An Economy and Property Markets in Flux Calls for an Important Shift in Priorities

Key Takeaways

  • Growing uncertainty over market conditions and the impact on real estate values is driving the need for more cautious and thorough loan underwriting due diligence.
  • The ability of lenders to maintain loan portfolio performance throughout this volatile environment depends on the strength of their capital.
  • Refinancing risk and potential distress is rising among highly leveraged marginal sponsors who will soon need to refinance cheap, short-term debt.

After the Federal Reserve’s latest 75-basis point increase in September, the federal funds rate rose to 3.25 percent and the 10-Year Treasury yield rose to 4.22 percent, the highest level since July 2007. With these rate increases to calm inflation, the Federal Reserve risks damaging the commercial real estate market and credit markets.

Unfortunately, inflation in September jumped 8.2 percent year over year and it is likely that the Fed will continue to raise the federal funds rate by another 125 to 150 basis points by the end of 2022. Based upon interest rate futures trading, more than a third of traders are signaling that the federal funds rate will climb above 5 percent by March of next year.

Price Discovery is Broken

While most categories of real estate showed consistent price appreciation over the last several years, that era is over. Coupled with a potential recession and rising geopolitical turmoil, rising interest rates are certain to move more lenders and investors to the sidelines as confidence and certainty in property values erode.

We have already witnessed a dramatic slowdown in investment activity. Commercial real estate sales of $43 billion in August represented a 41 percent decline from the prior year, according to MSCI Real Assets. The broad-based plunge in activity affected even darling asset classes like industrial, which saw year-over-year sales plummet by 63 percent to $5.6 billion. Apartment sales also dropped 26 percent year over year to $23 billion.

Meanwhile, some sellers have begun to acknowledge that their properties have fallen in value. In a somewhat extreme example, e-cigarette maker Juul has listed its 29-story office building in San Franciscos South of Market district for $174 million, reports the San Francisco Business Times. That is down from its asking price of $450 million a year ago, and it is $123 million less than the company paid for the property in 2019.

Time for Change

Growing uncertainty concerning the real value of properties demands that lenders shift priorities. While good deals can be found in any market, lenders today need a solid, tactical game-plan that focuses on assets that can perform amid higher interest rates, a recession and job losses. Lenders should reserve their capital only for familiar and proven clients who have strong balance sheets and sound development, acquisition, and refinancing opportunities. These opportunities can be adequately assessed and cash flow can be stressed.

Stiff competition for deals over the past couple of years has driven down loan pricing and requirements for loan structure. Many lenders now have dropped out of the market or reined in lending activity – pursuing strategic deals have an opportunity to achieve better risk-adjusted pricing. Lenders with strong and reliable sources of capital are in the best position to win the most attractive and promising deals. Debt providers that depend on the capital markets for their capital, especially via CLO or CMBS transactions, face a more challenging origination environment as buyers of the securities have become much more cautious.

As a result, many conduit lenders will be stuck with unwanted loans on their balance sheets/warehouse lines. CLO and CMBS securitization volumes through the third quarter were down 17 percent and 7 percent year-over-year, respectively, after a robust start to 2022, according to Trepp.

Bracing for a Downturn

Additionally, in a recent survey conducted by Trepp, nearly 53 percent of respondents expected commercial real estate fundamentals to worsen by the end of the year, and coincidentally, more than 80 percent predicted that loan delinquencies would rise over the next six months. Moreover, the survey indicated that office owners were most likely to experience distress. Indeed, Trepp reports that office loans accounted for 57 percent of $1.1 billion in CMBS debt that was recently transferred to special servicing. Retail loans made up 30 percent of the transfers.

But marginal owners of any property type that have cheap bridge loans issued at high LTVs are just as vulnerable to distress amid the spike in interest rates. As these sponsors see the value of their properties fall well short of initial underwriting assumptions, they face a significant increase in refinancing risk and will need to produce a substantial amount of additional equity to secure a loan. It is a safe bet that many will not be able to successfully refinance these loans and must sell their properties or give the keys back to the lender.

Vigilance Required

It is challenging to compare this period to others in the past. During the financial crisis, for example, there were much riskier loans issued, however we did not face 40-year high inflation that hamstrung the Feds ability to take accommodative actions – namely, dropping the federal funds rate by some five hundred basis points to near zero.

With the Fed moving in the opposite direction today, lenders and investors need to settle in for a disruptive interest rate environment that likely will not stabilize until at least 2023. But even then, the property markets could be wrestling with leasing softness due to recessionary pressures, which would also inhibit transactions. There are and will be opportunities in this market, however for the foreseeable future, we believe exercising caution, discipline and capital preservation is a far better strategy than waiting – or hoping – for a Fed pivot.

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