Rate hikes are about all anyone is talking about in commercial real estate these days. For good reason, as borrowing costs rise buildings become less profitable and therefore less valuable. Cap rate expansion (aka lower building value) is normal during periods of increasing interest rates.
But despite all of this many commercial real estate industry observers remain optimistic. Some even think that despite all of the headwind created by rising rates, property valuations will continue to rise. One researcher for NAR even went so far as to say “though interest rates have been rising amid mounting inflation and the Fed’s efforts to control inflation by raising the federal funds rate (with anticipated rate increases every quarter), investors are factoring in the strong demand for commercial assets and local economic conditions.”
It’s true, money is pouring into real estate right now. Commercial real estate occupies an interesting place in the investment landscape because it can appreciate like an equity but generates reliable returns like a bond. Investors are not seeing many other good places to park money right now. Even ten-year treasury bonds are barely paying more than two year notes.
The yield spreads of other bond-like investments are dismally close to the 10-Year Treasury Note, which does not give investors much reason to take on the risk.
And so real estate has seen an increase in both investors and lenders, who are hoping that the strong demand will keep valuations steady through this inflationary period. Many of these new lenders fall into a lending category called “debt funds.” Unlike large banks and insurance companies, these private lenders have greater flexibility in what they can invest in and the terms they are allowed to offer. More often than not they are choosing a loan structure called commercial real estate collateralized loan obligations, or CRE CLO for short.
Collateralized loan obligations are often short-term floating rate loans. They are often used for “transitional assets,” which is kind of a nice way to say risky. An example of a transitional property would be an office building with near-term lease turnover or a retail location that needs to find a new anchor tenant. The loans are often considered “bridge loans,” credit that is meant to help bridge the gap between a building acquisition loan and its long-term, stabilized debt.
Usually the terms for debt funds, transitional assets, and bridge loans include higher interest rates, but the increase in lenders in this category have brought those terms down quite a bit. What the new money in this category didn’t do, though, was reduce their risk. The risk of these loans defaulting goes way up when interest rates rise faster than expected, which is now all but guaranteed.
Currently there have not been massive foreclosures, but that might just be due to the lag time of leverage turning negative. If properties are not able to generate enough income to pay off their debt payments, we could see a massive amount of borrowers asking for new terms or giving the properties back altogether. To make matters worse, CLO defaults will likely scare away a lot of debt fund lenders, making it even more expensive for buildings to bridge this difficult borrowing period.
Everything is cyclical. Real estate has seen incredible appreciation in the last few years, despite the pandemic, so a recalibration of values might be healthy. What isn’t health for the industry, or the economy as a whole, is when financial systems fail. If enough real estate CLOs start failing it could throw the entire lending world into a spiral, much like what mortgage backed securities did in 2008.
Real estate is only a part of the leveraged loan market, many (transitional) companies also borrow with flexible terms. Added together leverage loans amount to a huge portion of our banking system. A report from December of 2019 by the Financial Stability Board estimated that the 30 biggest banks in the world have an average of 60 percent exposure to leverage loans. In the U.S., E.U., U.K., and Japan along these loans add up to over $1.5 trillion.
We are in the early innings of the commercial real estate industry’s fight against rising interest rates. Some distress is to be expected, there will always be buildings that struggle to pay their debts. But we need to realize the risks associated with widespread defaults. And our chances of a lending collapse is dependent on how a new kind of floating commercial real estate loan performs under an unprecedented amount of stress. – Franco Faraudo
This week we have seen a ton of traffic for real estate tokenization articles. Who knows, it might be that the crypto crash is finally softening some people’s diamond hands. Or it might be that retail investors are looking for new inroads into fractional real estate ownership. Either way, we are putting together some editorial that looks at what happened to some of the high profile tokenization projects in commercial real estate. If any of you have any insights or would like to introduce us to someone tokenizing real estate, please reach out.