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The past several years have been great for commercial real estate. Even amid an unprecedented global health crisis, supply chain woes, and rising construction costs, overall, commercial real estate has proven to be a solid, valuable investment. Commercial property values have benefited from historically low-interest rates, which bottomed out at 2.68 percent in December 2020. But with continued inflation and worsening market conditions, the Federal Reserve has made several rate hikes, a move that has led many investors and owners to re-evaluate deals and banks to shift their lending strategies.
Over the last couple of months, there have been some significant transitions in the real estate, equity, and debt markets. “Investors are working to figure out values to properties and how much demand there is in terms of demand to buy,” said Jamie Woodwell, vice president in the research and economics group at the Mortgage Bankers Association (MBA), adding that the rapid increase in long-term rates at the beginning of the year has “clearly” changed the dynamics of some deals as well.
Though there is plenty of capital waiting on the sidelines, experts are predicting that in the near term, there will be a slowdown in investment sales. The MBA has forecasted that total commercial and multifamily mortgage borrowing and lending will drop 18 percent this year. The organization also predicted that in the event of a recession, which it sees as likely happening in early 2023, lending and borrowing in commercial and multifamily markets would probably be even further impacted.
Executives at New York City-based landlord SL Green, the largest landlord in Manhattan, said during the firm’s earnings call this month that the higher rate environment has led the firm to shift its focus to shedding debt. “To mitigate the effect of those rising interest rates on earnings and especially cash flow, while further enhancing the balance sheet, we’ve pivoted our capital allocation strategy to prioritize debt repayment, particularly in corporate unsecured debt,” said SL Green CFO Matthew DiLiberto.
One major multifamily lender, New York-based Signature Bank, said in a July earnings call that it is focused on growing floating rate loans, which now make up 52 percent of the bank’s loan portfolio. Executives at the institution had previously said in a May earnings call they would slow commercial real estate lending going forward due to rising interest rates and cryptocurrency markets in a freefall.
On a recent Friday in July, the investment analytics company MSCI’s Chief Real Estate Economist Jim Costello spent the day trekking around Manhattan “sweating it out,” visiting clients, friends in the investment world, and even 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 sort of this expectation that there’s a next shoe that’s getting ready to drop, but it hasn’t shown up in a lot of numbers yet because the market is so slow,” he said. When it comes to commercial building valuation, it can often take 20-30 weeks to get a true pricing picture on a high-quality asset. But for now, many in the industry are feeling negative about the economic outlook.
Mortgage terms are changing and borrowers are pulling back, as “negative leverage” has become the latest buzzword floating around at the moment, Costello noted. When mortgage rates were at historic lows last year, a lot of money flowed into debt products so borrowers could get loans at bargain rates. The spread between mortgage rates and cap rates is a rough measure of how much leverage a buyer has in a deal. In today’s landscape, cap rates for assets that have sold are in many cases now lower than what lenders will offer for mortgages, so buyers don’t have as much leverage as they used to since lenders have tightened up so much.
Shorter-term rates have been trending up, and some will be very closely tied to the Federal Funds Rate, which is expected to rise again this week. With shorter-term rates on the rise and getting closer to long-term rates, property owners and investors may look at the trade-offs between the two. “There are reasons to do both, and it really has to do with what the business plan is for the property,” said Woodwell. “But now the fact that shorter-term rates are getting closer to long-term rates, it may change some behaviors and push folks to lock in longer terms.”
While deal volume overall grew in the second quarter numbers this year, smaller deals–like private investors picking up a small building for their portfolio—those kinds of deals fell since those buyers don’t have as deep of pockets as institutional buyers and are more leveraged. “It’s indicative of buyers and sellers staring each other down and not blinking,” said Costello. “Eventually, someone’s going to have to blink.”
Commercial real estate lending had a strong first quarter in 2022, despite ongoing inflation and geopolitical risks. According to CBRE research, debt funds and mortgage REITs had the largest share of non-agency loan closings in the first quarter at 42.7 percent, a 30.6 percent jump from the same time last year. Collateralized loan obligations, or CLOs, commonly used by alternative lenders to term finance their loan portfolios, also had a strong showing, posting $15.2 billion in the first quarter, an increase of $8.9 billion from the first quarter of 2021. “There still is a strong desire from lenders to make loans, and they’re working through what loans different properties can support,” MBA’s Woodwell said. While a slowdown is expected in the second half of this year, it isn’t expected to last long. MBA is expecting loan demand to eventually bounce back in 2023 and 2024.
What will happen next year is a big question on the minds of many in the industry. While many experts and economists are predicting a recession in the first quarter, there are also a lot of loans coming due in 2023. While overall CMBS delinquency rates have stayed flat since February, more than $33 billion in office CMBS loans are set to mature over the next 18 months, which could spell trouble for office owners, according to Colliers. The largest share of the loans is in New York City, with the rest spread across major cities around the country. “We have seen walls of maturities in the past and worked through them,” said Colliers’ Aaron Jodka, pointing to capital waiting on the sidelines and investors ready to seize bargain opportunities.
Adding rising interest rates to an industry already struggling with headwinds will certainly cause short-term fluctuations in the lending and sales markets, but it seems many veterans of the industry are optimistic about the future and are looking at this time as one to ride out. “Even with the higher interest rates, it’s a good place to put capital, and that’s what our clients are telling us, they’re actually using less debt to buy buildings because interest rates are higher and putting more of their own equity and cash into it,” Marcus & Millichap CEO Hessam Nadji told CNBC. Most experts don’t see interest rates coming back down until sometime in late 2023 or 2024, so until then, property owners and investors will have to take care to consider the best mortgage terms and pay close attention to the fast-changing environment.
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