Rising interest rates worry commercial real estate loans

The past few years have been great for commercial real estate. Even amid an unprecedented global health crisis, supply chain issues and rising construction costs, overall commercial real estate has proven to be a solid and valuable investment. Commercial property values ​​have benefited from historically low interest rates, which hit a low of 2.68% in December 2020. But with continued inflation and deteriorating market conditions, the Federal Reserve has made several rate hikes, a move that has led many investors and owners to reassess deals and banks to change their lending strategies.

Over the past two months, there have been significant shifts in the real estate, equity and debt markets. “Investors are scrambling to determine property value and demand in terms of buying demand,” said Jamie Woodwell, vice president of the Mortgage Bankers Association’s (MBA) research and economics group, adding that the rapid increase in long-term rates at the start of the year also “clearly” changed the dynamics of certain transactions.

Although there is a lot of capital waiting, experts predict that in the short term there will be a slowdown in investment sales. The MBA has forecast that total commercial and multi-family borrowing and mortgages will drop 18% this year. The organization also predicted that in the event of a recession, which it considers likely in early 2023, lending and borrowing in the commercial and multifamily markets would likely be hit even harder.

Executives at New York-based owner SL Green, Manhattan’s biggest landlord, said on the company’s earnings call this month that the higher rate environment has led the company to focus on debt reduction. “To mitigate the effect of rising interest rates on earnings and in particular cash flow, while further improving the balance sheet, we have pivoted our capital allocation strategy to prioritize repayment debt, particularly in unsecured corporate debt,” SL Green chief financial officer Matthew DiLiberto said. .

A major multi-family lender, New York-based Signature Bank, said on an earnings call in July that it was focused on growing variable-rate loans, which now make up 52% ​​of the bank’s loan portfolio. . The institution’s executives previously said on an earnings call in May that they would slow commercial real estate lending going forward due to rising interest rates and falling cryptocurrency markets. free.

“Rapidly Changing Environment”

On a recent Friday in July, Jim Costello, chief real estate economist at investment analyst firm MSCI, spent the day roaming around Manhattan “sweating,” visiting clients, friends of the world of investment and even to a “quasi-competitor”. What they all had in common was that they all asked Costello questions about interest rates, inflation and its impact on asset pricing.

“There’s kind of an expectation that there’s a next shoe that’s about to drop, but it hasn’t appeared in large numbers yet because the market is so slow,” he said. . When it comes to valuing a commercial building, it often takes 20-30 weeks to get a true price picture of a high quality asset. But for now, many industry players are feeling negative about the economic outlook.

Mortgage terms are changing and borrowers are pulling out, as “negative leverage” has become the latest buzzword right now, Costello noted. When mortgage rates reached historic lows last year, a lot of money was invested in loan products so that borrowers could obtain loans at attractive rates. The spread between mortgage rates and cap rates is a rough measure of how much leverage a buyer has in a transaction. In the current landscape, cap rates on assets being sold are in many cases now lower than what lenders will offer for mortgages, so buyers don’t have as much leverage as they once did, because lenders have tightened up so much.

Short-term rates have been on an upward trend, and some will be very closely tied to the fed funds rate, which is expected to rise further this week. With short-term rates rising and moving closer to long-term rates, owners and investors may be considering trade-offs between the two. “There are reasons to do both, and it really has to do with the property’s business plan,” Woodwell said. “But now the fact that short-term rates are moving closer to long-term rates, that may change some behavior and cause people to lock in longer term.”

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While the overall volume of transactions increased in the second quarter of this year, smaller transactions – such as private investors who buy a small building for their portfolio – these types of transactions have fallen because these buyers do not have the pockets as deeper than institutional buyers and are more leveraged. “It indicates that buyers and sellers are looking at each other and not blinking,” Costello said. “Eventually, someone is going to have to blink.”

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Commercial real estate lending had a strong first quarter in 2022, despite persistent inflation and geopolitical risks. Loan funds and mortgage REITs held the largest share of non-agency loan closings in the first quarter at 42.7%, a jump of 30.6% from the same period, according to CBRE research. last year. Collateralized loan obligations, or CLOs, commonly used by alternative lenders to term fund their loan portfolios, also performed strongly, posting $15.2 billion in the first quarter, an increase of $8.9 billion. dollars from the first quarter of 2021. a strong desire from lenders to make loans, and they are working on loans that different properties can support,” said MBA’s Woodwell. While a slowdown is expected in the second half of this year, it should not last long. MBA expects loan demand to eventually rebound in 2023 and 2024.

What will happen next year is a big question on the minds of many in the industry. While many pundits and economists are predicting a recession in the first quarter, many loans are also maturing in 2023. While overall CMBS delinquency rates have remained flat since February, more than $33 billion in office CMBS loans are expected to expire within the next 18 months, which could spell trouble for office owners, according to Colliers. The largest share of loans is in New York, with the rest spread across major cities across the country. “We’ve seen deadline walls in the past and we’ve overcome them,” said Aaron Jodka of Colliers, pointing to capital on hold and investors ready to seize trading opportunities.

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Adding rising interest rates to an industry already struggling with headwinds will certainly cause short-term swings in the lending and selling markets, but it seems many industry veterans are optimistic about in the future and see this period as a period to overcome. “Even with higher interest rates, it’s a good place to invest capital, and that’s what our clients tell us, they actually use less debt to buy real estate because the interest rates interest rates are higher and are investing more of their own equity and money in,” Hessam Nadji, CEO of Marcus & Millichap, told CNBC. Most experts don’t see interest rates coming back down until the end of 2023 or 2024, so until then homeowners and investors will need to take care to consider the best mortgage terms and pay close attention to the rapidly changing environment.

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