The Fed’s decision to raise interest rates over the last two years made San Francisco’s commercial real estate downward spiral that much worse. Borrowing money became expensive and impractical, making it difficult to get projects off the ground.
But last week, with inflation seemingly under control, the Fed announced that it will lower its benchmark rate by half a point, the first and biggest cut since March 2020. At least two more cuts are expected by the end of the year.
High interest rates are a major chilling factor in the deep freeze facing major real estate projects in the city. So will the decrease have a thawing effect? The short answer: Yes — but likely not until after the election, and it will take a year and a few more rate cuts.
Here’s a theoretical look at how the lower interest rates could be a tailwind for projects at the precipice, according to Robert Slatt, a principal at San Francisco commercial mortgage lender Gantry.
Take a $10 million construction loan. If factors such as labor and materials remain constant (and that’s a big if) a construction loan priced over the federal interest rate will see an immediate savings of at least $50,000 to the overall budget of the project due to the recent rate cuts.
If, as expected, officials cut another half a point from the interest rate by the end of the year, immediate savings could double.
But when it comes to the overall calculation of a project’s cost, the savings amount to less than 1%. That pales in comparison to the so-called hard costs that go into a building, which the city estimates at $360,000 per unit for low-rise construction to $450,000 per unit for high-rise and can be 50%-75% of overall construction costs.
Officials have tried to lower building costs; for example, dropping certain affordable housing requirements for new development, cutting certain taxes, and deferring fees. These have yet to spark a mass movement toward development but have been positioned by leaders as a way to prepare the city for a future when the overall economic environment improves.
Notably, the commercial real estate market had begun “pricing in” the interest rate cut well before the Fed’s announcement.
“If you’re expecting a substantial price decrease after last week, you are gravely mistaken,” Slatt said. “It’s been like ‘Groundhog Day,’ repeating that over and over [to clients].”
A developer who has entitled housing plans in the Bay Area agreed. Even as conversations around financing improve, they believe new construction won’t kick off until after the November elections, as investors look to gauge where local and national elected officials stand on certain tax and zoning issues.
“[The cut] just signals to us that the economy is sound again,” said the developer, who wished to remain anonymous to protect working relationships. “I think everyone is waiting for the other shoe to drop before they make moves.”
Rather than direct monetary savings, a key benefit of the rate decrease and the expectation of further cuts is creating a “psychological” momentum, which translates to more lenient negotiations around loans and refinancing, according to Jay Hawkins, a senior economist at PNC Bank’s San Francisco office.
However, financing the purchase of a commercial building through a traditional bank loan is still nearly impossible, according to the head of a real estate firm seeking to buy more properties in San Francisco who asked not to be identified since they are in active negotiations.
“This will give buyers more conviction and the ability to lean into their positive projections,” the investor said. “Anyone with a variable interest rate will appreciate the savings, but we’re still a long way out from getting back to a normalized environment.”
Case in point, high-net-worth individuals like local billionaire Gregg Flynn and the Pelosi family have become the de facto financial engines of San Francisco real estate transactions.
Ted Egan, the city’s chief economist, said his office projects a sluggish 2025, but construction is likely to see positive effects in the medium term.
“I expect we will see the benefits of rate cuts by 2026 and beyond,” Egan said. “These things take time to work their way through the economy. The Fed started raising rates more than two years ago, but it wasn’t until this spring that we saw notable signs of the labor market cooling off.”