Cities Need People, People Need Homes. Both Must Wait.

There’s a growing consensus that we need more housing and less office space as cities move forward with plans to transform themselves in a post-pandemic world.

The thought process is straightforward — in a world with more remote work, cities have too many offices, but in many cases not enough housing to accommodate everyone who wants to live there. Adding housing means residential density needs to increase, so it’s important that restrictions to development are reduced and that the “YIMBY” — yes in my backyard — movement notches policy wins. The problem is this planning vision clashes with the current financing environment. Cities and developers know what they want to build, but financing costs and lenders, for the most part, won’t accommodate it. Large-scale urban transformations will have to wait, perhaps for years.

The problem starts with higher interest rates. Policy tightening by the Federal Reserve has flowed right into the costs for commercial property developers. One Washington DC developer recently said that interest rates on construction loans are approaching 10% from closer to 4% in early 2021. The industry also faces a structural challenge in refinancing existing borrowing at higher rates as debt matures.

For developers, the slowing rental market is a problem as well since higher-density residential construction is most likely to focus on rentals. Nationally, asking rents for apartments are down from a year ago, vacancies are rising, and there are a lot of units being built that will be delivered over the next couple of years. That's good news for tenants looking for a deal on an apartment lease, but creates uncertainty for developers and lenders looking at potential new projects.

The banks and lenders who tend to finance real estate development are another challenge. While the high-profile bank failures in March may be a distant memory for financial markets, they've cast a pall over the property market that has yet to be resolved. Banks looking to offload property loans are struggling to find buyers. Blackstone Inc.’s $70 billion real estate trust has faced redemption pressure for months, and recently announced it is selling a minority stake in the Bellagio casino and resort in Las Vegas to raise liquidity. It’s generally not a great environment for new projects when huge funds are offloading high-quality assets.

This shows up in the Federal Reserve's quarterly Senior Loan Officer Survey. The July survey showed that a net 71.7% of domestic banks were tightening standards for commercial real estate loans with construction and land development purposes, with borrower demand for such debt showing extreme weakness.

Raising the Bar