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Commercial real estate lending trends in 2023

Published on January 5, 2023 by Rajeev Hota and Bhuwan Joshi

Introduction

Commercial real estate (CRE) is sailing through what it views as short-term headwinds i.e., rising interest rates, declining gross domestic product (GDP) and contracting investments. Like other sectors, CRE is not immune to such headwinds. However, it is one of the fastest growing, providing business opportunities in the multifamily, industrial, office, retail and hospitality space. A big advantage is attractive leasing rates with longer lease periods/contracts, giving CRE holders decent and consistent cashflow, based on occupancy. Investors also benefit from potential capital appreciation of real estate. The pandemic slowed the sector, and it is now recovering very gradually.

What impacts the CRE sector?

High inflation

With inflation, the cost of building increases and reduces supply and purchases. However, prices of all items declined from a peak of 9.2% in June 2022 to 7.8% in October 2022, according to the US Bureau of Labor Statistics. However, as the Federal Reserve (Fed) continues to raise interest rates to tame inflation, investors will likely continue to delay buying and refinancing CRE projects.

Soaring interest rates:

Rising interest rates keep CRE investors away. In November 2022, the Fed raised interest rates for the fourth consecutive time by 75bps. The target Federal funds rate is now 3.75-4%. By raising rates, the Fed tries to rein in inflation and pull some of the excess liquidity out of the economy. The Fed anticipates more increases in 2023, which would reduce the flow of CRE investments as it becomes costlier.

Interest rate hikes may have a larger impact on short-term loans than on long-term ones, due to variable-rate financing. Keeping an eye on the 10-year Treasury yield helps determine mortgage rates. The yield is also viewed as a sign of investor sentiment towards the economy. Rising yields may reflect higher levels of expected inflation in the long term, whereas falling yields may indicate lower inflation along with the possibility of a slowdown or recession. The 10-year Treasury yield is the benchmark used to decide mortgage rates across the US, and the 10-year Treasury bond is the most liquid and widely traded bond in the world. The 10-year Treasury yield was 3.4% as of 8 December 2022, which is not encouraging for the investors.

10-year Treasury yield

Real estate prices: CRE prices start falling as demand for all property types falls. CRE prices increased by 11.1% y/y, with industrial property taking the lead at 18.1% followed by multifamily at 15.9%, according to a CBRE report.

Evolution of employment

Due to the pandemic and the widespread adoption of work-from-home policies, many migrated. Low unemployment rates, growing pay and more remote work choices are being taken advantage of. Companies are reorganising workplaces, implementing flexible work hours and providing greater opportunity for career advancement and skill development. Office space makes up a large portion of CRE. Companies that own their own office space or rent or lease it are rethinking their use. Larger spaces no longer seem necessary, as they are aware they will never have the same number of employees working from office. They are choosing smaller offices, with employees coming in on a roster basis. Vacancy rates are gradually increasing, and more renters are subletting their offices until their leases expire.

Trends in 2023

The Fed’s interest rate hikes make borrowing more expensive. Interest rates play a significant role in determining CRE returns; investors worry about the cost of capital, capital availability, property prices, and transaction and leasing activities. CRE investment volumes declined 24% y/y to USD154bn as of 3Q22. Multifamily, the most immune investment avenue, was the leading sector with USD69bn worth transacted, although this was a 19% y/y drop.

Additionally, trends catalysed by the pandemic, such as working from home and ecommerce, have an impact on CRE prices. Increased teleworking, for example, reduces demand for office space (vacancy at 15.4% as of 3Q22), while ecommerce adversely affects the price of retail real estate as consumers shop online. As considerable uncertainty prevails regarding   the future pace and extent of such structural shifts, tighter financial conditions would compound these effects and increase downward price pressure in the affected segments.

Based on the current trend and market sentiment, if the Fed does not step in to tap the bond market more aggressively, the economy could enter a recession. We believe the Fed should reverse the course of interest rate hikes and work towards easing the stress in market. At the current level of reduction in and investor stress, the economy may take two to three years to return to normal. However, after the 2008 subprime crisis, stringent underwriting practices were implemented, making the current distress level acceptable.

Conclusion

The uncertainty in the global economy due to increasing Fed interest rates and higher inflation would reduce real estate transaction and activity in the coming months. Technology that improves efficiency, centralises data and simplifies operations would remain popular. Sadly, most investors do not believe the sector is ready to adopt such technology. Many CRE investors and owners would need to concentrate on strategic, investment decision making in both real estate and technology amid this significant uncertainty. The war in Ukraine and the potential for new COVID-19 variants are just two external factors to watch as the course of interest rates unfolds.

Sources:


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About the Authors

Rajeev has been with the firm since July 2013 and overall 18+ years of experience in Commercial Real Estate (CRE) industry. His responsibilities include managing one of the large CRE engagement and relationship, coordinating with client on new initiatives and services, working with teams to identify and improve efficiencies and productivity, training team members on complex and value-added analysis, and implementing industry best practices in the Acuity team for CRE risk analysis and underwriting..

Bhuwan has over 11 years of experience in working with leading global organizations in commercial real estate lending domains. His expertise spans a broad range of analyses, including CRE loan underwriting, loan servicing, due diligence, portfolio monitoring, escrow disbursement analysis, market research reports, and cash flow modelling. At Acuity Knowledge Partners, he is a part of a leading US based commercial bank, supporting big ticket size CRE loans.

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