The commercial real estate (CRE) industry is in unchartered waters, given the current interest rate increases and related economic upheaval that is slowing deal flow and creating significant uncertainty. All eyes are on debt and equity financing at this critical time, given the impact on transaction activity. This LightBox blog examines CRE financing and dives into:
- The impact of rising interest rates on the cost of capital
- How investors and brokers are navigating shifting lending requirements
- The impact of higher cap rates
- What’s ahead for CRE investment
“Investors are navigating a challenging environment where lending requirements, property valuations and debt service coverage are under more intense scrutiny, ” says Tina Lichens, Senior Vice President of Broker Operations for LightBox. “As buyers and sellers reevaluate their positions heading into 2023, we expect to see a rebalancing of pricing expectations that will ultimately lead to renewed growth in investment activity.”
While the first half of 2022 saw strong investment activity, interest rate increases pushed cap rates higher and caused a significant retraction in commercial real estate deal volume. As major money center banks retreated in the third quarter, the CBRE Lending Momentum Index, which tracks the pace of CBRE-originated commercial loan closings in the U.S., declined by 11% compared to the second quarter. This was nearly 5% below the level recorded in the third quarter of 2021.
Interest Rate Increases Shutting Down Buyers
The higher cost of capital has shut some buyers out of the market, and, as a result, third quarter investment was down 18% year-over-year and 16% below the second quarter. In response to interest rate increase and changing conditions, 28% of environmental due diligence consultants have lender clients who halted or curtailed originations in the third quarter, according to LightBox’s latest survey data revealed. “For loans that are proceeding, lenders are exercising far more scrutiny on assumptions about occupancy, rents, and property values. In today’s uncertain environment,” according to Dianne Crocker, LightBox’s principal analyst, “the numbers have to make sense.”
A Look at Credit Losses and Delinquencies
Larger banks have been more prudent in anticipating potential credit losses, but the credit losses and delinquencies haven’t been seen yet, says Jon Winick, CEO of Clark Street Capital. “Time will tell if they were ahead of the curve enough, anticipated problems that never occur, or had their heads in the sand.”
Given the backdrop of rising rates and the potential recession, credit risk and having a good handle on property values will be top of mind for lenders, says Raj Aidasani, Senior Director, CREFC. “Our market has yet to fully absorb the dramatic changes over the last year and, in addition, the standoff between buyers and sellers is expected to continue. Lower transaction activity translates to lower market price transparency, making the credit work lenders perform even more critical.”
Other key take aways:
- Underlying property performance remains strong for many asset classes, especially those that can raise rents to account for higher costs. Many companies and properties have experienced strong years given the momentum in 2021 and the start of 2022.
- Among the property sectors to watch are multifamily, which has seen record rent growth, and industrial, due to questions about whether demand drivers will remain as strong long-term.
- Debt capital is more difficult to find for office, hotel and retail properties, as lenders reduce their exposure to asset categories with higher risk.
- Many lenders are cautious about the office sector, given its lower occupancy levels due to return-to-work policies. Recent layoffs in the tech sector could add another layer of stress to some office properties.
Property Appraisal Volume Shrinks
Growing economic weakness has also prompted lenders to reassess their loan allocations as they attempt to balance portfolios that are seen as too heavily weighted for real estate. “We’ve seen a dramatic slowdown in appraisal activity this year, which provides an early indicator for loan activity,” says Candi Coleman, MAI, Head of Lender Strategy with LightBox. “The appraisal industry has been very busy for the past 18 months and now we’re in a holding pattern.”
The slowdown in lending also puts the spotlight on maturing loans and a potential risk crisis as cap rates and interest rates rise, says Coleman. “As a wave of loans sets to mature over the next 12 to 24 months, property owners will be faced with the potential for higher debt service and possible decreasing values. That puts borrowers in a tight spot when looking to refinance their loans.”