Rising interest rates clouded the conversations of commercial real estate participants in 2023. The impact was felt across the industry as uncertainty rose and transaction volume fell substantially. In 2024, there is renewed optimism that activity will pick up, perhaps later in the year. The direction of interest rates will influence the market as investors, owners, and developers determine the best way to navigate through such issues as debt, maturing loans, loan defaults, and potential distress in commercial real estate.
The industry saw a slowdown in 2023 across multiple avenues, from buying to borrowing. The reduction was largely driven by the fact that interest rates rose higher than cap rates. Kidder Mathews’ Jordan Carter, EVP in the company’s Portland office, summed up the situation simply. “That’s a recipe for little to no transactions,” he says.
Kidder Mathews’ Eric Paulsen, Regional President of Brokerage in Southern California and Arizona, agrees that the combination cast a shadow of doubt in the minds of decision-makers. “When there is movement in the industry, owners and investors will pause until they understand how it impacts them. With the rapid interest rate increases in 2023, the market froze.”
The rapid increase in rates sent most of the market to the “sidelines,” according to Kidder Mathews’ Eric Shain, VP in the company’s Irvine office. “Those who had to sell did so, whether for debt coming due or an ownership succession transition,” he says. The lack of transaction volume across all property types resulted in a significantly limited pool of 1031 Exchange buyers, too, which typically keeps the market afloat.
The Federal Reserve signaled it planned to start reversing increases in the federal funds rate in 2024, though recent indications are that rates could remain higher for longer. Carter notes that lower rates will help. In his view, “It’s going to need to be more than just a token rate reduction to make an impact. We’re going to need to see rates go down by 50-100 basis points to get some real momentum.”
Michelle Schierberl, SVP in Kidder Mathews’ Irvine office, notes there are a host of factors influencing buyers’ and sellers’ decisions today — though the impact of a rate reduction is likely minimal. “Sellers that do not need to sell are not motivated by pricing that is less than recent values,” she says. “Buyers are afraid that if they purchase today, the value may continue to diminish and leverage is not assisting returns.”
On the capital side, Kidder Mathews’ Brad Kraus, EVP in Century City, says advisors saw increased requests for bridge-to-bridge refinancing loans as sponsors needed additional runway to complete projects and existing lenders wanted to repatriate their loan dollars. Kraus says, “The biggest retardant for sales financing was the large buyer-seller gap that still exists. The Fed signaling a wait-and-see approach on cutting interest rates just stalls the transactional engine as sellers hope for a cap rate compression, along with lower rates, and buyers need price concessions for adequate risk adjusted returns with elevated rates.”
Get Aggressive or Remain Defensive?
“We have been seeing rates hovering in a tighter range recently, so it gives the market some comfort that we have stability,” says Paulsen. “If the rates decrease, as expected later this year, it would mean that the worst is behind us, and underwriting can get more aggressive instead of just defensive.”
Kirk Brummer, SVP in Kidder Mathews’ Irvine office, says, “Although it is still tough to pinpoint how much of the potential lowering of the Fed funds rate is already priced in the longer-term interest rates, we expect the cost of capital for commercial acquisitions to decline over time if the Fed lowers the rate, which should provide a tailwind for investors.”
Lower rates will instantaneously reduce the cost of capital, according to Kraus. “Lender rates have already begun to drop with certain capital providers acknowledging that rate cuts are inevitable and will be happening,” he says. “This first wave of lenders is what I call the ‘perception is 9/10th’s of reality’ participants. They are eager to fill their allocation buckets and gain market share on the earlier side.”
The expectation is that as rate cuts are announced, others are sidelined by cautious CCOs who will drop their rates in lockstep. Once enough lenders are back in the market and signaling a willingness to do deals, competition will heat up as credit spreads are compressed in an effort to win business. An efficient marketplace tends to drive down the cost of borrowing and the buyer-seller gap is also narrowed, resulting in higher transactional volume.
Another approach Shain is seeing investors take is waiting for rate cuts to either activate a buy or sell strategy. He says, “There has been a great disconnect between buyers and sellers for the past year and a half or so. If rates come down, cap rates should follow, and transactions should increase. That, combined with more inventory, should result in much more activity later this year and into 2025.”
The reaction to interest rate drops should be positive and quick for debt markets, too.
“Rates go up like a rocket and drop like a feather,” notes Paulsen. “The good news is that there is so much money out there in both debt and equity, that just sheer competition to place dollars will create a functioning market and could bring rates lower.”
Carter’s view is less optimistic. “Unfortunately, the signs of rate reductions aren’t looking real great at this point in the year, especially with gas prices now negatively impacting inflation again. I do think if we see drops, the market will react positively, but until then, we’re operating under a ‘survive ‘till 25’ mentality.”
Paulsen says that stability, or lack of it, is one of the issues borrowers with maturing loans face if interest rates don’t subside. “It is not so much the subsidence as much as the halt and retreat of rates,” he says. “The market can function at any interest rate; it just needs stability and an understanding of what the near-term future looks like to allow for transactions to take place.”
Solutions in a New Normal
Data is crucial to decision-making, and over the past year, the data keeps rapidly changing, causing decisions to either slow or stop. Paulsen is confident market participants will adjust to the “new normal” as part of a natural cycle of business, despite higher interest rates, greater expenses, rising inflation, and in an uncertain time with few comparative sales comps.
Paulsen says, “Solutions to these challenges depend upon the lender. If it is a CMBS loan, then the borrower will most likely face a significant increase in costs and possible foreclosure. If a bank, then there are greater odds that the bank will extend the maturity of the loan if the borrower is current and making payments.”
The challenge for investors who secured debt in the 4% range 10 years ago is what to do next if interest rates don’t subside. Shain says, “Depending on the property, vacancy, or market situation, a refinance might be extremely challenging at current rates. We are advising our clients in this situation to ‘dual track’ a sale and refinance scenario to ensure maximum flexibility. It is always best to get ahead of it —– listing a property for sale does not mean you have to sell. Exploring a refinance while you see where the market values your property can be a savvy strategy.”
Carter says, “Many borrowers are going to be in a tough spot, and already are. I expect them to need to bring new equity in to pay down loans to get the long-term debt they need, especially in the construction to perm financing world. Distress already has arrived in 2024. While not widespread just yet, it’s picking up steam and we will see more distress and foreclosures as the year progresses.”
Among the approaches being adopted to navigate maturing loans that Kraus is observing involves lenders continuing to grant term extensions as everyone waits for the market conditions to improve. That assumes, of course, that asset value is not underwater, and the borrower is able to continue servicing the debt. “In 80% of the cases, I’ve seen to date there is still imputed value and likely a refinance or sale scenario that stems the dreaded notice of default,” says Kraus, who adds that lenders prefer not to undertake the costly and time-consuming process of foreclosure unless there is truly no alternative.
Conversely, Schierberl expects few retail defaults in California and only likely because of tenant turnover. She also points out that there are loans that have matured but the lenders are not foreclosing, so the problems have not been resolved. Additionally, owners are simply putting capital back into their portfolio of properties versus acquiring new assets.
Is Widespread Distress Ahead?
Paulsen says the answer to whether there will be loan defaults is “It depends. Real estate is so individual in relation to location, product type, occupancy, micro and macroeconomics that it will be property specific.” He believes loan defaults will not be widespread nationally if rates don’t come down. That’s because most lenders learned from the GFC and had more conservative underwriting.
“Many product types are still doing well, so if I had to choose between the two, it would be isolated events, with an eye towards office properties, overbuilt markets, and borrowers who in the last three years acquired properties with floating rate short-term loans,” he says. But distress is already occurring in some markets and asset classes, points out Paulsen, who predicts, “Problems will be in overbuilt markets, office buildings; specifically, CBD and C quality, and borrowers that don’t have the equity to re-infuse into the asset.”
Defaults are likely going to be determined on an asset class basis rather than a geographic aspect. Kraus notes that office is problematic, and the fuse is shortening by the month as vacancy continues to rise. Multifamily is now struggling with stalled rent increases due to market and political pressure, insurance escalations, and higher expenses due to inflationary forces in isolated markets such as Los Angeles, where buyers paid a premium due to low rates over the past few years. That is a true volatile cocktail, according to Kraus. Strip- and grocery-anchored retail, along with industrial property types, continue to thrive. Hospitality in tourist destinations is exceeding RevPar forecasts and remains healthy for the most part.
If rates do subside throughout the summer, fall, and winter, the CRE landscape in Q1 2025 will be much improved. Schierberl says, “The fundamentals of the retail sector are strong, so with improved financing it should lead to higher buyer interest and deal activity. Buyers remain highly cautious today, with many groups just spectators on the sidelines. This is partly due to their own risk-adverse underwriting, but also lenders are keeping them in check.”
Interest rate stabilization will go a long way to positively shape perspectives and lead to a clearer indication of where the market stands and is headed in the short term. It is also likely to produce increased transaction volume and asset values. Larger institutions could interpret that as a sign to re-enter the market as sellers at a time when there’s reportedly more than $1T in capital available to invest in CRE. That would be warmly welcomed across the industry.
Contact
| BRIAN HATCHER President & COO brian.hatcher@kidder.com View Bio |
Stay in the know and subscribe to our monthly West Coast Market Trends report and our quarterly market research.