The Continuing Extraordinary Impact of Higher Interest Rates on Commercial Real Estate Investing

The 2022 rise in interest rates greatly impacted all industries across the economy. But the abrupt change since last June hit the highly leveraged real estate industry particularly hard. For real estate owner-operators and investors, interest rates are not only the price of debt but also the driver of asset values -- a double whammy. And, as seen in the accompanying table, the base rates used to price commercial mortgage loans grew by multiples last year. This resetting of rates reflects the market’s response to the Federal Reserve taking its foot off the accommodation accelerator, both through extraordinary increases in the federal funds rate and the reduction of its balance sheet holdings of mortgage-backed securities, ending a period of artificially low interest rates in favor of a market-based reversion toward the historical mean. While rates eased toward the end of 2022 in anticipation of a 2023 recession, a higher interest rate environment is likely here to stay.

In the years after the Great Recession, the Fed brought the federal funds rate near zero and did not let up even as the economy recovered. That brought a dozen years of artificially low rates, making properties more valuable and real estate investments more profitable. To illustrate this accommodation, the average 10-year Treasury rate since 1962 has been just over 5%. Contrast that to the average 10-year Treasury rate from 2009 through 2019 of 2.48%. And it got even lower during 2020 and 2021, the peak (hopefully) years of the pandemic when the average rate dropped to 1.19%. Today’s rate, therefore, is below the historical average. If the Fed remains diligent in reducing inflation, as promised, a higher interest rate environment is likely to continue for the foreseeable future. At the most recent FOMC meeting in mid-December, the median projection for the federal funds rate in 2023 was 5.1% tapering down to 3.1% by 2025.

For real estate investors, a higher and more unpredictable cost of capital has greatly increased the risk of new deals. Not only have the indices risen, but credit spreads have also widened as lenders try to assess the impact of higher rates on debt coverage and collateral value. As a result, commercial mortgage rates doubled last year from the mid-3% range to the mid-6% range. To further protect themselves lenders have lowered loan proceeds, requiring more equity and reducing the borrower’s leveraged returns.

The unpredictability of interest rates, inflation, and economic performance has significantly slowed the commercial real estate transaction market. This article describes how higher interest rates have impacted owners, lenders, and investors, forcing them to rapidly alter their strategies as they prepare for another year of disruption.

The Owner-Operator Perspective

Owners dealt with inflationary pressures throughout 2022. Early on, prices of goods rose with supply chain disruptions, which then eased. But higher operating costs remain, particularly wages and utilities. At the same time rent growth, while still positive, has slowed, even in the more attractive multifamily and industrial sectors. The combination has squeezed operating cash flow and lowered debt service coverage ratios. For properties financed with floating rate debt that was not adequately hedged through rate caps or swaps, owners have been paying excess cash flow to their lenders rather than the equity investors. Renewing hedges, or attempting to hedge rates now, has become prohibitively expensive. As a result, there are increasing incidents of debt service coverage ratio and debt yield covenant breaches, often resulting in a lender requiring a partial paydown, or resizing, of the loan.

Maturing mortgages are as large a problem for owners. A higher interest rate may mean that operating cash flow is insufficient to meet a lender’s stricter underwriting standards. And even if the interest rate is not much greater today than when the loan was originated, current lower leverage requirements will likely force many owners to pay down a portion of the loan balance to extend or refinance the debt.  The size of the required cash infusion will depend on the existing loan’s leverage, and many loans in the past few years were full term interest only, potentially requiring a larger paydown. For properties with weaker performance, including B-class malls, hotels reliant on business travel, and offices with high lease turnover rates, the liquidity may not be available to fund newly required equity, and distressed situations are already popping up across these asset classes. These owners must then choose between expensive rescue equity that will dilute their share in the property, a forced sale of the property at discounted values, or losing the property to the lender and paying significant debt forgiveness taxes. Projections for higher delinquency and default rates abound, and distressed debt funds have been actively circling the perimeter.

The Lender Perspective

Lenders have no upside on real estate loans. They need the loan to be paid back in full and to receive a healthy margin between the rate they charge borrowers and their cost of funds. A lender’s first concern is collateral value, and the lack of comparable transactions has made valuations elusive. It remains unclear where benchmark rates will find equilibrium in the next twelve months and to what extent capitalization rates will follow the upward trend, driving down property values. The shift in cap rates is likely to vary widely depending on the strength of the market, the property type, and the tenancy. As mentioned above, this has caused lenders to reduce leverage on all types of commercial mortgage products. Lenders of course are also focused on current collateral cash flow. Most properties have performed very well as the tight job market continues to drive demand. But higher rates on a floating rate loan or a newly financed loan can wipe out the debt service coverage cushion. Lenders are therefore tightening their underwriting by raising debt service coverage and debt yield requirements and strengthening loan covenants for ongoing performance monitoring.

Banks currently have an opportunity to increase their net interest margin because many are charging today’s rates on loans while continuing to pay depositors yesterday’s artificially low rates. And yet many of the larger banks have pulled back from real estate lending due to the credit concerns mentioned. Unlike banks, private debt funds and public mortgage REITs raise capital through various types of warehouse and credit lines. Accordingly, their cost of funding has risen along with the market rates and they are subject to a potential margin squeeze during the life of the loan or a collateral call if values fall. As a result, these lenders have also reduced origination volumes. CMBS issuance has also stalled, in part because investors in the bonds have the same credit concerns as the lenders and can find more attractive risk-adjusted returns elsewhere in the fixed income market.

Debt capital is still available to the real estate sector but not at the robust levels of the past few years. Like real estate owners, lenders are carefully reassessing the creditworthiness of their portfolios, proactively working on potential problems, and finding opportunities to redirect available capital to the better performing markets and asset classes. Caution is abundant, making new deals far more difficult to close.

The Investor Perspective

The uncertainty caused by interest rate volatility and the macro withdrawal of the sector’s liquidity are causing real estate investors to focus on shoring up their existing portfolios rather than providing fresh capital to new transactions. Investors are updating their cash flow models to reflect current market conditions and comparing newly projected yields to expectations at the outset of the deal. They are also combing through their loan documents to better understand and monitor performance against covenants and assess whether to accelerate or decelerate planned refinancings. For private equity players, a big focus is on re-estimating promotes, and some deals with higher operating expenses and floating rate debt may now be “out of the money.” A common strategy for private equity sponsors is to refinance the debt after improving the property and paying out the excess cash flow to the investors. This strategy, which not only provides new capital for real estate investment but also increases the investors’ yield and the sponsor’s promote, has become extremely difficult to execute when interest rates are so much higher than anticipated at the outset of the deal. The bottom line for passive investors: lower distributions than anticipated and less upside, despite strong property performance.

Despite these obstacles, new deals are of course getting done. Financing is still available for multifamily transactions through Fannie Mae and Freddie Mac, and other lenders are selectively providing capital for the “right” investments. That typically means properties in markets where there is still economic and employment growth, enabling owners to raise rents. While 2023 performance may not match the past two years, multifamily and industrial remain the favorite asset classes, with many lenders avoiding office and retail. A key concern for investors is negative leverage, when the borrowing rate is higher than the cap rate, or investment yield. The only way out of that hole is rent growth. In this period of uncertainty, investors are wisely performing more detailed analysis on prospective transactions and running scenarios in their models to determine the range of potential yields in a stressed rent growth and operating cost environment, as well as an array of exit strategies and prices. Deals can only move forward when the market and property competitiveness, now or after repositioning, will support sufficient rent growth to enable the desired leveraged returns.

Investors are also developing new properties, again within growth markets, hoping all the current turmoil will be history by the time the property is delivered. Depending on the property type, lenders are supportive of new development; however, they are still concerned with value trends and are therefore tightening their underwriting criteria. For example, multifamily construction in targeted in-migration markets continue to see favorable loan terms, particularly since bank and fund lenders take comfort that the agencies will take them out at stabilization. The risk here, though, is a prolonged or severe recession that mitigates space demand and slows leasing or even causes rental rates to fall.

The Painful Transition to a New Interest Rate Environment

Higher interest rates in the last year have driven down the predictability of real estate cash flow and yields and upended owner-operator and investor strategies. We have seen a major slow-down in transaction volume. As we journey through the transition from the artificially low rates of the last decade to a new, but still unknown, interest rate environment, liquidity will continue to pull back from property markets. Asset valuations are decreasing, but how far down will they go? Unfortunately, the reduction in transaction volume is likely to greatly extend the process of price discovery. The market will ultimately adjust to a new level of interest rates. Until then, it is the unpredictability of yields and valuations, today and at a deal’s projected exit, that is causing capital to seek alternative investments.