By Taylor Williams
At its mid-December 2023 meeting, the Federal Reserve delivered the news that investors of all types were waiting for: the cycle of interest rate hikes had concluded and that as many as three rate cuts could be forthcoming in 2024.
But the first rate cut by the Fed won’t occur until at least March. That’s when the Federal Open Market Committee (FOMC) is scheduled to meet again. In January, the FOMC opted to hold interest rates steady, keeping the target range for the federal funds rate at 5.25 to 5.5 percent.
The January jobs report, which showed total nonfarm payroll employment rose by 353,000 — nearly double many economists’ forecasts — has clouded the issue of when rate cuts may be forthcoming. A robust job market argues against the need for immediate rate cuts.
The Fed’s every move is tracked closely by the stock market, which responded with a furious rally in December 2023 on expectations for rate cuts in 2024. The Dow Jones Industrial Average closed above 37,000 on Dec. 13, a record high at the time, within hours of the Fed indicating the possibility of three rate cuts of a quarter percentage point each in 2024. Conversely, the Dow closed down 317 points on Wednesday, Jan. 31, after Fed Chairman Jerome Powell indicated that the central bank may not cut interest rates in March.
But commercial real estate is not the stock market. In addition to being illiquid relative to stock trading, owning and operating real estate is a capital-intensive business, and lenders and equity sources for those deals are not quite ready to break out the champagne. Rate hikes, when they happen, are likely to usher in small relief, not an opening of the floodgates.
“The joke is that even when rate cuts do happen, there really won’t be that much magnitude of immediate relief [for borrowers],” says Joshua Bernard, principal at Bernard Financial Group, a commercial mortgage banking firm based in Southfield, Michigan. “The misnomer is that the Fed is going to quickly reduce short-term rates back to 1 or 2 or even 3 percent. But really all the Fed is saying is that it will monitor rates and maybe begin some reduction, but it won’t translate overnight.”
Waiting to Exhale
Instead of rushing to deploy funds on the news that rate cuts are likely coming this year, many commercial debt providers and arrangers are waiting for the market to reset. That means establishing new benchmark ranges for short-term interest rates and yields on U.S. Treasury notes that are in line with historical averages and not kept artificially low to juice the economy. At the same time, lenders and borrowers need to collectively accept these new parameters as conducive to healthy business activity.
“There’s going to need to be a significant reset in valuations within the next 12 to 24 months,” says Martin Nussbaum, principal at Slate Property Group, a New York City-based lender and owner. “We don’t believe it will be as severe as people think, because ultimately interest rates will decline, though we’re not likely to see [all-in] 3 percent interest rates again.”
“But if [all-in] interest rates decline into the 4.5 to 5 percent range, which is historically where they’ve hovered, a fair amount of assets will recover,” he continues. “That excludes office, which is experiencing a seismic shift across the asset class versus a supply-and-demand issue.”
The trajectory of the U.S. 10-year Treasury yield also presents a challenge to the stability of the commercial real estate market. Prior to the onset of rate hikes by the Fed in spring 2022, the benchmark rate used to price permanent, fixed-rate loans yield routinely hovered between 1 and 2 percent. But after a series of rate hikes by the Fed, the 10-year yield began to steadily climb, briefly breaching 5 percent in mid-October 2023. The 10-year subsequently receded and stood at 3.9 percent on Jan. 31 before rising again to 4.1 percent by Feb. 5.
With the Fed opting to hold rates steady at its January meeting, the 10-year should once again demonstrate more stability.
“The Treasury market has provided a little stability and guidance for equity sources to make decisions. So, when they’re underwriting deals they have conviction in their sales prices and cap rates, which is very helpful,” says Brian Linnihan, vice chairman of the debt and structured finance team at CBRE’s Atlanta office.
“But if you’re underwriting with the expectation of getting to a 2 percent Treasury yield, that’s not realistic based on where the forward curve is pricing right now,” he continues. “Historically, those forward curves have never been completely accurate because there are certain unknowns in the market that force yields up or down. But today, it’s hard to imagine going back to a 1 to 2 percent, or even a 2.5 percent Treasury yield.”
In Bernard’s view, a major reset hasn’t yet occurred partly because even as the capital markets have been fraught with risk and uncertainty, a sizable contingent of investors has refused to remain on the sidelines. According to MSCI, the average sales price across all commercial property types fell by 5.9 percent year-over-year in 2023. Deal volume on the commercial acquisitions front was much more muted however, declining 51 percent year-over-year in 2023, according to MSCI (see table).
“That’s partially why asset prices haven’t necessarily collapsed the way we thought. There was so much liquidity sitting and building up on the sidelines from 2020 to 2022 that, as prices have fallen, there’s been enough investors to buy as the knife is falling,” he explains. “The flip side is that investment sales brokers now have no inventory to move. Investors who bought assets a few years ago and got a 3 or 4 percent fixed interest rate have little incentive to sell. So, there’s a disconnect.”
Theoretically, a marketwide recalibration should bring stability to the debt and equity markets over the long term. There will also inevitably be pain in short term. Investors will have mixed views on this dynamic depending on their exposure to various securitized liabilities like older office buildings and maturing bridge debt. But the lending community generally recognizes the need for a market correction.
“The recalibration is necessary, even if there will be some losers, though we don’t see a ‘black swan’ event except for those assets that are economically obsolete,” says Matt Rocco, president at Colliers Mortgage. “When values were as high and cap rates as low as they were [in 2021 and early 2022], that was unhealthy for the market. Most of our clients see the recalibration in values and projected decline in interest rates as supportive to their investment objectives.”
“There’s a new normal in the market, but it’s really a reversion to the old fundamentals,” adds Mitch Sinberg, senior managing director at Berkadia’s South Florida office. “Cap rates had gotten so low because of the — correct — concern over massive inflation, and money was almost free [to borrow]. Now we’re simply reverting back to where cap rates have normally been.”
“If you go back to 2019 or before, cap rates were always in the 5 to 6 percent range,” Sinberg continues. “We all got spoiled when debt got so low, and people were buying assets at 2 or 3 percent cap rates with the expectation of massive rent growth and almost-free debt. So, we’re just reverting back to where we were pre-COVID, and that’s a normal and healthy place to be. It’s just a little bit of a painful road to get there.”
As it pertains to asset values, the magnitude and timeline of the reset will undoubtedly vary greatly from one property type to another. Office, for example, is much further along in its recalibration than multifamily, though some might say that what’s happening in the office sector could better be described as a death spiral for certain buildings.
According to MSCI, the average sales price in office transactions declined 16 percent in 2023 on a year-over-year basis, whereas pricing for multifamily deals fell by about half that amount. The average price for industrial assets actually increased ever so slightly (0.5 percent) between 2022 and 2023.
“Multifamily, which is generally the best performer, could have an even bigger price reset than hotel or retail because people were paying more and getting very aggressive financing terms on those properties,” notes Brett Forman, managing partner at Forman Capital, a direct lender based in South Florida.
“When it comes to hotels and retail, investors weren’t paying those same multiples and cap rates and getting the same debt financing terms,” he continues. “So, the value created by the change in interest rates isn’t nearly as pronounced for those assets, and the reset in prices won’t be as big on a percentage basis.”
Lending Volume Rebounds
Commercial banks hold 38 percent, or $1.8 trillion, of all U.S. commercial and multifamily debt, according to the Mortgage Bankers Association (MBA). These institutions sharply pulled back their lending activity in 2022, when rate hikes unfolded at a frenetic pace in response to then-rampant inflation. Commercial bank loan originations faltered again in March 2023 when Silicon Valley Bank and Signature Bank collapsed within days of one another.
However, by the latter part of 2023, volume was once again trending upward. The total volume of U.S. commercial and multifamily debt increased by $37.1 billion (0.8 percent) in the third quarter of last year on a year-over-year basis, according to MBA. The association predicts total commercial and multifamily loan production to increase by $576 billion in 2024, a 29 percent year-over-year increase from the $444 billion originated in 2023.
Banks accounted for about 38 percent of the total non-agency commercial debt market in the third quarter of 2023, down from 43 percent in the second quarter, according to CBRE. The figures are based on permanent fixed-rate loans closed by the global real estate services firm.
The data from CBRE also reveals tightening lending standards. Loan-to-value ratios on commercial deals averaged 58 percent in the third quarter and 62.5 percent on multifamily deals. That’s a far cry from the pre-COVID days when leverage ratios tended to be upwards of 70 percent on most deals, all other factors being equal.
“Banks, for the most part, are still on the sideline and aren’t good sources of liquidity right now or are requiring heavy deposits, which makes things unpalatable,” explains Linnihan. “Banks have issues they’re dealing with on their existing books. So, it’s taking a lot of time for the banks to work through issues with their existing portfolios, and that should continue this year.”
Overall lending volumes are expected to increase in 2024 on the back of interest rate cuts. But sources say that private lenders will have an especially attractive opportunity to be aggressive post-recalibration.
“The current cycle represents one of the first times in the last decade in which there’s been a real lack of liquidity in the commercial banking world to offset the amount of loan maturities that are coming due,” explains Nussbaum. “For that reason, we expect private lending to be very active this year and to pick up much of the credit that the commercial banking world has typically handled.”
The Wall Street Journal, citing data from New York City-based research and analytics firm Trepp, reports that roughly $540 billion in commercial debt came due in 2023. The financial newspaper further noted that more than $2.2 trillion in commercial loans is expected to mature between now and the end of 2027.
Bridge is Brutal
Unlike with single-family home mortgages, borrowers of commercial mortgages mostly pay interest for the majority of the life of the loan, then repay principal at the end. The maturation of the loan brings with it the biggest financial obligation, commonly referred to in the industry as a “balloon payment.”
That structure allows borrowers to be flexible with their operating capital — one thing you can’t have enough of as commercial owner — and to refinance with either short-term bridge debt or long-term permanent debt before the big balloon comes due. In other words, it keeps the money moving. But this particular structure also explains why there’s an unusually high amount of angst over this cycle’s impending maturities.
Last August, Affinius Capital provided a $90.6 million acquisition loan for this four-building, 1 million-square-foot industrial property in Houston. While sources of rescue capital are at this point in the cycle targeting a lot of industrial deals, the question is whether those deals will actually be the ones that need help if the loans backing them mature in the near future.
Bridge loans tend to carry short terms and high interest rates. The trouble arises when bridge loans are originated at rates that are significantly below where rates are when the loan matures and long-term debt structures are needed. Borrowers in that scenario usually sacrifice equity in the deal to avoid locking in a high-rate loan for the long haul.
Extrapolating that scenario translates to major distress throughout the market as a whole.
“The bridge market is a problem,” says Rocco. “There was a massive amount of product put into shorter-term, floating-rate debt when rates were at or close to zero percent. When you impute today’s cost of capital, the effect of valuations across commercial real estate declining and associated operating stagflation and expenses, you have value destruction.”
“The major distress in the market is the high-octane, overleveraged bridge loans,” concurs Sinberg. “That’s because people were borrowing at 80 percent leverage, plus capital improvement budgets and closing costs that ended up accounting for about 90 percent of the asset value. With a drop in values, equity has basically been wiped out in a lot of cases.”
Bridge loans are also typically priced on the Secured Overnight Financing Rate (SOFR), another index that has shown a lot of fluctuation over the past couple years. The rate was close to zero during the throes of the COVID-19 pandemic but rose steadily in 2022 as rate hikes were regularly implemented. Although SOFR leveled off around 5 percent last year and has held fairly steady since then, the major runup from early 2022 to mid-2023 has made new bridge debt originations quite expensive. Meanwhile, impending bridge debt maturities are serving as an acute source of distress within the market.
Sources are careful to point out that, office assets aside, this form of distress is strictly a function of the machinations of the capital markets, not real estate fundamentals. The multifamily sector, which epitomized the soaring rents and valuations that defined the market in 2021 and early 2022, is perhaps the most pertinent example.
“Even though multifamily markets are generally very strong in terms of demand and occupancies, people capitalized them with high-leverage bridge loans — call it SOFR plus 600 [basis points] — and those interest rates are now over 10 percent,” says George Mitsanas, principal at Gantry, a commercial intermediary headquartered in San Francisco.
“Those borrowers did capital improvements, and rents have risen, but operating expenses have also risen significantly,” Mitsanas continues. “So, if net operating income (NOI) is equal to what it was a year or two ago, but bridge loans are coming due and you can no longer sell at a 3 or 4 percent cap rate, you either have to put more cash into the deal or sell.”
Of course, short-term loans come due every year, and some inevitably run into interest rates that are higher than their origination levels. The key difference this time around lies in the magnitude of rate hikes. So much money was put into bridge structures when rates were near zero percent coming out of the pandemic, a period that was marked by the worst inflation since the early 1980s.
Rapid rate raising, in turn, had to happen. But the price of that activity is an inability for many borrowers to refinance their loans or source new equity infusions — whether theirs or others — without significantly eroding their positions.
“The equity coffers that new syndicators had to potentially reinvest in their properties when money was super-cheap aren’t usually as liquid or deep as they were for existing proven owners because those new syndicators need the leverage,” explains Bernard.
The industry has spent much of the post-COVID era waiting for a deluge of distressed asset sales that has yet to materialize. But for properties potentially facing that fate, it could well be the equity — not debt — side of the market that makes or breaks that scenario.
Concluding Thoughts
Commercial real estate exists in cycles, even if it’s almost impossible to recognize the inflection points that distinguish those cycles until a retrospective lens is applied.
Ebbs and flows are the essence of cyclical events. Those terms are subjective by nature, but in the case of commercial real estate, achieving a reset will be made easier by having most players in the industry agree on “new normal.”
“The low interest rate environment that we were previously in is an era of the past. Now the question is when we’ll see sellers understand realities of the cost of capital,’” says Mitsanas. “That was the problem in 2023 — there wasn’t capitulation to recognize where the market was at.”
“When rates are zero, there are no cycles, and it makes everything and everybody look really good,” says Rocco. “But unfortunately, that’s not normal.”