The U.S. economic picture is an opaque one for lenders and borrowers alike as inflationary pressures persist and the massive swings in interest rates are still working their way through the economy. At its May meeting, the Federal Open Markets Committee (FOMC) raised the federal funds rate for a 10th consecutive time to a target range of 5 to 5.25 percent.
The fed funds rate is the interest rate that U.S. banks charge each other to lend funds overnight. This time a year ago, the short-term benchmark rate was at a range of 0.75 percent to 1 percent.
Raising the feds fund rate is the primary way that the Federal Reserve combats inflation, which was at a 3 percent annual rate in June, according to the Bureau of Labor Statistics’ Consumer Price Index (CPI). The CPI is at its lowest level in more than two years, which is generally viewed as a positive sign for economic stability, though the June figure is 100 basis points more than the Fed’s target inflation goal of 2 percent.
Jason Scott, managing director and head of conventional loan production at Regions Bank, estimates that it can take six to eight months for each interest rate hike by the Fed to be fully realized.
“To hit its goal of 2 percent inflation, the Fed needs to continue to increase rates because there are still a few more percentage points to strip out,” says Scott. “The economy has trillions of dollars that were injected during the pandemic, and it is still everywhere.”
The FOMC decided at its June meeting to pause rate hikes, which was the first time the central bank elected to not raise rates in 15 months. However, the governing body’s projections call for two more rate hikes before the end of the year, which would take rates as high as 5.6 percent.
The Fed is fighting from behind to wrangle inflation, which peaked in June 2022 at an annualized rate of 9.1 percent. Peter Mekras, president of Aztec Group, was encouraged that the central bank showed at the June meeting that it can stagger rate hikes despite inflationary pressures.
“The Fed is willing to be a little more reactionary and let the market know that it is willing to wait and see and then react accordingly,” says Mekras. “However, the Fed knows we can’t afford to miss out on stamping out inflation because it can be very sticky.”
Because of the upward trajectory of interest rates, finding a consensus on property values is a challenge for all parties — borrowers, lenders and financial intermediaries. Susan Mello, executive vice president and group head of capital markets at Walker & Dunlop, says that the current period of value discovery is causing lenders to tighten their purse strings.
“Lenders are being more conservative because there is less visibility on value,” says Mello. “For borrowers, it’s more difficult to find liquidity than it was a year or two ago.”
The Mortgage Bankers Association (MBA) concurs. The Washington, D.C.-based organization is forecasting that commercial and multifamily lending will total $654 billion in 2023, a 20 percent decline from 2022 volume.
Aftermath of bank failures
Banks will dole out less funds in 2023 than in 2022, Scott predicts. Part of the reason is that 2023 represents the single-biggest year for bank failures in U.S. history in terms of total assets.
The three banks — Silicon Valley Bank and Signature Bank that failed in March and First Republic Bank that failed in May — combined for $548.5 billion in total assets affected, which eclipses 2008 when 25 banks failed, representing $373.6 billion in total assets.
In 2022, banks of all sizes provided nearly half of all acquisition debt activity and more than 60 percent of all construction lending activity, according to data from MSCI Real Assets. Scott says that the ripple effects from the bank failures have been widely felt in real estate lending circles, but it’s important to note that all 23 of the large banks tested in the Fed’s annual bank stress test showed solvency during severe recession scenarios.
Additionally, Scott says that banks large and small have diversified their business models to withstand any potential headwinds in the future.
“Diversifying has enabled us to be a source of consistency and strength for our clients, particularly during challenging economic cycles,” says Scott. “We place a high premium on the prudent allocation of capital. We conduct appropriate due diligence. And by having deep relationships with our clients, we’re able to meet their financial needs while considering the broader economic backdrop at all times.”
Martin Fayer, senior managing director at NewPoint Real Estate Capital, says that banks avoiding risk and not allocating their money into real estate has a compounding effect because of how integral these institutions are to the industry, especially local and regional banks.
“Banks provide financing to other real estate lenders to finance their debt before they securitize it, so there are a lot of secondary effects that aren’t fully appreciated,” says Fayer. “There is a multiplier effect when banks aren’t active, beyond just bank lending.”
Michael Edelman, president of M&T Realty Capital Corp., says banks are currently going through “the tough times.” His parent company, M&T Bank, is sticking to deals with repeat clients, though the bank has experienced an uptick in inquiries from clients of those failed banks.
“We are sticking to our core clients, and we’re not trying to expand and add new clients that we haven’t been with through the good and bad times,” says Edelman. “We are sticking to our knitting.”
Jeff Erxleben, president of debt and equity at Northmarq, says that less liquidity for banks means opportunities for other capital sources, such as Freddie Mac, Fannie Mae, non-traditional balance sheet lenders, CMBS and life companies, among others.
“Life companies have experienced an increased flow of lending opportunities as borrowers seek to capitalize projects in different ways,” says Erxleben. “Less liquidity from the banks has made it even more important for a borrower to have a complete canvassing of the capital markets.”
Risks by property type
The property sectors that lenders and financial intermediaries agree are the least risky, therefore the most attractive, are industrial and multifamily. The two asset classes have sustained demand through the highs and lows of the COVID-19 pandemic.
The U.S. industrial sector’s vacancy rate as of second-quarter 2023 was 4.1 percent, well below the 10-year historical average of 5.3 percent, according to research from Cushman & Wakefield. The sector also posted a 16.1 percent growth in asking rental rates year-over-year in the second quarter.
Rent growth was much tamer for the multifamily sector. Through the first five months of 2023, asking rents for U.S. multifamily rose by 2.6 percent year-over-year from May 2022, according to Yardi Matrix.
The surprise sector for lenders has been retail, which has exceeded expectations despite the short-term pain the industry faced in the early days of the pandemic, as well as the years leading up to the health crisis when several large-scale retailers closed their stores for good.
“Retail was a very undesirable place to borrow five or six years ago. Many lenders turned it down without listening unless it was grocery-anchored,” says Mekras. “Today, lenders are much more tolerant to lending on retail because they have recent performance and COVID. The retailers that survived demonstrated their resiliency.”
Mello adds that investors who had been hesitant to do retail deals are now intrigued because of the yields that shopping centers and other retail assets can produce.
“People are starting to recognize that there are really attractive opportunities in the retail sector,” says Mello. “In many cases, you can still get positive leverage — more so than in industrial and multifamily, which sometimes feel like they are priced to perfection.”
The sector that lenders are deeming a “no-fly zone” is office as hybrid and remote work schedules have drastically reduced the demand for office real estate.
Cushman & Wakefield estimates that the U.S. workforce will only require 4.61 billion square feet of office space at the end of the decade, assuming office-using employment grows by 6 percent over that period. If realized, the 1.1 billion-square-foot glut of excess office space will represent a 55 percent increase from the amount of obsolete office space in fourth-quarter 2019.
Edelman of M&T Realty Capital says the company is avoiding the office sector until those issues dissipate and buildings can boost their net operating income.
“Office has been a challenge; occupancy as well as rents have been both going down,” says Edelman. “We obviously monitor our existing portfolio of office assets, but it’s not something we are looking to lend in aggressively right now.”
“We are seeing that bank lending on office properties has really dwindled, and that’s creating a lot of pressure for owners in that sector,” adds Fayer of NewPoint.
Office lease terms typically range from three years to seven years. Scott of Regions Bank says that office users are still rightsizing their real estate footprints, which will continue to take time as these leases roll.
Ultimately, Scott believes that office demand will return in the future because of the importance that companies place for in-person training and building a corporate culture, which are hard to replicate over Zoom or Teams.
Next steps
Edelman says borrowers are being hit from all sides in terms of capital expenditures, not just elevated borrowing costs. Costs are also rising for labor, construction materials, insurance premiums, land and property taxes for most all borrowers.
“Inflation has had a big impact,” says Edelman. “If this was a nine-inning game, we are probably in inning four or five. We’re just waiting for the volatility in the capital markets to shake out over the next 12 to 18 months. We’re not out of the woods yet with respect to rate hikes. There’s too much rate uncertainty for borrowers to dive in with two feet.”
“Overall, borrowers and lenders are still adjusting to the rapid increase in rates and seeking stability on those rates, which has not occurred yet,” adds Erxleben.
Sources say that the uncertainty in the capital markets is the ultimate roadblock to lending activity, not so much the high interest rates themselves.
“Stability is something the market craves, even more so than lower rates,” says Mello. “We all like the lower rates, but both lenders and borrowers feel like a stable market gives them visibility regarding their investment plans.”
Mekras adds that a growing number of borrowers are of the mindset that today’s interest rate volatility is the worst it’s going to be and some relief is just around the corner. He cautions against this line of thinking because it ignores what the Fed has signaled and doesn’t account for history or geopolitical and black swan events that can’t be foreseen and could cause more inflation.
“There is liquidity in the market, but it’s a cost of liquidity that is challenging to accept. The fact is that expectations and reality are very far apart,” says Mekras. “No one does well with a very rapid change. We are all accustomed to volatility, but not at this magnitude. So the deals that are getting done are on the basis of necessity and unique motivations from the borrower.”
Aztec Group recently closed a $22.3 million Freddie Mac loan for the refinancing of Oak Plaza, a 156-unit apartment community in Miami. The deal was the third transaction between Aztec Group and the borrower, Melo Group, in the past 12 months.
Mello agrees with Mekras that there’s liquidity in the marketplace, although it is more selective and at lower loan proceeds and higher borrowing costs.
“There is some positive momentum,” says Mello. “The message we’re trying to get across is that commercial real estate is still a good space in which to invest, whether as an owner or a lender.”
Sources say that there is a huge buildup of debt and equity capital waiting on the sidelines, and some say that the levees are starting to just now be breached. Scott says that the first five months of 2023 were slow for Regions Bank, but the past 30 days have been productive.
“Over the past 30 days we’ve seen a material increase in deal flow,” says Scott. “It’s been over $1 billion, which puts us on a strong run rate to finish the year at a solid loan production level. It’s nice to see deals come in and close after a lot of fits and starts earlier in the year.”
— John Nelson