While no industry is immune to the gravitational pull of the financial markets and the health of the national economy, commercial real estate is particularly sensitive to the ebb and flow of financial fundamentals. Which is why understanding the future of commercial real estate starts with dollars and cents.
More specifically, it starts with the federal funds rate: the rate set by the Fed for financial institutions to engage in overnight borrowing that impacts interest rates across the board. With interest rates increasing from less than 1% to more than 5% in the course of a year (largely in an attempt to tamp down inflation), the cost of capital borrowing has more than quintupled in a relatively short period of time. The speed with which rates have risen can be attributed, at least in part, to COVID, which not only kept rates lower longer, but also infused a lot of capital into the system through grants and government programs. Today, the fast-rising rates trend is part of an economy-wide dynamic that has significant implications for the future of commercial real estate.
Here’s why every developer and investor should be paying close attention:
The banks that own the bulk of commercial debt in the U.S. are required to maintain a certain level of capital as a loan loss reserve. The amount those banks are permitted to lend is predicated on having sufficient funds on hand to cover some of those loans. The problem is that the same time interest rates have been rising precipitously, the rate of return on financial instruments like money market accounts has risen to a point where money is being moved out of traditional savings accounts and into those more flexible and profitable accounts. With less capital on hand, growing numbers of banks are being forced to rethink some of their outstanding loans.
Consequently, when, for example, a loan with a 5-year term and a 20-year amortization period comes due, commercial real estate borrowers are increasingly faced with a choice that boils down to either paying a large remaining lump sum they cannot afford, or refinancing under dramatically higher interest rates. Declining property values add another element of uncertainty. Higher interest rates tend to drive down property values (sometimes significantly), and lower appraisals make it even more difficult to borrow based on the amount of your loan five years ago.
In some cases, banks aren’t even writing that next loan, they are just calling it in. And with each default, a bank’s loan loss reserve shrinks—potentially requiring them to call in still more loans. You see where this is going. Declining property values. Property owner defaults. Tighter credit. It’s a self-reinforcing cycle which some refer to as a “doom loop.”
An additional issue is that some of the funds that banks have available as a loan loss reserve are invested in, among other things, short-term commercial mortgage-backed securities (CMBS). But some of those companies selling those securities have written literally billions in short-term loans with floating interest rates—and as rates skyrocket, those can go underwater. While banks are likely to have their capital invested in higher quality assets that are considered to be the safest and therefore offer a more modest rate of return, that lower ROI can complicate matters when a bank needs to sell to address the potential liquidity concerns described above. Buyers can be scarce when treasuries can offer twice the rate of return, and banks forced to sell quickly can lose a significant portion of their investment. And if CMBS pools see the kind of losses that now seem possible (at least 20-30%), the downstream impact on commercial real estate and the economy could be pronounced. We don’t have to look back very far to see what happened the last time we experienced a CMBS crash in 2008 (caused in part by cheap money and perverse incentives for over-lending and over-leveraging). While today’s scenario is by no means identical, there are enough similarities that commercial real estate professionals need to be paying close attention.
The dynamics described above are just now starting to manifest themselves in the marketplace. So, while optimistic statements about a stronger-than-expected job market, the potential for a “soft landing,” or even to avoid a recession entirely are enticing, they also might be somewhat naïve. Because without a significant rate rollback and recognition about what is happening, a potentially dramatic commercial real estate crash seems increasingly inevitable.
There is good news, however. Leaner times highlight the value of higher-quality assets, and well-capitalized developers and investors can find themselves in an advantageous position relative to the competition. Additionally, and perhaps most importantly, developers and investors who can recognize these economic and industry trend lines—and have the resources and strategic vision to take advantage of emerging opportunities—can capitalize on lucrative opportunities. Short sales, auctions, devalued/undervalued real estate, and banks willing to take significantly less to balance their ledgers all present tantalizing medium-to-long-term value plays. Now is the time for commercial real estate professionals to be looking to position themselves and their assets for what’s to come. This is a business where the most successful operators aren’t looking at next month but are operating based on what they see coming 2-5 years or more down the road. Understanding the larger forces shaping our industry is essential. Because looking ahead to forecast the future contours of the financial sector and commercial real estate landscape is not tangential to what we do, it’s essential.