Commercial real estate lenders and investors are expecting to see a slower than anticipated easing of monetary policy, with expectations rising that the magnitude of eventual cuts could be lower – and slower – than expected, market participants told Real Estate Capital USA at last week’s ExpoReal conference in Munich.
The US Federal Reserve has increased interest rates by more than 500 basis points since March 2022, with the European Central Bank and Bank of England taking similar measures over the same period.
This rapid increase in rates has meant a significant decline in lending and investment activity, said Christoph Donner, chief executive, US, for PIMCO Prime Real Estate. “People are looking at various products and deals, just to stay active, but the market is showing a significant dislocation,” he added.
But there is still no real clarity on what comes next.
“We are getting to the end of the interest rate cycle, and we can speculate over whether there will be one more rate hike in the US, if there will be a recession and what the outcome of the US presidential election will be next year. But all it means is that there will be noise over the next 12 to 18 months that will make it hard for momentum to pick up,” Donner added.
The root of the problem
Part of the stasis in today’s market can be attributed to the rapid rise in interest rates seen over the past 18 months, said Duco Mook, head of treasury and debt financing for the EMEA region at CBRE Investment Management.
“Interest rates have increased, but the problem is not just that rates are higher – the problem is that the increase was greater than the market expected,” Mook said. “As a real estate manager, you want to have a long-term business plan and you need to be able to have a cost of debt that stays there for the long run.”
Matthew Murray, a director in the asset servicing team at London-based Mount Street Group, said the market is just starting to adjust to the realization that interest rates will be higher for longer.
“Moving from historically unparalleled low interest rates, there is a lot of hesitancy,” Murray said. “There are still a significant number of wishful thinkers on the equity side, but there are no two ways about it.
“The market is likely to see a baseline interest rate of more than 5 percent for the next two or three years, Murray added. “That said, across the board, we have not seen widespread insolvencies yet.”
Although the Federal Reserve has also indicated rates will be higher for longer and the European Central Bank made a statement last month that it had completed what it believed to be its final increase, market participants are not expecting any near-term, dramatic decreases.
“Hopefully, after summer next year, the ECB has a view when inflation comes down to the 2 percent level and the ECB can lower rates. The risk is that this may take more time than the market expects,” Mook said.
“The ECB hiked rates tremendously fast, increasing them from -50 basis points to 4 percent. The ECB will unlikely lower their rates before summer 2024. When they do, it will go down slowly and likely to be in increments drops of 25 basis points once a quarter. That means we will only see rates lowering by 1 percent over a 12 month period.”
Borrowers continue to seek shorter-term loans to try to ride out the current higher rate environment. The company is seeing many requests for bridge-to-bridge loans, which results from a rising number of sponsors who want additional bridge financing to wait for a more attractive rate environment.
“There is too much demand for capital, but not enough capital available, especially in certain sectors,” Donner added. “Most lenders are working with their borrowers to work through problems. In situations in which values are still at an acceptable level, borrowers are extending loans. But lenders are in the driver’s seat.”
The valuation question
The question of property valuations is becoming increasingly important for lenders and borrowers, particularly as rates are expected to remain higher, noted Frank RoccoGrande, managing partner and head of capital markets for Deutsche Finance International, a London-based manager that invests in the US and Europe.
“I think one of the negatives we could see is around the repricing of real estate assets,” RoccoGrande said. “If you want to mark [an asset] to market, you’ll find valuations are under pressure because there are very few transactions. There a not a lot of comps and valuers are being very conservative.”
This uncertainty is in turn having an impact on allocations to the sector, with RoccoGrande noting many institutional investors are also over their target allocations because of the denominator effect.
“It creates an issue for these investors to invest in the opportunities you have,” RoccoGrande said. “Valuations will be done at the end of this year and into next year and, hopefully, as more transactional evidence starts to present itself, valuations should tick in a more normalized direction.”
Alex Lukesch, a managing director at Madison International Realty, noted that the firm believes there are opportunities to reduce the friction around investing. As a direct secondaries investor that takes minority stakes in properties, vehicles and portfolios, the firm can step in and recapitalize transactions through a variety of equity and even preferred equity strategies.
“We have been seeing more opportunities to work with investors on special situations in which we can reduce the friction in their portfolio,” he said.
One of the biggest risks going forward is that there is less liquidity in the market for a longer period, CBRE IM’s Mook said.
“If there are not transactions happening, banks are not getting any prepayments. As a result, borrowers are asking for loan extensions until they find an exit,” Mook said. “We know there will be increased regulation for banks because of Basel Four [regulations around the calculation of risk-weighted assets]. Another element that will affect general liquidity is that central banks are not pushing billions into the market every month anymore, through quantitative easing, like they did following the GFC. If there is less liquidity in the market, it ends with liquidity being scarce.”
Mount Street’s Murray believes the market is in a transitory period, a sentiment widely espoused at ExpoReal.
“There was a lot of hesitancy this time last year, but you had a feeling you could see the way out. I’m not sure we have that clarity now,” he added.
“While there was hesitancy this time last year, there was also considerable hope that we might see materially lower rates in the not too distant future. This no longer looks to be the case, so we’re seeing more hesitancy over how various difficult assets and sectors will be resolved”
But RoccoGrande believes there is cautious optimism about next year.
“Many of the large institutional investors are keeping their powder dry for the remainder of this year and they believe next year will be a very interesting vintage,” RoccoGrande said. “It’s good to see people are not afraid, that they are actively talking about ideas and trying to figure where they want to be next year.”
That wasn’t the case six months ago, when there was a very different feeling and a general nervousness. “Across the board, people feel that we’re near the end of the interest rate cycle and people can form a view. Six months ago, it was hard to do,” RoccoGrande said.
“The US has been slow to recover, primarily because of the availability of debt financing. The CMBS market is still pretty much out [of commission] and we’re in the land of the debt funds, which is a very high cost of capital.
“Until the debt adjusts in the US, it is going to hold back transaction volume, but I do believe when it opens again, it will open fast.”