Commercial property

CRE is preparing for the impact of the rise in interest rates

Hugh Kelly, Ph.D., Economist

As the commercial real estate industry weighs the impact of the Federal Reserve’s current 75 basis point interest rate hike, experts are offering various predictions on how the series of hikes will affect investment. and capital markets.

Wednesday’s rise, the second 75 basis point increase in two months, pushes the federal funds rate into a range of 2.25% to 2.5%. This range was last seen in late 2018, long before the COVID-19 pandemic hit in early 2020 and started what economist Hugh Kelly calls a series of earthquakes and of aftershocks to the economy which is now on the brink of recession. The Fed began raising rates in March with a 25 basis point hike followed by a 50 basis point hike in May and a three-quarters percentage point hike in June, the largest since 1994 .

Wednesday’s increase, which was announced after the central bank’s Open Market Committee meeting, is expected to precede several more hikes later this year. The Fed’s goal is to raise the federal funds rate to around 3.25% as a tool to fight inflation.

Richard Barkham, Chief Global Economist and Head of Global and Americas Research, CBRE
Richard Barkham, Chief Global Economist and Head of Global and Americas Research, CBRE. Image courtesy of CBRE

Richard Barham, CBRE The world’s chief economist and head of global and Americas research said the latest inflation figure of 9.1% means the Fed still needs to align demand in the economy with supply. Noting that it will take some time to bring inflation back to the normal 2-3% range, Barkham said he expects the Fed to continue some hikes next year before dropping them quickly thereafter. .

JLL Chief economist Ryan Severino, who expects a further 75 basis point increase, said he believed inflation was at its highest level for the year and should start to decline.

“The economy is starting to slow down. They’re really telling the market they’re serious,” Severino said of the Fed’s actions.

In the meantime, Kelly said real estate investors should protect their business plans against shocks to deal with these ongoing aftershocks.

Ryan Severino, Chief Economist, JLL. Image courtesy of JLL

“That means flexibility in your contracts. It means a long-term assessment of where the risk is greater and where it is less,” Kelly said.

Lee Menifee, PGIM Real Estate‘s Head of Americas Investment Research, said he was also among those anticipating a further 75 basis point rate hike today, but noted that the long-term situation and the impact on the commercial real estate for the second half of the year are less clear.

“US real estate investors have largely priced in this series of interest rate hikes, so the market as a whole should be relatively indifferent to the Fed’s upcoming decision. But that doesn’t mean the volatility is going away. Real estate sentiment is driven by underlying worries about a recession and broader factors, like the war in Ukraine, that are largely beyond the Fed’s control,” Menifee said.

Lee Menifee, Americas Research Manager, PGIM Real Estate
Lee Menifee, Americas Research Manager, PGIM Real Estate. Image courtesy of PGIM Immobilier

Menifee said the larger question is whether this interest rate cycle will alter the long-term outlook for US housing.

“We doubt it. Demographics are going to remain the defining force shaping the U.S. real estate market for decades to come,” Menifee said. “The American population is aging and will spend less, while labor market growth will continue to slow. These are powerful disinflationary forces that will prevail beyond this market cycle.

READ ALSO: CRE Investor Sentiment Signals a Change in Perspective

CRE impacts felt

Economic uncertainty, rising interest rates, falling prices and falling loan-to-value levels are already impacting the world of commercial real estate as borrowing costs rise and cause a lot of capital is retreating to the sidelines in a high degree of caution, Barkham says.

“I would call it a moderate slowdown in capital markets activity that reflects the higher cost of capital and greater nervousness about the economy,” he said. CPE. “But deals are in the works and there are a lot of things going on.”

Barkham said retail, which has a higher cap rate, has been active, especially for suburban assets, as more people live and shop in the suburbs since the start of the pandemic. pandemic.

“The office really jumped in the first quarter, but demand was down a bit,” Barkham said. “What we see in the office is a flight to quality.”

Brian Stoffers, Global Head of Debt and Structured Finance
Brian Stoffers, Global Head of Debt and Structured Finance, CBRE. Image courtesy of CBRE

The industry, which still has strong fundamentals, including very low vacancy rates, is also attracting investor interest, although properties that have locked-in long-term leases may see less activity as investors are looking for value-added deals with more lease turnover and rent increases. He said demand for multifamily properties and life sciences continues due to strong fundamentals.

However, the rising cost of equity and debt financing along with rising interest rates led to lower multifamily sales volume in July, according to the National Multifamily Housing Council. Quarterly survey of apartment market conditions.

NMHC Chief Economist Mark Obrinsky said in prepared remarks that higher rates have reduced investors’ proceeds. He said many sellers were reluctant to lower prices, leading to a sharp drop in sales volume. The survey’s sales volume index came in at 10, well below the break-even point of 50, indicating lower sales volume than in the previous quarter. A large majority of respondents, 83%, reported a drop in sales volume.

READ ALSO: The impact of interest rates and inflation on industrial real estate

The Mortgage Bankers Association updated its baseline forecast for the second half of 2022 and forecast an 18% drop in total commercial and multifamily borrowing and mortgages to $733 billion, down from record 2021 totals of $891 billion. dollars. Multifamily loans alone are expected to decline 10% to $436 billion from last year’s record high of $487 billion. However, Jamie Woodwell, the MBA’s vice president for commercial real estate research, said he expects borrowing and lending to rebound in 2023 to $872 billion in commercial real estate loans and $454 billion. billions of dollars in multi-family loans.

He noted that even with the lower volume levels expected this year, 2022 will remain the strongest year for commercial and multifamily borrowing and lending since 2021.

Woodwell said Fed rate hikes affect short-term adjustable loans more than those that would be refinanced with longer-term rates.

“When you look at what’s maturing this year and the year ahead, it’s generally shorter term variable rate loans. It will be a lot of CMBS, SASB (single asset, single borrower) loans, and loans from inventory-focused lenders like finance companies and mortgage REITs,” Woodwell said.

“When you go to subscribe to them, the situation will be very different from two years ago,” he said. CPE.

Brian Stoffers, global president of debt and structured finance at CBRE, called the current funding market “unstable.” He said debt financing is still available, but lenders are taking out more cautiously and at higher rates.

“Underwriting standards have tightened across the board for all asset classes,” Stoffers said. CPE. “Underwriting for offices, particularly suburban offices and Class B and C offices, is particularly challenging at this time given some uncertainties around the subject of returning to work.”

Stoffers said the tumult in credit spreads has caused CMBS and SASB funding to slow considerably. He also noted that many debt funds have also become less competitive. But borrowers still have options available for construction and acquisition financing.

“Regional and local banks appear to be taking market share from large banks which have slowed their demand for trade and construction. Life insurance companies continue to lend on commercial and multi-family projects, but have recently declined given the higher relative value currently seen in fixed income and private placements. GSEs Freddie Mac and Fannie Mae are expected to increase activity the rest of the year given the death of other sources of multi-family loans,” Stoffers said.