Late for work the other day, I quickly approached a blinking yellow light at a four-way intersection. Quickly, I had to assess my risk of getting T-boned by another harried driver – also late for work -- before crossing. That situation sums up where I see CRE investing these days. According to the latest RCIS survey, 71% of U.S. companies felt the commercial real estate market was in a downturn. And that was before the Federal Reserve’s sixth straight interest rate hike earlier this month.

Rising financing costs, combined with inflation and a probable recession, have put plenty of pressure on CRE transaction activity since the Fed’s first major rate hike last June. Case in point, total lending fell by 17.3% in 2022, according to the Mortgage Bankers Association (MBA). And the MBA is projecting another 4.7% drop in CRE lending in 2023 to $700 billion.

“My biggest concern for CRE markets is they need clarity,” said Tom LaSalvia, director of economic research at Moody’s Analytics in a Commercial Observer report. “If the economic data isn’t pointing strongly enough toward inflation being under control, and we know rates are going up, then CRE markets are going to remain a little illiquid. Or, certainly we’re going to see transaction volume remain subdued for the time being,” LaSalvia added.

Tighter financial conditions

Rising financing costs amid economic uncertainty have already put increased pressure on CRE transaction activity since the Fed’s first jumbo rate hike in 28 years last June. I’m witnessing the tightening firsthand as many perm lenders price themselves out of the market due to growing liquidity concerns. As CoStar reported this week, bank loans for CRE hit a record high in the fourth quarter of 2022. However, those lenders also set aside more money to cover potential losses from that financing amid recession fears. Higher loan loss provisions, consumer deposit withdraws to make ends meet, and deteriorating CRE valuations due to inflation worries, have me peering over my dashboard for oncoming traffic. While the sharp rise in CRE lending creates the potential for wider profit margins, it also increases the risk of delinquencies if the economy tanks, Fitch Ratings said in a Jan. 31 report.

Many believe future rate hikes are already baked into the market as buyers proceed with caution about property valuations. However those bets are stuck on the craps table as both hiring and consumer spending seem resilient thus far as just reported in the WSJ. The bid-ask spread between where buyers want to transact and where sellers are willing to trade remains wide. A lot of that gap is related to rates and where people can finance their acquisitions and properties.

Some say lending spreads may compress near-term to compensate for higher interest rates as a clearer picture on valuations emerges. However, leverage levels will remain a big constraint as lenders try to size up debt service coverage ratios on loans that hit the market when interest rates were far lower.

Xander Snyder, a senior CRE economist at First American, told Commercial Observer that today’s higher cost of capital is a big part of the “dislocation” between buyer and seller price expectations. He expects transaction volume to remain “muted” for the first half of 2023 before picking up in the latter half of the year. “I think that once the disconnect on prices resolves, you’ll begin to see transaction volumes pick up at that point,” Snyder asserted. “With the cost of capital uncertain in the short run, it will be harder for buyers and sellers to agree on prices in any asset class,” he added.

CRE at a crossroads

So that’s why I’m not pulling a moving stop at the four-way intersection. Employment remains incredibly robust nationwide, and consumers are piling on credit debt at a record pace. The annual rate of inflation has gone down seven straight months, but only minimally. Most public companies are beating earnings estimates. The stock market is only down about 7% from its record high level of 12 months ago.

Something needs to give.

Even as the economy normalizes with higher interest rates and higher financing rates, Moody’s’ LaSalvia believes “buyers and sellers will find a way to come together by the middle of this year without there being 15% or 20% percent property value declines in CRE,” LaSalvia predicted. I concur since I’m in the trenches daily. I’m watching assets clear at an average increased 25bp to 50bp cap rate due to the incremental increase in the cost of debt over the past 12 months.

CRE research firm Green Street told BisNow last week that commercial property prices are nearing a bottom, if not there already. Green Street’s Commercial Property Price Index, which tracks all sectors of CRE, is down 14% from its peak reached last March, falling 0.6% from December to January. Core sectors — office, industrial, multifamily, and retail — are down 17% from their peak, per Green Street's latest report, released Monday.

According to Green Street, apartment values and malls have fallen more than any other asset types — each down 20% in the last year. ​ Office prices are down 17% from their March peak, but their price decline is accelerating with a 4% fall in the last month. Industrial prices are down 15%, but haven't fallen at all in the last month, Green Street said.

As an EisnerAmper report noted last week, multifamily and CRE investors have enjoyed a decade and a half of consistently rising property valuations thanks to plenty of cheap capital. But, in light of the Fed’s actions, the transition from a “policy-induced boom market to a market-based real estate investment environment will be rough for a lot of owners.” I have to agree with Eisner here since we know at the end of every cycle, those who bought at the top are usually the first out in the CRE game of musical chairs

Even if the Fed hits the brakes on rate hikes later this year -- or in 2024 -- many including Eisner believe today’s higher rates are here to stay. “The biggest deterrent to capital flows is uncertainty. Not knowing where rates will land will keep liquidity on the sidelines and prolong the process of price discovery,” noted Eisner. “The search for clarity won’t be solved in a few months, it will take time for sellers to capitulate to new pricing and for lenders to believe in the new valuations,” Eisner asserted.

Meanwhile, as the aforementioned EisnerAmper report concluded: we may not understand the full extent of “sector distress” until the hundreds of billions of dollars of loan maturities takes place over the next several years. “But real estate companies and banks are healthy, property fundamentals remain relatively strong, and, like so many times before, the industry will adjust to the new market conditions and capital will flow once more,” Eisner added.

Conclusion

CRE has been trading, and will continue to trade, since the market continually adjusts to find a clearing price. I have yet to finance a deal with negative leverage, although there are plenty of lenders hopeful that will be the case. Buyers requiring leverage just need to turn over a few more stones to find the best rate and terms that work for their acquisition return analysis. If your relationship lender can’t fit the bill, feel free to reach out. We’re happy to arm you with market intelligence to get the deal done.