Chatham Financial fears rate hikes will slow CRE debt markets

The advisory sees a situation in which interest rates and cap rates are moving together.

As the Federal Reserve considers another large interest rate hike to tame out-of-control inflation, Chris Moore, managing director at Chatham Financial, is concerned about the impact on the commercial real estate lending markets.

Already, interest rates and cap rates are edging dangerously close together. “I think there are [many] situations where financing costs might exceed cap rates on the real estate assets that are being purchased,” Moore told Real Estate Capital USA. 

Once borrowing costs approach the potential cap rate of a transaction, the incentive to tap the debt markets shrinks. “I think anytime you start to see financing costs that are getting close to or exceeding cap rates on the assets being purchased, there’s going to be a need for market participants, whether they’re buyers or sellers, to step back and reevaluate where assets are trading,” he said.

And recent trends seem to indicate many are stepping back and reevaluating. A June report by MSCI Real Assets showed that commercial property sales growth declined to 3 percent in May, a drop from the double-digit growth seen in the first quarter of 2022.

“With lower leverage and rising interest rates, buyers must reevaluate if return targets can be reached at current prices,” states the report.

Still, there are some positives. Declining 2022 growth still outpaces pre-pandemic growth, and markets remain flush with liquidity. Declines are not equally represented across the major food groups, with multifamily, hotel and retail sectors outpacing their May 2021 gains.

But, despite multiple rate hikes inflation is still raging, and now the Federal Reserve is reportedly mulling a full percentage point hike during its meeting. The constant uncertainty over borrowing costs is throwing a wrench into usually orderly term sheet signings, according to Moore.

“There’s been lots of situations over the last couple of months where the client has signed a term sheet thinking that their interest rate cap is going to cost one number, and then they get to the closing and it’s up 25 percent or more,” Moore said. “A big part of what we do is help clients manage risk on floating rate loans by putting hedges in place, and in a lot of cases the hedges are required by their lenders, and they’re often interest rate caps.”

And Moore does not see much clarity coming anytime soon.

“I hope I’m wrong, but from where I’m standing now I expect that we’ll see a decline in financing activity in the commercial real estate space over the next couple of months, as market participants sort of realign expectations on where things trade.”