “The one thing people are really holding line on is proceeds,” said Goldman. For example, typical conduit loans still cover just 50 percent of the value of a real estate property, compared with loans that covered as much as 70 percent during the last real estate boom, said David Lehman, global head of real estate finance for Goldman, Sachs & Co.

However, as all-in interest rates begin to rise, loans are likely to get smaller. Most permanent loans are limited in size by lender requirements that the property show income equal to at least 1.25 times as much as the payments on the loan. “The minimum debt-service-coverage ratio is the constraint on loan size, particularly for multifamily,” according to Lehman.

Many large banks are now subject to regulations mandated by the federal Dodd-Frank Wall Street Reform and Consumer Protection Act, passed after the financial crisis. Those regulations have finally been written and have come into effect. Nonbank lenders, such as private-equity funds that focus on debt and other nonbank lenders, have begun to fill in the gap

“This capital is needed and the banks are not going to do it,” said David Schonbraun, co–chief investment officer for SL Green.

A few leading real estate development companies like SL Green have also formed their own lending arms to provide this kind of mezzanine financing to construction projects, often in partnership with banks that provide senior construction loans. “Who better to assess the risk of a development deal than a developer,” said Marty Burger, CEO of Silverstein Properties, who led a session on nonbank lenders.

“We have already moved the market,” said Andrea Balkan, managing partner for Brookfield Real Estate Financial Partners. “Banks are no longer looking to do ‘stretch’ senior loans. They are looking to us.”