The Federal Reserve’s well-publicized program of interest rate hikes – including a move Wednesday to implement another 75 basis point increase – have created more challenges for commercial real estate debt market participants in the last three to five months more than anything else happening across the landscape.
Carl Chang, chairman of the Federal Reserve Bank of San Francisco’s Los Angeles branch board and founder of Santa Margarita, California-based Kairos Investment Management, said that while expected, the rate increases have led many lenders to hit pause.
“Everybody is being cautious especially balance sheet lenders, because of the market uncertainty and so most are taking a defensive posture,” Chang said. “We have several large banking relationships and they’re only considering new loans with their tier one borrowers, not considering doing any new business at the moment.”
The wait-and-see stance is creating less liquidity in the market, which Chang said will have a negative effect on the sector as a whole. With the Fed reducing its balance sheets alongside the rate hikes, Chang said the bond market will also miss out on one of the largest liquidity providers in the bond markets. He noted the next three to six months will be interesting to see play out, especially with CMBS origination already down.
Chang said preparations for future rate hikes will revolve around refinancing, pricing adjustments and sector rebalancing. In scenarios where there may be debt maturity issues on a given asset or portfolio, he said lenders and borrowers have to get in front of it now given the difficulty and cash required to refinance.
Wednesday’s rate hike was the Federal Reserve’s second 75 basis point hike in as many months. Fed chair Jerome Powell said during a July 27 conference the central bank will continue to try to stymy inflation, with intentions of ending the year with a key rate ranging between 3.25 to 3.5 percent. With the 75bps hike, the Fed’s key rate now ranges from 2.25 to 2.5 percent.
“We’re trying to do the right amount,” Powell said. “We are not trying to have a recession and we don’t have to.” He noted doing too little on interest rate programming would leave more uncertainty in the economy and do greater pricing damage to consumers.
The fresh hike marks the Fed’s fourth increase this year and arrives after a similar 75bps uptick instituted in June. In its July 27 note, the central bank said it anticipates ongoing increases in the target range will be appropriate to continue fighting macro pressures.
Rob Gilman, partner and co-leader of New York-based advisory Anchin, Block & Anchin’s real estate group, said the rising interest rates will require landlords to pay more on debt service when refinancing for the same amount.
“With decreases in values – especially commercial properties – it was already difficult to replace existing debt coming due with a new loan at the same amount,” Gilman said. “Add in higher interest rates, and the amount you can borrow will be even lower. This might trigger landlords to have to contribute more capital into the property. Typically in periods of rising interest rates, prices and values decrease. This will also have an effect on refinancings.”
For current development projects with construction loans on a variable rate, Gilman said expected profits on a deal will be reduced. “Landlords and developers need to monitor the rising rates and might have to consider selling off units quicker to pay off debt to keep profits higher,” he said. Anchin’s team has already been meeting with clients to plan for the upcoming 12 to 18 months to account for the changing environment.
Delving into sector-specific effects, Chang said his team has seen some pricing discovery and adjustments. Multifamily and industrial remain stable on pricing – despite some negative leverage on the industrial front – while retail and office begin to unfold further.
Closed-end funds present another area of reflection for managers and institutions amid the rate increases. “Pricing discovery is difficult at the moment,” Chang said, citing closed-end funds nearing the end of their fund life. “We are seeing some discounted pricing in CRE which maybe a window of opportunity for those that want to be contrarian and consider a value play.”
For the commercial real estate debt landscape, the central bank’s rate increases have served as a slight damper on the burgeoning loan activity taking place across asset classes and most sizably in the multifamily and industrial sectors. Insurers, banks and alternative lenders steeped in the space have all noted adjustments to deal frequency, with more borrowers and investors cautious on taking on any heightened risk in the changing rate environment.
Alongside the hike, the Fed also plans to continue reducing its holdings of Treasury securities, agency debt and agency mortgage-backed securities as part of its initiative to shrink its balance sheet. The Russia-Ukraine conflict was cited as a continuous driver of human and economic hardship by the bank, especially because of the resulting upward pressure on inflation.