The 2022 interest rate hike has hit all industries in the economy. But the sudden turnaround since last June has hit the heavily leveraged real estate industry particularly hard. For real estate owner-operators and investors, interest rates are a driver of property values, not just the cost of debt — a double whammy. And, as shown in the accompanying chart, prime rates for commercial mortgage loans have increased several times over the past year. This price reset reflects the market’s reaction to the Federal Reserve taking its foot off the accommodative accelerator, ending a period of artificially low interest rates with an extraordinary increase in the federal funds rate and reduction in mortgage-backed securities. A price that supports market-based reversion to the historical mean. With rates cut in late 2022 in anticipation of a 2023 recession, higher interest rates are likely here to stay.
| January 2022 | June 2022 | January 2023 | |
|---|---|---|---|
| Federal funds | 0% – 0.25% | 1.5% – 1.75% | 4.25% – 4.50% |
|
10-year Treasury rate |
1.63% | 2.94% | 3.80% |
| SOFR | 0.05% | 0.80% | 4.30% |
In the years following the Great Recession, the Fed brought the federal funds rate to zero, and the economy did not stop as it recovered. That led to a decade of artificially low prices, making properties more valuable and real estate investments more profitable. To illustrate this accommodation, the average 10-year Treasury yield since 1962 has been above 5 percent. Compare that to the average 10-year Treasury rate of 2.48 percent from 2009 to 2019. And it even decreased in 2020 and 2021, the peak (hopefully) years of the epidemic, where the average rate dropped to 1.19 percent. So today’s rate is below the historical average. If the Fed remains as diligent in reducing inflation as it has promised, a high interest rate environment is likely to persist for the foreseeable future. At the mid-December FOMC meeting, the median forecast for the federal funds rate in 2023 was cut from 5.1% to 3.1% in 2025.
For real estate investors, higher and more unpredictable cost of capital has increased risk for new deals. Not only have indexes increased, but credit spreads have widened as lenders try to assess the impact of higher rates on debt coverage and collateral values. As a result, business loan rates have doubled from the mid-3% range to the 6% range over the past year. To further protect themselves, the lenders reduced the loan proceeds, required more equity and reduced the borrower’s leverage.
Interest rates, inflation and the unpredictability of economic performance have greatly reduced the commercial real estate market. This article describes how high interest rates have affected owners, lenders and investors, forcing them to quickly change their strategies as they prepare for another year of recession.
The owner-operator view
The owners They have accommodated inflation throughout 2022. Initially, commodity prices rose due to supply chain disruptions, which subsequently declined. But high operating costs remain, especially wages and utilities. At the same time, rental growth, while still positive, has slowed even in the more attractive multi-family and industrial sectors. The merger squeezed operating cash flow and lowered the debt service coverage ratio. For floating-rate debt-backed assets that are not sufficiently capped or flexibly held, the owners have been paying excess cash flow to their lenders rather than equity investors. Hedging, or trying to hedge prices now, has become too expensive. As a result, debt service coverage ratio and debt service covenant violations tend to increase over time, often requiring the lender to partially repay or reduce the loan.
Growth loans are a big problem for owners. A higher interest rate may mean that cash flow is insufficient to meet the lender’s strict compliance standards. And even though interest rates are not much higher today than they were when the loan originated, the current minimum spending requirements force many owners to pay off a portion of the loan balance in order to extend or refinance the loan. The amount of cash infusion required depends on the current loan amount, and in the past few years many loans have been full-time interest only, which can require large payments. For underperforming properties, including B-class shopping malls, hotels dependent on business travel, and offices with high lease sales values, liquidity may not be available to support newly required equity, and distressed conditions are already emerging in these asset classes. These owners must choose between an expensive salvage equity option that dilutes their equity in the property, sells the property at a discount, or forfeits the property to the lender and pays high debt forgiveness taxes. Predictions of high delinquency and default rates abound, and distressed debt funds are actively circling the perimeter.
Lender’s view
Lenders have no change in real estate loans. To repay the loan in full, borrowers need to make a healthy margin between the price they charge and the cost of their money. A lender’s primary concern is collateral value, and the lack of comparable transactions has made appraisals difficult. It remains unclear where capitalization rates will be heading over the next twelve months and whether they will follow an upward trend driving down property values. Depending on the strength of the market, the type of property and the type of tenant, the rental price can vary significantly. As mentioned above, this has led to lenders reducing interest rates on all types of commercial mortgage products. Lenders are also focused on current collateral cash flow. Most properties have performed very well as the tight labor market continues to drive demand. But higher debt service coverage with a floating loan or newly refinanced loan can wipe out the cushion. Consequently, lenders are strengthening their debt portfolio by increasing debt service coverage and debt provisioning requirements and strengthening loan covenants for ongoing performance monitoring.
Banks currently have the opportunity to increase their net interest margins because many of them are paying off today’s loans and paying depositors yesterday’s artificially low rates. And yet many of the big banks have pulled back from real estate lending because of the aforementioned credit risks. Unlike banks, private debt funds and public mortgage REITs raise capital through various types of collateral and lines of credit. Accordingly, their finance costs have increased with market value and they are exposed to potential margin squeezes over the life of the loan or foreclosure calls if values fall. As a result, these lenders have reduced their initial rates. CMBS issuance has also stalled, in part because investors in bonds have the same credit risks as lenders and can find more attractive risk-adjusted returns elsewhere in the fixed-income market.
Debt capital is still available for the real estate sector but not at the strong levels of the past few years. Like real estate owners, lenders are reassessing the creditworthiness of their portfolios, proactively working on potential problems and finding opportunities to shift available capital to better performing markets and asset classes. Caution abounds, making it more difficult to close new deals.
The investor’s view
Uncertainty created by interest rate volatility and the macro outflow of liquidity in the sector is causing real estate investors to focus on existing portfolios rather than providing fresh capital for new transactions. Investors are using their cash flow models to reflect current market conditions and compare new proposed products with expectations at the start of the deal. They are also trying to better understand their loan documents and monitor performance against covenants and evaluate whether to speed up or slow down planned refinancing. A big focus for private equity players is re-evaluating promotions, and some deals with high operating costs and floating rate debt may now be “out of the money”. A common strategy for private equity sponsors is to refinance the debt after renovating the property and paying investors excess cash flow. This strategy not only generates new capital for real estate investment, but also promotes the product to investors and sponsors, which has become extremely difficult to execute at a time when interest rates are much higher than originally anticipated. The bottom line for active investors: Despite strong asset performance, lower-than-expected spreads and slightly higher upside.
Despite these obstacles, new agreements are being concluded. Financing for multifamily transactions is still available through Fannie Mae and Freddie Mac, and other lenders are choosing capital for “right” investments. That means property owners in markets that are still experiencing economic and job growth will be able to raise rents. While performance in 2023 may not match the past two years, many lenders are moving away from office and retail, which remain a popular asset class. A key concern for investors is negative leverage, if the amount of the loan is higher than the amount of capital, or the return on the investment. The only way out of that hole is to raise rents. Amidst this uncertainty, investors are increasingly making more detailed analyzes of future transactions and scenarios in their models to determine potential yield and exit strategies and pricing strategies in a tight rental growth and operating expense environment. Deals can only move forward when market and asset competitiveness, now or after relocation, support sufficient rent growth to achieve the desired benefits.
Investors are also developing new properties, again in emerging markets, hoping that all the current turmoil will be history by the time the property is delivered. Depending on the type of property, lenders provide support for new developments; However, they are still concerned about value trends and are therefore tightening their underwriting standards. For example, multifamily developments in targeted migration markets are seeing favorable loan terms, especially as bank and fund lending agencies are confident that they will be able to issue them on a stable basis. The risk here, however, is a prolonged or severe economic downturn that reduces demand for space and lowers rents, or lowers rents.
The painful transition to a new interest rate environment
High interest rates in the past year have reduced real estate cash flow and profitability forecasts and upended the strategies of owner-operators and investors. We have seen a slowdown in high transaction volumes. As we move from the artificially low rates of the past decade into a new, but still unknown, interest rate environment, liquidity will continue to be pulled back from asset markets. Property values are falling, but how far will they go? Unfortunately, reduced trading volume can significantly prolong the price discovery process. The market will eventually adjust to the new interest rate. In the meantime, today and in the ups and downs of the deal, it’s the unpredictability of yields and valuations that keeps capital looking for alternative investments.