These are the Headwinds Facing CRE

As most of the industry will tell you, the greatest challenges facing the commercial real estate sector today largely stem from the Federal Reserve’s aggressive rate increases during the past 15 months, according to John Chang, client services, Marcus & Millichap.

And while many CRE professionals have become personally and painfully aware of the knock-on effects this monetary policy has had, it can be helpful to see them enumerated and explained to help plan strategy. 

Simply put, because the Fed pushed the overnight rate up by more than 5% in such a short time, the cost of debt capital increased, distress risk was created, investors began pulling capital out of the market and into bonds, lenders initiated tighter underwriting and debt capital shrank.

Furthermore, buyers now require a higher return on commercial real estate and many property owners are choosing not to sell at the current market clearing prices.

In 2021, investors could access commercial real estate loans for as low as the mid-3 % range.

Today, most commercial real estate lending rates run somewhere between 5.5% and the mid-8 % range, depending on the property type, location, leverage, term, borrower strength, et cetera.

“That dramatic rate increase has structurally changed the commercial real estate market, redefining property values and investor expectations,” Chang said.

The market also faces distress risk as the interest rate surge pushes some properties with variable rate debt into a negative cash flow position, he said.

“As a result, some investors may need to recapitalize assets or feed cash into the properties to keep them afloat,” Chang said. “Additionally, properties with an existing loan that’s coming due could also face cash flow challenges as the old loan matures and owners refinance at the new substantially higher rates.”

In those cases, Chang said, operators may need to add capital to align with new loan-to-value standards or to meet more aggressive debt service coverage ratio requirements.

“This has the potential to force some investors to sell properties that no longer pencil especially assets that have underperformed for the last couple years like urban offices.”

He said that seeking more stable returns, some investors are pulling capital out of the market and into bonds.

Both the three-month and the six-month treasuries have been delivering yields over 5.25%, “which is a pretty attractive risk-free rate,” Chang said. “This has given investors a reasonable return on parked capital while they wait for the commercial real estate market to reprice.”

Because short-term bonds have been paying a rate north of 5%, investors expect commercial real estate to offer cap rates that deliver some level of risk premium above that, he added.

“Where those cap rates will ultimately land remains uncertain,” Chang said, “as there’s still considerable variance between the different property types, asset classes, and locations.”

Tighter lender underwriting and a shrinking volume of debt capital also are affecting CRE.

“Although lenders remain active and debt is widely available for most property types and locations, banks have tightened their underwriting and reduced their lending so they can shore up their balance sheets,” Chang said.

Since the bank runs forced the closure of Silicon Valley Bank and First Republic Bank, most small to midsize institutions have reduced their lending to build their reserves and mitigate risk.

As a result, locking in debt capital “has become more challenging, and in some cases, lenders have walked away from deals late in the process, leaving borrows to scramble for debt capital at the last minute,” Chang said. “That of course, can make it more difficult for investors to close transactions.”

Finally, buyers now require a higher return on commercial real estate and many property owners are choosing not to sell at the current market clearing prices, he said.

That pricing expectation gap is restraining transaction velocity. Chang said that would cause opportunistic investors to rejoice and prices to reset, creating a wave of defaults and potentially reinvigorating the commercial real estate market.

“But this remains highly unlikely, for most property types,” according to Chang.

Delinquency rates are closely tracked for CMBS debt and only office properties are showing a material rise in late payments, he said. Office property CMBS delinquency rates are up about 125 basis points in the past month, but are still only in the 4% range, according to Marcus & Millichap, “that’s quite low from a historical standpoint,” Chang added.

Another relatively low probability event that could free up the markets would be for the Federal Reserve to reduce rates, he said.

“But the Fed has reiterated multiple times that they don’t expect inflation to fall enough to make that a likely path, at least not this year,” Chang said. “The most likely path to a more active commercial real estate market will be through interest rate stabilization, which will enable the markets to recalibrate and normalize.”

During the last 15 months, it has been very difficult to underwrite assets amid the shifting interest rate landscape.

“If rates flatten and the Fed signals that rates will likely remain stable for a while, the market will begin to normalize,” he said.

“We’ve already started to move that direction, so although pricing hasn’t fully stabilized and there are still questions about what will happen with interest rates over the short term.”

A short-term perspective would be that this is the backside of the commercial real estate market disruption,” Chang said.

“When investors take a long-term perspective the opportunities available today may become more apparent.

“Remember, commercial real estate is often best viewed in a long-term context and investors may see opportunities when they keep their eyes on the horizon.”