Who would argue that higher interest rates weren’t the biggest financial story this year? Certainly no one in the commercial real estate business.
Higher rates choked off the flow of commercial real estate investment sales. They stamped out new commercial construction. And they led to a frustrating year for developers, brokers and commercial financing professionals.
But what about 2024? Now that the Feder Reserve Board has signaled that it is done boosting rates, and might cut them next year, will commercial sales activity pick up? And will it be easier for owners and developers to acquire the commercial financing they need to bring their projects to life and acquire new properties?
We spoke with commercial finance veteran Rafi Golberstein, chief executive officer of PACE Loan Group in Edin Prairie, Minnesota, about the impact that interest rates have had on commercial financing throughout the last 12 months and what he expects to see in the coming year.
Here is what he had to say.
We all know that higher interest rates were a huge story in 2023. What impact did you see in the local Twin Cities CRE market?
Rafi Golberstein: What is interesting about the rates we’ve seen this year is that historically they’re not that high. I’m fairly young to the industry. I started my career in 2006. But back then, interest rates were higher than what they are now. There has been an entire generation of developers over the past 15 years who started their careers after the Great Recession ended who have never experienced interest rates at the level we are seeing today. Historically, though, these rates are not crazy.
There was a whole slew of developers who had no way of understanding how to develop when rates are like this. Older developers understood. They know that this is a cycle. Rates go up and rates go down. They understood that these rates are high, but not historically crazy.
The higher rates caught some folks flat-footed. A lot of people didn’t think about stress-testing their assets at higher interest-rate levels to see how they would perform.
Rafi Golberstein, chief executive officer of PACE Loan Group
How did these higher rates affect commercial real estate?
Golberstein: The effect has been a huge slowdown. Many developments ground to a halt. A lot of deals that were on the finish line stalled out. This has led to a lot of sunk costs, a lot of predevelopment work getting shelved. All the work people did on legal issues, getting permits, the specs, it has all been shelved. Those projects might be mothballed for the next 12 months.
Still, some projects are getting done. The leverage is lower. The old saying “cash is king” has never been truer. If you can put down 40% equity, you can still get a deal. If you need 70% or 80% leverage, that’s not in the cards.
The Fed has signaled that it is done raising rates and might cut them next year. Is this stability what the industry needs for sales volume and new construction pick up?
Golberstein: I am a lender by trade, so I am more pessimistic than most people. But I don’t think we’ll see a lot more rate hikes. But I don’t anticipate a significant drop in rates, either, maybe 50 or 75 BPS. Hopefully, we can normalize a bit over the next 12 to 18 months.
But I do think stability is what people are looking for. If that comes, I think next year we will see more sales and development activity.
Is the feeling in the industry during this challenging period different from what we saw during the Great Recession in 2008?
Golberstein: In 2008 and 2009, things were contentious. Properties were going back to lenders. There were all these workouts. It was intense. In this cycle, we have not seen that at all. Even when projects are going into forbearance and foreclosure, it hasn’t gotten nasty. I don’t know what accounts for that other than the acknowledgement across the board that we all got too loose on interest rates. Too many thought that these interest rates would last forever. It wasn’t bad real estate at the heart of these challenges, it’s just real estate that can’t be refinanced out of its current debt.
Not all commercial assets, though, are seeing the same difficulties today, either.
Golberstein: Yes. Office is the troubled child of all the asset classes. That is pretty close to the bottom right now. Office is largely unfinanceable. The one we are keeping our eye on is multifamily. Think about the record numbers of permits pulled for multifamily projects in 2022 and 2021. Think about all those construction loans that are three-year terms. Those are coming due right now or 12 months from now. A lot of multifamily product will be going back to the lender. They simply can’t refinance out of their debts. We haven’t seen that yet, but it is coming.
What kind of deals are getting financing right now?
Golberstein: We are PACE lenders. We lend on properties that have energy efficiency improvements. About 60% of our portfolio is ground-up construction and 40% is existing buildings. One of the interesting things we are seeing now are deals that allow retroactive PACE financing.
Most states allow retroactive PACE funding. Say you have a building that you built two years ago and you have added energy efficient features to that property. We can enter the picture and say, ‘You have $5 million of retroactive eligibility.’ We can infuse $5 million of liquidity into the deal. Building owners can use that to get extensions on their construction loans. We are doing a ton of retroactive PACE deals. We infuse liquidity to properties and help their owners get extensions so that they are not facing these maturity defaults.
What do you have to show with these older buildings to qualify for retroactive PACE financing?
Golberstein: On an existing building, say a warehouse or office building, you have to show that you are replacing older, inefficient systems with new, efficient ones. Maybe you are converting an old warehouse space into hipster residential. You can show that you have made energy efficient improvements with the windows, HVAC, plumbing or electrical systems. Anything that increases the efficiency of a building is dollar-for-dollar PACE eligible.
In 2024, most of our business will be retroactive PACE financing deals. We are coming in to infuse liquidity to properties that the owners can use to right-size their debt and create a path to a viable refinancing.
For which asset classes are you providing the most financing today?
Golberstein: Our top asset classes are hospitality, senior living and market-rate multifamily. We are doing some office. We have a position in the LaSalle Plaza office property in downtown Minneapolis. That entire acquisition is complicated, but PACE financing is a critical part of it. What we liked about the deal is that it was a fresh acquisition with a ton of cash coming into the deal. What we shy away from are folks who already own an asset who are looking to refinance their current debt without bringing any fresh money into the deal. That is scary for us. We liked the story a lot with LaSalle Plaza. Office isn’t dead. But it must have the right story.
I know it’s difficult to predict the future, but what do you see in terms of commercial financing next year?
Golberstein: I do see an uptick in volume in 2024. Folks on the sell side are realizing that prices are not what they want them to be, but that they will have to work around that if they want to be active this coming year. I think we will see a more productive year than we saw in 2023. But 2023 was our company’s best year ever. We believe that 2024 will eclipse 2023 for our lending book.