Given current capital markets, many commercial real estate owners are debating whether to start the financing process for their properties now or wait until the first quarter or second quarter of 2023.
The thesis for waiting is predicated on the thought that capital availability will be greater in the new year than it is today, leading to more competition and better loan economics. The risk to waiting, however, is that even if the market is more liquid, loan terms could still be worse in a volatile environment of rising interest rates.
On recent transactions, we have seen 10% to 15% of lenders fully or partially sidelined for the balance of 2022. Lenders provide a variety of reasons for the capital reductions, but there are common responses.
Some have already lent their 2022 allocations and, instead of requesting more funds, are evaluating market conditions. Several money center banks reduced or halted lending in response to harsher regulator-induced balance sheet stress tests, while other banks cite concerns over future regulator scrutiny or are focusing only on existing clients. Others have expressed concerns about upcoming loan maturities in their portfolios due to higher interest rates or about the health of existing loans.
Matthew Wurtzebach, Draper & Kramer
As a result, there is certainly less capital available now for financing than we typically see, and the remaining lenders are using more conservative underwriting assumptions compared with six or nine months ago. Barring something unexpected – geopolitical risk, higher rate-induced market stress – 2023 should bring more liquidity with fresh capital.
Higher rates on the horizon
Though more capital should be available, rates will almost certainly be higher. By the end of 2023, the Federal Open Market Committee is expected to raise its benchmark rate to a median estimate of 4.6%, from 3.25% as of mid-October, with an anticipated hike of 75 basis points at its early November meeting.
With the September inflation report running hotter than forecast, several market participants are even betting the Fed funds rate will ultimately exceed 5%. If these forecasts hold true, it is conceivable that commercial real estate note rates could meet or exceed 7% by year-end 2023. That’s before contemplating Treasury Secretary Janet Yellen’s recently expressed concern about liquidity in the U.S. Treasury market due to the oversupply of Treasuries.
Most loans we underwrite today are constrained by debt coverage, not value or cost. Higher interest rates lead to higher debt service payments and, in many cases, lower loan dollars. As interest rates rise and persist, cap rates should also (asymmetrically) rise, which would put pressure on property values and sale prices.
Higher interest rates and occupancy issues are already causing some distress, particularly in the office sector. Those datapoints will start to appear in appraiser analyses, adding pressure on refinances.
What this means for borrowers
Crystal balls are less clear than normal, and there is more market tail risk than we have seen in quite some time. Next year should bring more capital availability, but with stressed balance sheets, fewer loan payoffs and a potential looming recession, availability may not meet expectations. Furthermore, more lenders quoting loans compared to the fourth quarter of 2022 may not improve terms if note rates continue the current path.
Despite these challenges, the good news is that the capital markets in the U.S. are functioning, loan dollars are still available and appropriately underwritten transaction still receive multiple viable debt bids. Borrowers need to balance the timing of capital availability against the prospect of future rate increases.
Hesitation carries risk
In times of market volatility and uncertainty, if there is a need to finance, it is generally better to secure the deal that works now than wait in the face of likely deteriorating fundamentals.
Debt markets should be more liquid in the first quarter of 2023 as lenders have new allocations, which should mean more competition for loans, but the degree of more availability is far from certain. And if interest rates are higher, increased liquidity probably will not help the main economic drivers of the loan – dollars and rate.
Borrowers that can start the financing process or secure financing now, particularly fixed-rate financing with an early rate lock, should consider exploring options sooner rather than later. In some cases, particularly with life insurance company capital and some banks, it is possible to lock a rate in 2022 and fund in 2023, potentially securing a lower rate now while tapping into early next year liquidity, especially with lenders looking to get some dollars out the door early to start the new year.
Borrowers concerned that high rates today are an aberration that should abate in 2024 or 2025 may consider shorter duration loans or negotiating pre-payment flexibility.
Matthew Wurtzebach is senior vice president of the commercial finance group of Chicago-based Draper & Kramer.