In many ways the meteoric rise in CRE value over the past three years was as ubiquitous as a bunny popping out of magician’s top hot. Under the illusion of doing what’s best for the American people, historically low interest rates conjured by the Fed were combined with abundantly cheap debt and equity, courtesy of Wall Street. Take that low cost of capital, wave the magic wand and abracadabra, everyone’s a real estate genius – until suddenly they’re not.

Less than one year ago, as the Fed was starting its aggressive rate hiking cycle, Eisner Amper observed that CRE was “transitioning from an artificial landscape of monetary and fiscal stimulus that inflated returns and asset values toward a market-based interest rate and pricing environment as both the federal government and the Federal Reserve withdraw.”

As they say in the magician’s trade: “Now you see it; now you don’t.”

For instance, The Wall Street Journal reported that nearly $90 billion in securitized mortgages are estimated to be at risk of default, with almost half tied to apartment buildings. Sure, property owners like non-recourse mortgages associated with higher leverage. Seemed a no-brainer a mere 12 months ago to take a low-rate floater to juice a stabilized return or complete a rehab/construction project. What could possibly go wrong? Plenty, it turns out, when rates are rising fast.

“Some of the same characteristics that made these loans attractive to property owners also made them riskier and more vulnerable to sudden changes in borrowing rates,” The Journal explained. “Last year’s surge in interest rates, a softening rental market and rising expenses mean many landlords no longer earn enough money to pay back their loans.”

There’s also another challenge we haven’t seen in our industry in a while: “The cost of interest-rate caps has gone from being a minor nuisance to front and center of mind,” Carol Ng, managing director of hedge advisory Derivative Logic, told The Journal recently. In many cases, interest-rate caps bought during the pandemic are still protecting landlords from higher debt costs but are due to roll off in the next year or two. And now buying new hedges can be very expensive.

Fixed rate re-financings are a readily available solution for most stabilized assets. Hopefully, the savings amassed from the floating rate loan are kept in gold bullion (not in crypto), since stricter underwriting guidelines and higher fixed rates may result in an infusion of fresh equity.

It’s like being sawed in half during a magic show and then watching the magician leave the stage in a huff due to a dispute over his contract.

With the cost of capital continually rising, IRR’s on new deals are dropping and crimping investors’ plans for existing deals. No one should be surprised that both investors and their lenders are taking more time to model out (and in many cases revise) cash flows and valuations.

As EisnerAmper opined: The new landscape will bring “both opportunity and pain” as we go from a “sprint of the last few years to a marathon.” With a longer, more demanding race ahead, EA said will take more capital and sweat to achieve success in real estate investing. From where I sit, the time of reckoning for broken rehab and construction projects is at hand. Not everything pencils for profitability. Projects that do will likely require investor capital calls in order to limp across the finish line.

Not all doom and gloom

Sure, it looks bleak when scouring the CRE trade publications, websites and social media pundits. And yes, the vacancy rate for office buildings nationwide rose to a record high of nearly 20% by late 2022. But if you look closer, a number of sectors are doing quite well. And with the Fed watching this sector very closely, I don’t think urban office woes will spread into other CRE sectors or ignite a financial contagion.

Vacancy rates in warehouse and industrial space nationally are low, according to Cushman and Wakefield data. STR research said hotels are racking up record revenue per available room since both occupancy and prices surged post-Covid. Meanwhile retail vacancy rates are only 5.7% nationwide, according to a CNBC report – an impressive showing in the online shopping age. The average rent landlords asked for available shopping-center space also reached an all-time high in Q1 of this year. A WSJ report last week noted that even online retailers are signing leases for bricks-and-mortar space. Why? Ironically, it’s because rising digital-advertising costs are making it more difficult and expensive to attract new customers online.

How’s that for a magic trick gone awry?

While the work-from-home trend will likely continue decimating high rise offices in major cities, it’s been a boon to the suburbs. Pedestrian foot traffic in U.S. urban downtowns was down about 25% in April compared with the same month in 2019, according to real-estate software provider MRI Springboard. To that end, The Decline of the Five-Day Commute Is a Boon to Suburban Retail,” a WSJ headline screamed last week.

Meanwhile, a Motley Fool report explained last week, that “out-of-city retail spaces are seeing a massive resurgence” and that Site Centers and Phillips Edison, two large shopping center owners, reported “record high occupancy and leasing in first-quarter earnings reports.” Simon Property Group also said overall occupancy rate is over 94%, just short of pre-pandemic norms, while foot traffic is up from last year. According to real-estate firm CBRE, the second half of 2022 marked the first time since at least 2013 that urban retail space vacancies surpassed suburban levels. Maybe all your friends who ditched city life were right.

Mountains of perm debt coming due

The massive amount of perm debt coming due means tough choices ahead for some sponsors. ​ For instance, almost one in four mortgages on office buildings must be refinanced in 2023, according to Mortgage Bankers’ Association data, at much higher interest rates than the 3 percent you see on banks’ portfolios now. As Xander Snyder, senior commercial real estate economist at First American, told CNN recently, that as low-interest office loans come due, we’re running into a situation in which “office-owners have to refinance at a higher rate and only 50% of the building is being used. That doesn’t translate to good cash flow metrics for the lender.”

Bridge loans that were made before floating rate indexes surged have put extreme pressure on sponsors to rework construction and rehab budgets -- and not for the better. Transactional volume on stabilized CRE has slowed to the point that many buyers and sellers are just staring at each other's benches.

Snyder explained that with credit becoming scarcer and more expensive, it’s hard to know exactly what buildings are worth. “You get this gap opening up between sellers and buyers: Sellers want to get late 2021 prices and buyers are saying ‘we don’t know what things are worth so we’ll give you this lowball offer.’” And the result of that price differential, said Snyder, is what’s bringing deal activity down.

Uncertainty within the economy and the underlying pressures within the banking system have created what golf legend Gary Player would call “paralysis of analysis.” The buyer-seller gap that I wrote about last July can feel almost insurmountable to many CRE investors in today’s environment. But I promise that deals are getting done. There’s nothing wrong with taking a little pursuit risk as a buyer. Heck, back in ‘74 Evel Knievel attempted to jump over the Snake River in Idaho. He risked it all and didn’t let the gap slow him down!

Conclusion

Remember, CRE is a very broad and diverse industry. Just like the stock market, some sectors are leading and some are lagging. Avoid the temptation to says everything’s down in CRE However, if your relationship lender can no longer help you make a deal pencil, feel free to reach out. We’re happy to arm you with market intelligence to get the deal done. ​ Here at Ascension we, don’t use a magic wand or cape though I’ve been told we’re great at pulling rabbits out of hats.