At the start of this year, it was widely predicted that 2023 would bring more turbulence to the commercial real estate market. And many of the difficulties discussed then have played out exactly as expected.
The Federal Reserve has continued with its mandate to curb inflation by raising benchmark interest rates. While data reflects that this policy has certainly contributed to the general downtrend in inflation throughout the year, the impact on commercial real estate has been dramatic and not so positive.
“It is difficult to be optimistic about the remainder of 2023 or the early days of 2024.”
This year will prove to be one of the more challenging in recent memory for commercial mortgage originators. At this point, the outlook for 2024 does not appear markedly different as the sector manages the higher interest rate environment, which will potentially result in a rash of loan defaults and modifications.
Myriad troubles
In the residential real estate sector, limited housing supply has contributed to elevated prices despite a higher interest rate environment. Conversely, the commercial property sector this year saw asset values and loan origination activity plummet across all segments. Office and retail have suffered the most as lenders pull back from these areas.
Coupled with a higher interest rate environment, the market dealt with a short-lived banking crisis that ended before it even started. Sure, some banks dissolved due to a series of problems, including mismanagement and a flight of deposits. But there were others, including the nation’s largest banks, that weathered the storm and became even stronger.
The calendar years of 2021 and 2022 were generally ones of prosperity in both the commercial and residential sectors, fueled by low rates and insatiable demand. But as Warren Buffett was famously quoted as saying, “You don’t find out who’s been swimming naked until the tide goes out.” Many banks did not sufficiently hedge their Treasury portfolios, leaving them exposed to higher Treasury rates.
A number of vertically integrated real estate companies also found themselves holding high-rate bridge or construction debt, and they had no true exit strategy as a result of higher rates hampering their debt-service-coverage ratios. Couple that with higher property taxes and exponential increases in property insurance, and you have a perfect storm for which there is no port.
Many lenders, originators, developers and operators have entered the market over the past decade. A portion of these newcomers thrived due to timing rather than knowledge or skill. But times have changed and many areas of the commercial real estate business have dried up. As an old saying goes, “When fish are swimming into the net, you are not truly a fisherman. It is when they don’t that you learn whether you are.” Many of these novices have found this year that they are not truly fishermen. Deals have not only been harder to come by but harder to qualify and close.
Dark outlook
It is difficult to be optimistic about the remainder of 2023 or the early days of 2024. The Federal Open Market Committee (FOMC) has stated that it will keep interest rates higher for longer to curb inflation. While the FOMC may not raise rates further, borrowing costs are likely to remain elevated for some time. This climate will restrict lending volumes for commercial real estate as deals will continue to be debt-service constrained, limiting proceeds.
There are also growing concerns about inflation in wages and services, which may push any rate-cut projections further into the future. Another major fear is that a wave of new multifamily properties set to be delivered will drag down rents and curb construction in this sector. In addition, increased costs for energy, labor and materials could add to the woes of multifamily operators as they move forward.
Nearly $700 billion in short-term, low-rate loans on multifamily housing are expected to mature in the next two years, and many of these will have problems being refinanced. The near future also will bring defaults for office properties in many major markets. But as more companies require workers to come back to their cubicles, there is hope that the office sector will make a comeback.
Another area that reaped a post-pandemic boost in demand was the industrial sector, although signs of softness have started to emerge. And hospitality, a sector that sees lender interest vary, is on the tail end of an upturn since the lifting of pandemic-era restrictions. Recently, the appetite for hotel lending has begun to wane.
Glimmers of hope
One area of commercial real estate that may show continued strength is owner-occupied loans. Lenders are aggressively pursuing such deals, as well as the potential depository relationships afforded by these business clients.
Lenders also prefer using the U.S. Small Business Administration (SBA) platform to facilitate these owner-occupied deals, offsetting risk and exposure. Additionally, the secondary market for SBA 7(a) loans remain robust and represents a far more profitable transaction to lenders — with a fraction of the risk.
Although it seems unlikely that lending volumes will increase soon, there are reasons for optimism due to the fact that virtually every deal financed during this period of higher interest rates presents a refinance opportunity down the road. This is because any deals closed today are, in essence, bridge loans of sorts as borrowers wait for rates to fall.
As a rule of thumb, it is best to limit prepayment penalties on any newly financed transactions. Mortgage brokers should also avoid any defeasance, rate-swap or yield-maintenance transactions so that when rates do come down a bit, borrowers have no restrictions that prohibit them from refinancing and taking advantage of better terms.
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As any loan originator will tell you, 2023 has been a difficult year. And unfortunately, 2024 doesn’t look to be much better. The key to surviving this period will be persistence and a focus on the segments of the market where financing remains readily available, such as multifamily housing and SBA loans for owner-occupied deals.
Using these tools should help you set the table for what will likely prove to be a more opportunistic time once the Federal Reserve has reversed course on its cycle of rate hikes. This will be a testament to Darwinism: Only the strong will survive, and those without the fortitude, experience and ability to excel in a down cycle may find themselves in another field. ●
