Rising interest rates – impacting CRE returns?

Published on April 20, 2023 by Nithin Kumar and Vinod Choudhary

Investing in commercial real estate (CRE) has grown in popularity among investors seeking to diversify their portfolios and produce consistent profits. The returns on CRE investments can, however, be impacted considerably by several factors, including interest rates. The cost of borrowing money is directly impacted by interest rates, which can have an impact on CRE investors’ capacity to purchase new properties, maintain existing ones and produce cashflow.

It is critical that investors wishing to make wise investment decisions comprehend the effect of rising interest rates on CRE returns. This blog examines how increasing interest rates may affect CRE returns and offers suggestions on how investors should deal with this difficult situation.

There were early signs of a collapse in the property market before interest rates started to rise. Real estate development of new homes has halted, while mortgage rates have increased. The Mortgage Bankers Association increased its forecast for commercial and multifamily mortgage borrowing and lending by 19% y/y – to USD872bn in 2023 (close to the high of 2021) from USD733bn in 2022.

Although owners and investors of multifamily properties could be impacted negatively by rising interest rates, there may be some positive effects as well. Delinquencies may be tightened if they get out of hand and exceed the lender’s permissible loss cap. Financing would almost certainly be available to consumers, but it will likely cost more than the increase in the Federal Reserve’s (Fed’s) interest rates.

CRE interest rates are expected to increase, affecting borrowing costs across the sector. The St. Louis Fed reported that the 10-year Treasury rate was 1.63% and the 10-year yield was 3.61% as of 21 March 2023, down from its 52-week high of 4.23% on 24 October 2022. It is crucial to understand that although the borrowing costs investors are paying may not exactly match the rate on the 10-year Treasury note, the patterns are similar.

The 10-year Treasury note is frequently used as the starting point for calculating the market interest rate for CRE finance, and a spread is then added to get the rate the investor would pay. The bigger picture in the second half of 2022 shows that lending and buying across sectors would gradually slow until the end of 2022 as a result of rising interest rates. This includes the senior housing, industrial, office, retail, hotel and other related businesses.

Significant market anxiety was caused by the ongoing interest rate increases and the knowledge that additional increases were imminent. The Fed wants to lower market inflation by steadily and gradually raising interest rates. The CRE sector is negatively impacted by the rate rises in a number of ways, including commercial lending, development costs and rent rates. Rate increases may indicate greater volatility in 2023, but they would not stop investors from purchasing CRE. A few sectors, such as multifamily housing, office and industrial, saw significant growth in 2022, and this trend will likely continue in 2023.

Going back to 2022 could help us see which cities in particular stood out as the best CRE opportunities. Many operators have opted to use floating-rate loans correlated to the SOFR rate index to finance their transactions in recent years. The SOFR was roughly 0.05% for the first quarter of 2022, where it had been for almost two years.

As capital was so cheap, many of the loans extended at that time had low rates and better-than-usual cashflow. Future effects of the higher rate include changes in both cashflow and market values for commercial properties. Conflicting viewpoints are influencing the CRE forecast for 2023.

There are several indications that CRE may struggle in the years to come; these include rising interest rates, overvalued markets and the looming threat of economic instability. The abovementioned concrete data ought to promote growth, but the continued discussion and anticipation of a future recession could have the opposite impact.

The impending economic slump is not anticipated to be at all comparable to the crisis of 2008. The CRE sector will at the very least continue to expand modestly until 2023. Current questions regarding the prospects for CRE in 2023 were posed to a panel of economists and top real estate personnel worldwide. 40% of those surveyed predicted revenue increases, 48% predicted revenue decreases and 12% predicted no change. The poll may not be screaming for growth in the capital markets, but it is a long cry from the alleged worldwide recession that some expect.

 

Level 1 impact

 

Many lenders have already made their loan pipelines more restrictive for 2023. When lenders are evaluating their loans, a debt-service coverage ratio (DSCR) of 1.25x is typical. This has, for the most part, reduced the loan to value (LTV) on most loans by 50-65%. Transactions have been impacted significantly by the differential between that and the 75–80% that most lenders lent just a year earlier. The quantity of equity needed to complete the deal has increased as a result of the discrepancy in loan proceeds, which also has an impact on the return on that equity.

Funding will still take place, but it might involve lenders other than those preferred in recent years. Due to the fact that many operators are looking for unconventional methods of financing their deals, creative finance would also be used. A recession and high loan rates would make 2023 a difficult year for CRE. Even though inflation started to decline in late 2022, it was still above 7%. The Fed will likely keep raising rates unless it observes a meaningful decline in inflation that brings it closer to its 2% target. In general, weak fundamentals and a high cost of capital will lower asset value.

• Even if sales may decline, certain sectors such as industrial and life sciences may continue to perform well. A record 551MM square feet of industrial space was absorbed in the 12 months ended April 2022, according to Marcus & Millichap.

• The office market has adjusted significantly to the post-pandemic work-from-home setting, leaving a large number of vacant spaces. Office spaces now entail a risk to owners and investors, with employees preferring to work from home, caused in part by sharp increases in gas. Office is facing headwinds from external forces and any asset not protected by inflation has been impacted negatively. Financial conditions (i.e., low real interest rates and other market conditions that make it easier to obtain financing) saw commercial property prices decline slightly and recover quickly amid the pandemic. CRE prices have also increased in countries with more generous financial aid programmes, greater vaccination rates and fewer strict public control measures to slow the spread of the virus. Hence, a sharp tightening of financial conditions might put the CRE sector under new pressure, particularly in regions with poor prospects for economic growth and if strict containment measures are put in place to stop future waves of infections.

 

Impact by property type:

 

• Multifamily:

   

  Demand for multifamily housing has held up amid tight single-family home supply and affordability challenges, with multifamily housing starts still close to the highs of the cycle. A recession will likely have less of an impact on this subsector as there is a shortage of multifamily housing in general, particularly affordable housing. Trends affecting demand for multifamily rental homes support this viewpoint. More and more people are renting because single-family homes are still relatively expensive and mortgage rates are high. Several federal, state and local government programmes also support demand in the affordable housing market. Hence, the dynamics of supply and demand will likely mitigate the impact of a recession in this sector.

• Industrial:

   

  Federal policies supporting this sector ensure the country would not be exposed to supply shortages. Demand in this subsector would be driven by the desire for national self-sufficiency, reducing the effects of a recession. In addition, there would always be demand for warehouses and distribution hubs if a significant portion of shopping is done online. However, CBRE expects leasing activity in the industrial and warehouse sector to fall by 10-15% in 2023, and lending to be available only to very strong counterparties, with other borrowers finding it difficult to secure finance.

• Senior living:

   

  Although inflation has had a significant impact on this subsector, long-term trends in this sector could mitigate the impact of a recession. Demand for senior living facilities would increase as baby boomers reach retirement age. In January 2023, lenders in the mid-market senior space were more active, as they believed interest rates had stabilised sufficiently. Some development deals are being made with the hope that construction will be completed after the current economic downturn.

• Hospitality:

   

  This subsector has benefited financially from a rise in both business and leisure travel. However, a recession is likely to result in less travel, which could cause some financial hardship. The distress would be worsened by other causes. Competition from Airbnb and other such alternatives has increased and will likely continue to have an impact. In addition, some areas are overbuilt with hospitality facilities. This subsector is expected to be impacted negatively by a recession.

• Retail:

   

  With more people choosing to shop offline rather than online, retail business has increased. Unfortunately, holiday sales were disappointing, with retail sales in December 2022 falling 1.1% from the previous month. We are aware of a few retail buildings that experienced lender foreclosure. A recession will probably stress this subsector more. When more people lose jobs and become anxious about losing their jobs, spending would decline. Moreover, a recession will result in slowed wage growth. The pandemic has altered consumer behaviour, meaning that online purchasing may still undermine sales at physical stores. This subsector is particularly susceptible to the negative effects of a recession because of these factors.

• Office:

   

  This subsector is the most vulnerable to a recession, given its already depressed state. Office vacancies reached 12.3% by the end of the third quarter of 2022, according to the Wall Street Journal, matching the peak level amid the Great Recession. The office vacancy rate is more than 25% in San Francisco, and just 40% of the available space is being used compared with before the pandemic. The pandemic has significantly altered workplace norms, undermining the office subsector. If these behaviours persist over time, the office subsector and many downtown areas would see a permanent transformation. While some office space is being converted to multifamily housing, the long-term solution is uncertain. Additionally, some office properties have had deeds in lieu of foreclosure accepted by lenders, who are now working to figure out how to maximise value for these properties.

 

Ways in which rising interest rates can impact CRE returns:

 

• Lower property values:

   

  As interest rates rise, the cost of borrowing money increases, and this can cause a decrease in property values. This is because higher interest rates make it more expensive for buyers to finance the purchase of real estate, which can reduce demand and drive down property values.

• Higher borrowing costs: Rising interest rates can also increase the cost of borrowing money for CRE investors. This can reduce the amount of money available for investing in new properties and may lead to a decrease in property acquisitions or expansions.

• Lower cashflow: When interest rates rise, debt payments increase, leading to lower cashflow for CRE investors. This can reduce the amount of money available for property maintenance, upgrades and other expenses.

• Increased cap rates: As interest rates rise, cap rates may also increase. Cap rates are used to value real estate investments and represent the expected rate of return on a property. When cap rates increase, the value of the property decreases.

What can CRE investors do to navigate this challenging environment?

The following are a few strategies:

• Consider fixed-rate financing: Fixed-rate financing can help CRE investors lock in a set interest rate, protecting them from rising interest rates in the future. This can provide stability and predictability of cashflow.

• Focus on properties with long-term leases: Properties with long-term leases can provide stable cashflow, even in a rising interest rate environment. These types of properties can help mitigate the impact of rising interest rates on cashflow and property values.

• Monitor market trends: Keeping an eye on market trends and interest rate forecasts can help CRE investors make informed decisions about their investments. This can help investors anticipate potential risks and adjust their investment strategies accordingly.

Finally, increasing interest rates may have a substantial effect on CRE returns. Investors seeking to make wise investment decisions must understand how interest rates affect cashflow, property values and cap rates. Investors could manage this difficult climate and make wise investment choices by taking into account fixed-rate financing, concentrating on properties with long-term leases and keeping an eye on market trends.

How Acuity Knowledge Partners can help:

At Acuity Knowledge Partners, our CRE Commercial Lending teams provide offshore support to banks through Loan Origination/Underwriting, Portfolio Monitoring and Loan Risk Grading. Our CRE analysts provide granular insight of market level trends and help banks’ underwriting team to identify potential risks in CRE lending.

Sources:

• www.investopedia.com

• www.imf.org

• www.tylercauble.com

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