The CRE Finance Council holds a conference twice a year, most recently meeting in New York City in June. It’s a large gathering of some of the nation’s most prominent commercial real estate finance experts, and investors and real estate professionals often use it as a market barometer.
The tone of the previous sessions in January was one of relative optimism. The Council’s Chair Eric Thompson made the opening remarks on Day 1 of the conference in January, noting the strength of industrial and multifamily performance, and closed his remarks with a brief recap of 2021, talking about robust issuance, a 50 percent decline in delinquencies, and positive credit performance outside of retail and lodging.
In January, Thompson and the attendees at the conference had good reason to be cheerful, and not just because former New York Yankees legend Derek Jeter was a featured speaker. The commercial real estate market’s recovery that started in the second half of 2021 continued into January 2022, with all core commercial sectors experiencing net positive absorption at the time. Rents were rising and, except for the office market, vacancy rates were trending down for all asset classes.
What a difference a few months makes. The vibe at the most recent CRE Finance Council conference a few weeks ago in NYC was, well, much different. Many observers said the tone was pretty negative, and it’s hard to blame the crowd. During the meeting, news spread about the Federal Reserve raising the Federal Funds rate by 75 basis points, the largest single rate hike since 1994. “More than one banker at the conference said they were pulling back on loan issuance,” said Darrell Wheeler, Senior Director of CMBS Research at Moody’s Analytics, who was in attendance and spoke on a panel. “It’s definitely a difficult time for the market, and times are different than even early June.”
Wheeler told me that the Fed’s aggressive rate hike has the market reacting much quicker than many may have thought and the market may be overcompensating for the increases. He added that the early evidence is financing is being withdrawn from the real estate market, and lenders are putting the brakes on. “The real estate market will have to adjust to the rate increases,” he said. “This could lead to a stand-off between buyers and sellers and freeze transaction volumes.”
It’s not 2007, right?
In a recent post, Wheeler writes that lenders still quoting loans are saying the increases in Treasury rates and issuance spreads are creating commercial mortgage rates that are unacceptable to most borrowers (5.5 percent to 6.25 percent). The higher mortgage rates are also decreasing debt service coverage ratio levels, thus limiting the leverage being offered to borrowers and leading to lower proceeds. Other lenders are hesitant to even quote loans because they expect cap rates to increase and cause loan-to-value risks. Wheeler writes that, overall, borrowers are being offered rates that are in many cases 300 basis points higher than the rates they were getting at the beginning of the year. “This is challenging for borrowers with maturing loans, as most lenders and B-piece buyers are looking for higher debt yields, which create lower proceeds,” Wheeler says.
As rates increase, real estate borrowers’ net operating income has to be about twice as high because more cash will be needed to meet obligations. And Wheeler notes that the number of commercial mortgages not paying off over the last two months has increased. He said the commercial property market is hyper-sensitive to anything that looks like the lead-up to the financial crisis in 2007-2008, but he added that “it’s not 2007, or at least we don’t think so.”
Still, Moody’s Analytics released a report in April about commercial mortgage-backed securities (CMBS) during the Great Recession, and it got a tremendous response, with about 600 webinar attendees. “The market has incorporated worst-case assumptions,” Wheeler said. “But making those worst-case predictions can be self-fulfilling sometimes.”
The commentary at the recent CRE Finance conference suggests to Wheeler that mortgage markets are frozen, which could increase the percentage of loans not re-financing at maturity. The most recent past maturity figure is down 27 basis points thus far in June, but it’s up 52 basis points over the past two months to 1.29 percent. He said many commercial real estate loans will likely struggle to re-finance in the current monetary environment, so Moody’s has added the past maturity category to its overall troubled loan index. The percentage of past maturity loans may start to increase if re-financing conditions stay ice-cold for more than a few months, according to Moody’s report.
Wheeler’s assessment of the CRE Finance conference tone was pessimistic, but other real estate finance experts aren’t feeling quite as gloomy. Lonnie Hendry, Head of CRE & Advisory at Trepp, a real estate data and analytics provider, noted tons of uncertainty in the market, saying, “With the uncertainty comes panic and pessimism.” Commercial mortgage interest rates have been at historic lows over the past decade, and now that they’re up significantly, Hendry said it’s provided a shock to values and returns. “The negativity comes from not knowing where the federal interest rates are going to end up and what will happen with inflation,” he said. “And there’s some sticker shock. Lenders will be looking closer at rent rolls and tenant rosters.”
Many borrowers may walk away from loans, which is what Hendry and others thought would happen at the beginning of the pandemic. That didn’t come to pass as much because of government support like PPA loans. Hendry said some properties are also on the “cusp of purgatory,” where they may not even be sure if they want to refinance. In his opinion, certain properties like Class B and C offices will bear the brunt of a possible downturn, but Class A properties in office and multifamily will likely be okay. “I’m still bullish on commercial real estate in general,” Hendry said. “Real estate is a lot more predictable compared to other markets. Investors will probably see lower returns, but they may still be positive.”
Hendry believes we still haven’t seen enough data to point to a widespread commercial real estate market decline. Borrowers and lenders may be tapping the brakes, but if it’s like that four months from now, then we’ll know that’s where the market’s really at. At the beginning of COVID, commercial real estate transactions essentially froze for 60 days but came roaring back, Hendry noted. “We don’t expect that same thing to happen because of some of the macroeconomic factors at play right now,” he said. “But the volume of transactions could still pick back up.”
Commercial property sales were down 16 percent in April compared to the same month a year ago, according to MSCI Real Assets. The decline in April happened after 13 red-hot months of consecutive increases in property sales. The 16 percent decline in sales in April was also an abrupt turn from March, when total commercial real estate sales had risen 57 percent from the previous year. “The speed of that transition is shocking,” said Jim Costello, chief economist at MSCI Real Assets.
Commercial real estate sales volume, change for a year earlier
Some experts consider a drop in sales an early indicator of stress in real estate markets because pricing is usually slower to change. With higher interest rates, real estate investors that typically rely on large amounts of cheap debt to buy buildings could be falling out of the market. Borrowing costs are higher, and some investors are discovering that their near-term return rate is below the mortgage’s interest rate.
Taming inflation is the Federal Reserve’s top priority, and many observers expect the Fed to raise interest rates even higher at the next two Federal Open Market Committee meetings in July and September. CBRE expects the federal funds target range to be between 2.75 percent and 3 percent by the end of this year and possibly rise to between 3.25 percent and 3.5 percent in 2023. CBRE’s recent brief says the higher rates should cool down inflation and, while they don’t predict a recession being imminent in the near term, “risks of one, particularly in 2023, are building.” Talk of a recession is seemingly everywhere now, with Goldman Sachs saying there’s a 30 percent chance of one within the next year, Elon Musk saying it’s all but inevitable, and even rapper Cardi B tweeting about it.
The impact of higher interest rates on the commercial real estate market remains to be seen, but Wheeler of Moody’s Analytics indicates it has already made borrowing more challenging and slowed down, if not frozen, lending in some cases. CBRE, though, expects lower economic growth “should still support continued strong commercial real estate fundamentals this year.” A tighter credit market will drive adjustments in real estate investment markets in the short term, and investment market performance will likely be uneven. High-quality assets will probably be favored in higher-performing markets, and CBRE “anticipates this to be the case across property types as investors look to lower risk.”
The pandemic-induced recession in 2020 was short, but it still drove mortgage delinquency rates to levels not seen since the 2008 financial crisis. While the pandemic recession may not have lasted long, it left inflation in its wake, and some landmines lay ahead for commercial real estate investors and owners. Real estate may be a good hedge against inflation, but a Trepp historical analysis of the correlation between inflation and property values shows real rates of return in real estate likely will flatten as interest rates increase. And as cap rates have already increased, property prices will soften, too.
Trepp points out that higher interest rates typically lead to a spike in corporate bankruptcies, which could be bad news for properties leased to single tenants. Fortunately, Trepp also discovered that only about $10 billion of securitized CMBS loans are backed by single-tenant properties, so the risks to real estate investors may not be so great. The near-term future for real estate borrowers is clearer: lending rates are getting higher and creating challenges for borrowers, investors, and developers.
The impact of rising rates will depend on various factors, including the type of lender that buyers are using and the buyer’s relationship with their lenders. A Marcus & Millichap report notes that enormous volumes of capital are still chasing commercial properties because of the perceived inflation hedge, and “even though interest rates went up more than many expected and the expectation gap between buyers and sellers may widen, a broad-based pricing correction remains improbable.”
What isn’t improbable is that many in the commercial real estate industry are feeling jittery with all the headwinds. The tone at big gatherings like the CRE Finance conference has gotten more negative because uncertainty is high. Commercial real estate finance experts will gather again at the CRE Finance conference in January 2023 in Miami Beach, and the market will certainly be much different. Hopefully, the vibe won’t be as pessimistic.