In its efforts to curb rising inflation, the Federal Reserve on Sept. 21 raised its benchmark interest rate by three-quarters of a percentage point. The Fed also said that it plans to boost this rate in the future to fight inflation.
The Fed also said it will continue to enact hikes until its benchmark rate hits 4.6% in 2023.
This move, of course, sent another ripple of concern through the commercial real estate industry, with CRE professionals wondering how many commercial deals the higher interest rates might scuttle.
We spoke to commercial financing professionals about the Fed’s move and what it might mean for their business. The consensus? Expect a slowdown in activity as investors determine how best to operate in an environment of higher interest rates.
Walker & Dunlop
Let’s start by addressing the big question: What impact has rising interest rates had on the demand for commercial financing?
Chad Kiner: It has certainly impacted demand. Everything rolls downhill. You have the rising interest rates along with the higher costs of construction materials and labor. Everything has bubbled up to a point where it is now starting to affect the liquidity of banks and life insurance companies.
Last December was our first real taste of construction costs going up. But interest rates were still low at that point. When you add in the complexity of an environment in which rates are rising, the uncertainty of what tomorrow looks like, you start to see a pullback in liquidity.
Chad Kiner, Walker & Dunlop, Columbus, Ohio
Even with rising rates, are investors still interested in commercial real estate?
Kiner: Rising costs, rising rates and compressed cap rates are all the ingredients from an investor perspective in which you should stay away from real estate. But for the right asset classes, mainly multifamily and industrial, there is still a lot of investor appetite. There is uncertainty in the stock market, too. The stock market has performed poorly this year. That makes commercial real estate an investment opportunity that is still attractive.
From an institutional perspective, the funds, endowments and life insurance companies, real estate will remain a part of their portfolios. We see the appetite for those investment vehicles continuing to grow. It is sort of counterintuitive to what is happening in the market, but we still see a lot of appetite for investment dollars coming into the right asset classes.
Not all commercial real estate assets, though, are viewed as favorably by investors, especially today, right?
Kiner: Hotels, retail and certain portions of office are still looked at as very challenging asset classes today. We were starting to see more activity in these classes before interest rates started rising. We were seeing some capital shift into those sectors. But now that rates are rising, we are starting to see a slowdown again in investor activity in alternative sectors such as office, retail and hospitality.
Overall, though, multifamily and industrial remain very attractive investments. Those sectors are like a bond alternative. Multifamily today, even more than industrial, is viewed as an alternative to investing in bonds. It’s a coupon-clipper investment.
Taking a look at your own local market, how strong is financing activity in Columbus?
Kiner: We are fortunate to be in a market like Columbus. The population here is growing. We are the state capital. We have one of the top universities in the country. There are a multitude of industries here. We don’t rely on just one industry here.
The announcement by Intel that they are going to develop a $40 billion facility in Columbus is another plus. There will be a lot of growth spurred on by that Intel announcement that we weren’t expecting. People are moving here, which will create housing demand. Rents are growing on the multifamily side. Our single-family housing stock is always stressed. Columbus is like a blue-chip stock. We are never going to see our real estate activity rise as fast as it does in some of the southern cities. But in a downturn, we are steady-Eddie stable.
What are the most common types of financing requests that you are seeing today?
Kiner: Multifamily, mixed-use and industrial are the big three. We are doing a financing in Dayton, Ohio, right now. It’s a mixed-use project with a major multifamily component.
When you do receive a financing request, what factors do you consider when deciding whether to take it on?
Kiner: We look at the strength of the market and the strength of the sponsor. Where the property is located is much more important today. The old adage of “location, location, location” will never change. In down times, banks and lenders are also paying close attention to the strength of the sponsor. A lender today might be more likely to do a deal in Columbus because it is such a strong market. It has performed well over a long stretch of time. Lenders also look at where a market has been and where it is today. What is the job growth like?
When it comes to the sponsor, we’ll look at whether we’ve done business with the sponsor before. Can we trust them? What are their strengths? If something goes wrong, can they still write a check? Is the project they are bringing to us sustainable?
It’s difficult to predict, but what do you see in the near future when it comes to the demand for acquisition financing?
Kiner: There is going to be a lot more thoughtfulness from investors on where they want to put their money. We are going to see a lot more discernment. I think we’ll see a general pullback. Investors will still invest in real estate. What are the alternatives? But there will be some pullback as investors wait to see where rates will land.
Senior Vice President
Senior Vice President
How has the Fed’s latest hike in its benchmark interest rate impacted demand for commercial financing?
Sam Miller: Obviously, the Fed is going to continue to raise its rate. The Fed made it clear that its target is to get the benchmark rate to 4.6%. This is happening in real time right now, so everyone is feeling it. The rising rates are definitely slowing things down. The higher rates are making deals more challenging to close.
The saving grace for a lot of folks, especially in multifamily, is that rent growth has continued, too. That helps to absorb some of the shock from rising interest rates. The reality is that there is still a massive shortage of housing. There is a lot of demand for housing. And because of that, the demand for multifamily is growing, too, which means that owners can still grow their rents. That is helping to blunt some of the impact from interest rates.
Sam Miller, Bellwether Enterprise, Columbus, Ohio
Conor Lee, Bellwether Enterprise, Columbus, Ohio
Conor Lee: From a real estate perspective, supply and demand is still in great shape. There is a ton of demand for housing in general. The number of units being developed is not fulfilling that demand. Are there potential layoffs and a recession ahead of us? If so, we might see bad debt creep into collections. We might start seeing occupancy issues. People who are looking for one-bedroom apartments might start looking for two-bedrooms so that they can bunk up with roommates to lower their monthly costs.
Right now, we are still seeing multifamily assets performing well. But what does your capital stack look like? If you have a refinance event, if you have a certain debt load you are at, can you get out of that debt? Can you return equity to your investors? That is challenging when rates are high.
Does it look like multifamily is resilient enough to remain a good investment even during times of higher rates?
Miller: From a housing-market perspective, in some ways we are fortunate that it has been hard to build single-family housing for the last 10 years. When you look at the supply and what the vacant inventory was going into the great financial crisis of 2008 and 2009, it was so much more than it is today. There is not a huge glut of supply sitting there. Most people who own homes are possibly financed at 3.5% or lower. People don’t have to move now. If they don’t have to move, they won’t move. Why trade your 3.5% mortgage for a 6% mortgage? That further makes the case for multifamily. There are going to be more homes that don’t go on the market. That will increase demand for apartment units.
Are you seeing more multifamily supply coming on the market to help meet the high demand for it?
Lee: This is in flux right now. We are already seeing in Columbus developers pulling the plug on or pausing projects. That started because of the rising construction costs. Now with interest rates going up, that pause is going to continue. Couple construction costs with the cost of debt, that makes it more challenging to build anything. Construction lenders are starting to pull back. Underwriting metrics are more challenging. This environment is making it more difficult to get projects out of the ground.
I’ve asked others in the industry this, but even these rising rates are at historic low levels. Is there any acknowledgement of that in the commercial business?
Miller: We have been a little bit of doom-and-gloom here. At the end of the day, though, what is causing a lot of the pain right now is the uncertainty. A 3.75% 10-year treasury is not the end of the world. But expectations need time to reset. If we start to level off and find a place where the Fed stops raising rates and lets things take their natural course, I think everyone will feel better. Everyone will have to adjust, but they will do that. It’s just been a big change in a short period. I’m hopeful we will come out of it with a soft landing. It’s just difficult right now to know where the dominoes will fall.
Lee: Our strategy right now is to keep moving. We are trying to find ways to do deals. There is still a ton of capital out there. There are still a lot of debt providers in the market. As long as capital is still available, people will figure out how to do deals. If capital goes away, then we have a bigger problem.
We’ve talked a lot about multifamily. But how attractive of an investment is industrial real estate right now?
Miller: Industrial has a lot going for it. There is a massive need for more industrial product. From a development standpoint, though, industrial is a little trickier than multifamily. You might have one to three tenants in a typical industrial building. You are entering into long-term leases of five, seven or 10 years with these tenants. The challenge you’ve seen recently is with the increase in costs, both from construction costs that are rising and rising interest rates. You might agree to a 10-year lease with FedEx. You might have agreed to that lease in July, but you’re not able to build until October or November. Suddenly, you’re costs are up 10% because interest rates have gone up. Everything changes so fast now. That million dollars of profit that you were counting on as a builder might now be gone.
But from a fundamentals standpoint, there is still room for rent growth in industrial. The mechanics of getting deals built is changing. Everybody is going through that, but we are seeing it more in industrial.
What are you seeing right now in terms of deal velocity?
Lee: It is definitely slowing down. Things will slow. Velocity will slow. I don’t see how it doesn’t. But as long as capital is available, the market finds itself. We just need calmness. We can’t operate in this day-to-day volatile market. It’s hard to give guidance when things change so quickly.
Chief Operating Officer, Agency Lending
The big question is an obvious one: What impact will the Fed’s latest interest-rate hike have on the demand for commercial financing?
Hal Collett: The rate hike does make things more complicated. There are a lot of factors to consider. You have the rate environment and the Fed trying to catch up and curb inflation. The Fed was probably slow to react and is now trying to catch up, yet we are probably heading toward a recession now anyway. Then you have the general volatility in the economy. You have low cap rates and tremendous rent growth in the multifamily sector. The volatility with interest rates just adds more uncertainty to the commercial real estate market. Add in the geo-political risks and an election year, and you might see people put their pencils down for a while as they adjust.
At the same time, construction costs are rising. Does this increase the chances of a slow down in investment and development activity?
Collett: I think so. The rising construction costs and the delays in getting materials are contributing factors in slowing down development activity. People are more cautious about what they are going to do. Now the rate environment is increasing the cost of capital. That just adds more hurdles to getting deals done.
Hal Collett, Colliers Mortgage, Minneapolis
We’ve had several volatile years in a row when you factor in the impact of COVID. How is this long-term stressful period impacting the market?
Collett: That’s interesting. We have never been through a global pandemic. How do you react to that? What impact does that have on the business decisions people make? When the pandemic started, we thought it would be catastrophic to the lending space. It turned out to be the opposite. We had a strong 2020 and an even stronger 2021. But I think we are starting to really feel the financial effects of the pandemic now, cost issues, supply issues, so much other uncertainty that you can put into the same bucket. We have seen those things occur before, but we have never seen them occur after you’ve been through a global pandemic. I think that we are just starting to feel the financial impacts of the pandemic now.
The worst healthcare impacts of the pandemic are hopefully behind us. But the economic impact is just starting to be felt.
Even with this all this uncertainty, is commercial real estate still a solid investment when compared to other investment vehicles?
Collett: We spend a lot of time in the multifamily space. Multifamily has remained a solid investment. It’s getting more difficult for people to afford to buy a house. Multifamily, then, becomes more attractive. There is a bit of a recession-proof aspect to multifamily. Owners can raise or lower rents and remain competitive. It’s not completely recession-proof, but generally speaking, multifamily is a wise bet. In some ways, you have a natural arbitrage against what is going on in the economy. Multifamily, self-storage and industrial are all good investment options today. They are more resilient than office and retail right now. Throughout recessions or down cycles, people find opportunities to execute business, just not at the same volumes as they might have in the past.
Are you surprised that multifamily has remained such a strong investment during these tumultuous times?
Collett: I’m not really surprised. We have had an unprecedented run here. It’s been going on more than 14 years. There is a massive problem in this country when it comes to the lack of affordable housing. People need a place to live. The single-family-housing markets have been on an unprecedented run of price appreciation. That is playing a large factor in the strength of the multifamily market.
A lot of folks are renting longer than they would have before. Houses are not affordable. They have several other loans they must pay off. The rental market will hit some bumps. But demand for multifamily housing will remain strong.
Is there still more demand for multifamily housing than there is supply in most markets across the country?
Collett: The demand in a lot of markets is not diminished in any way, shape or form. There is still a gap between demand and supply.
What type of financing requests are you mostly seeing today?
Collett: A couple of years ago, there was an opportunity to refinance a bunch of deals because we were in an all-time-low interest-rate environment. There are still some refinance opportunities for people, but most of our financing requests today are for acquisitions. More buyers are out there buying deals. A lot of buyers are flooding to multifamily and real estate in general. I’d say the mix today is closer to 60/40 of acquisition deals to refinance deals. Two to three years ago, it was 70/30 the other way.
Are investors looking to buy in Midwest markets today?
Collett: The Midwest markets are our sweet spot today. We play better in the secondary or tertiary markets. Those markets tend to be more resilient, in my opinion. We find opportunities in those markets to be fruitful. The bigger markets are covered effectively by larger players, institutional players. We find better opportunities in the secondary and tertiary markets. Those markets are continuing to grow. We have seen tremendous growth, for instance, in Nashville.
When you consider financing requests, what factors do you look at?
Collett: We look at transactions in three ways. First, we look at the strength of the borrower. That is pretty consistent across the industry. Do they have experience in the market? Do they have the financial wherewithal and liquidity?
We also look at the market. We want to understand what is going on in the market or in the submarket in some cases.
The last piece is the unique piece that each lender looks at differently. Where do we have exposure? Where do we want more exposure? Is this a new client that we want to do more business with? This is about where we want to grow. We want more exposure from a footprint perspective in some markets. Other lenders might want less exposure in those markets. It’s more about lenders making their own decisions about their own book.
Back to interest rates, do people understand that today’s rates, though higher, are still at historically low levels?
Collett: I feel like that is driven more by the number of years people have been in the industry. The anomaly with rate is the last 10 years. Being at 2% or 3% is the uncommon factor. If you have been through cycles before, you realize this. If you have been in the market for four or five years, you know nothing different than this low interest-rate environment. This feels different to them. They don’t understand the anomaly.
Do you think a slowdown is coming in commercial financing requests now that the Fed has raised interest rates again?
John Manos: I do. The Fed has been warning us about the moves they were going to take. They told us they were going to go from one rate hike to another. Most of us, and the investors, anticipated that. The first two quarters of this year, then, were incredibly busy. What surprised me was the amount of purchase transactions we saw. We anticipated that anyone and everyone who could refinance would take advantage of that opportunity to hurry up and refinance before rate hikes would take effect. Because of that anticipation, the first two quarters of this year were very busy, and that activity trickled into the third quarter. But over the last three or four weeks, we have definitely seen a slowdown.
The last time the Fed raised its rate this aggressively was in November of 1994. I think investors were anticipating that and wanted to get all their deals completed as soon as they could, which explains why we were so busy at the beginning of this year.
John Manos, BankFinancial, Willowbrook, Illinois
Has the fact that the Fed didn’t raise rates gradually but instead in two large jumps created any uncertainty in the commercial real estate landscape?
Manos: The Fed, by making their increases that steep and that frequent, have made a statement that they are going to fight the threat of inflation aggressively. I think people have gotten that message, and it has altered their investment plans. Being in the Midwest, what has surprised us is the amount of money coming in from the coasts, primarily from California. A good number of investors are purchasing properties here in the Midwest, primarily in the Chicago area. They’ve found higher cap rates and better returns than what they were seeing in their home markets.
Why is commercial real estate in the Midwest so attractive to investors?
Manos: The cap rate opportunity is the big reason. The Midwest is a place where investors can still find 7.5%, 8% and 8.5% cap rate opportunities in multifamily. In their home markets, they might be finding 3.5% and 4% cap rate returns. That is not very lucrative for them. They have nowhere else to invest their money that is as safe as in Midwest real estate. The stock market seems to have peaked, too. I would say that investing in commercial real estate, and especially in multifamily, is the safer bet today.
Speaking of multifamily, what has made this commercial sector such a strong investment for so long?
Manos: Rising interest rates mean that less people can afford to buy homes. More people, then, will be renting for a longer time. Inflation will slow rent increases in multifamily. But the demand for apartments is still strong, so occupancies will remain high and vacancy rates will stay low. Higher interest rates could lead to higher vacancies in retail and office. Multifamily, then, looks like the better of the commercial property types.
From what we have been reading, there is not enough housing and not enough apartment units to meet demand, especially for low-income housing. We try to focus on that. We try to work with investors that invest in and grow in low-income census tracts.
When the pandemic started, we all worried that apartment dwellers would stop paying their monthly rents. For the most part, that didn’t happen. Are you surprised by that?
Manos: People made paying their rent a priority during the pandemic. We jumped on that early, too. We asked our borrowers if they needed support or if they had the need for any additional financing that we could help them with. A small percentage took advantage of that. We supplied lines of credit, gave them the ability to get through those challenging times. They all paid us back ahead of time and ahead of schedule. We thought it was important to come up with a program, to be proactive with our borrowers as opposed to them getting in trouble. We jumped ahead of the curve on that. Our borrowers appreciated it. I like to think it carried through to the tenants and gave them an opportunity to get back on their feet or gave them an extra month or two to find another job.
What type of commercial financing requests are you seeing today?
Manos: We lean toward multifamily, which we specialize in. But we are seeing business across the board. Multifamily is our primary source of business. We also get into retail. When we look at retail financing requests, we are careful about who the tenants are and what the lease structures are. Service-related retail businesses are more appealing today than are other businesses that might be more hit by supply chain slowdowns. We are focusing more on borrower experience and liquidity. We are also looking at and considering more multi-tenant properties rather than stand-along, single-use commercial facilities.
The industrial market has been hot for a long time, too. Are you seeing many financing requests for industrial acquisitions?
Manos: We do. We still try to focus on working with requests for multi-tenant properties. That way, you don’t have the Amazon effect. If Amazon is 80% of the income in a property and then leaves, it doesn’t bode well for an owner. It’s the same with grocery-anchored shopping centers. If the grocery store is 70% to 80% of a center’s income, if the grocery store leaves, you have a large, dark, empty box. That will hurt, no matter if you have other smaller tenants.
I know it’s difficult to predict the future, but what do you think will happen now that the Fed has committed to raising its benchmark rate?
Manos: I think as the Feds have done historically, they are doing what they need to do to control the economic cycle we are in. They will continue to move aggressively. Then I feel that things will flatten out. I think they’ll pull back in the early first quarter of next year and let things play out. I believe that the investors who could refinance have already refinanced. I anticipate purchases on any and all commercial real estate to slow and give the market a chance to catch up. We are already starting to see properties stay on the market 30 days and 50 days. We will see more of this. And certainly, the overheating of the market the last couple of years made it a sellers’ market. Interest rate hikes will slowly convert it to a buyers’ market again probably by the third or fourth quarter of next year.
We will work through it, though. I don’t think we’ll keep seeing multifamily rents grow, but I do believe multifamily occupancies will remain high. Retail is still adjusting and finding its way to get occupancies back up again. They have done tremendous work. The office sector might lag a bit. From what we’ve heard, businesses are trying to get their people back into the office. How does that work out? We are still waiting to see. Industrial has been on fire with all of the trucking and supply chain routes happening. That is starting to settle down a bit. We’ll see where that lands in the first and second quarter of next year. These are certainly interesting times.