This has been a perfect storm for the commercial real estate lending industry. Higher interest rates have slowed down the economy and made loans prohibitively expensive. Falling property prices and liquidity fears are causing banks to slow or stop lending on commercial properties. And stubbornly high seller expectations have reduced transactions to a fraction of pre-pandemic levels.
All of this combined to push commercial lending to a standstill. The second quarter numbers of the Mortgage Brokers Association show commercial and multifamily loan origination dropping by an unbelievable 54 percent year over year. I can’t think of any industry that could survive more than half of the revenue drying up in less than one year.
So, how has the industry adapted to this systemic shock? The first change is that a new type of lender has stepped in to fill the void left by regional banks. Unlike banks, these lenders are not constrained by Dodd-Frank regulations and do not have to worry about a run on deposits. These non-bank lenders charge a higher interest rate than banks, but the skew between the two has shrunk. Plus, many owners have no other option. But as much as these lenders have been able to provide much-needed liquidity into the lending market, they are not all created equally. “Some debt funds both originate loans and buy notes from other institutions,” said Tim Milazzo, founder of StackSource, an online marketplace for commercial real estate debt and equity.
The distinction between the two is important because the funds that also buy loans are slowing down their lending in order to preserve capital for acquisitions. “Banks are not in the business of holding underperforming loans on their balance sheet, so non-bank lenders know they will be able to buy up these notes for pennies on the dollar when they go into default,” Milazzo said. So, while the debt funds that are originating loans are still doing so, those that also buy loan portfolios are slowing their lending to preserve some capital for a buying spree if and when more distressed loans start coming up for sale.
When the lending environment gets bad, large construction loans are often the first on the chopping block. Not only are these loans expensive for borrowers (loans get more expensive the further the building is from being stabilized), but they are also an administrative burden for the lenders. Construction loans get paid off in “tranches” that correspond with the completion of certain milestones. Inspecting each part of the project in order to make those payments can mean more work and more risk of error for construction lenders.
Like commercial mortgages, the construction loan market is also seeing a lot more activity from non-bank lenders. With a few exceptions like NYC, the majority of construction lending comes from regional banks, which has all but dried up after the bank closures earlier this year. “Now that bank lending has all but dried up in some cities, we are seeing a lot more lending coming from other entities; even life insurance companies that generally only buy already developed properties are leaning into development lending,” said Riley Thomas, Senior Vice President of Markets at Built Technologies, a construction finance technology platform.
If the high-interest rates have made non-bank lenders more competitive, you would think that a drop in interest rates would diminish their competitive advantage. But that might not be the case. “ I think the shadow banking system will only continue to grow even when rates go back down,” Thomas said. “These organizations are much less regulated and are designing themselves to be quicker than banks, something that could be a huge advantage even when banks come back.”
Rates are certainly a strong consideration for commercial property borrowers, but they are not the only ones. Other things like down payment, payback period, and speed of underwriting can also make certain loans more attractive, even if they carry a higher interest rate. The continued growth of debt funds and non-bank lenders is good news for the commercial real estate industry. When the Federal Reserve does finally decide to drop interest rates, it will do it incrementally, just like it did when it raised them. That means there will be a period when rates will start to go down, but the positive effects of lower interest rates on property valuations will not be felt yet. Loan demand will likely pick up before the supply, so the more money being lent on commercial real estate, the less competitive it will be. The high-interest rates and bank failures have already changed the commercial property lending landscape. Hopefully, those changes will help the industry long after this lending crisis is in the rearview mirror.