What is the 18-month forecast for commercial real estate capital markets?
As we close out a volatile year, the financial markets remain in turmoil. This is in reaction to both inflation and the Federal Reserve’s heavy-handed response. Because commercial real estate is extremely sensitive to interest rate changes – particularly hotel assets that rent rooms by the night – the commercial real estate capital markets are responding accordingly. Current conditions are stalling transactions because of a wide bid/ask spread between buyer and seller, with buyers demanding higher cap rates than what sellers are willing to accept. This is about to change in the next 18 months, however, when a significant number of loans mature. To avoid foreclosure, owners will be pushed to either sell or refinance at a higher interest rate, potentially also adding equity to right-size their loans. This dynamic will disrupt how the normal market usually functions.
PROJECTIONS VS. REALITY
The next economic downturn likely will be led by commercial real estate. During the past three years, many transactions were closed at cap rates (NOI/price) that are lower than current interest rates. Multifamily will feel this pain especially, as many past deals assumed that projected cap rates would be lower than what we are seeing now post-Fed hikes. Today’s higher-than-anticipated rates put pressure on the projected cap rates, creating a negative delta. As a result, the value of an asset will be lower at the time of loan maturity than the asset’s loan balance. This creates a potential for market dislocation, followed by a slew of defaults that could spiral into something even bigger.
LOOMING WAVE OF MATURITIES
Contributing to this bleak landscape are the $52 billion of CMBS mortgages due in the next 18 months that must be refinanced into new mortgages (source: Trepp). Maturing bridge and permanent loans put pressure on an already-pressured transaction market. To grapple with this issue, capital markets have introduced a new, five-year CMBS product that underwrites most loans on an interest-only basis. The key difference between this and a traditional 10-year product is that the new, five-year CMBS loan originations are happening exclusively in a pool with other five-year loans. Lenders can then price the five-year paper much more aggressively than pools that include longer-term loans. For example, at the time of writing, most five-year fixed rate CMBS hotel loans are pricing between 6.25% and 6.5%. These new, five-year loans also are attractive because they’re typically interest-only for three years and have lower yield-management penalties than their 10-year counterparts. Because the term is shorter, the calculated breakage fee is lower. Plus, there is an open period built into the final six to 12 months of the loans, during which a borrower can pre-pay or sell without penalty.
THE GIFT OF TIME
This new, five-year CMBS loan has the potential to be the No. 1 loan product in 2023 because most borrowers believe today’s higher interest rates are temporary and that the Fed will reduce rates once inflation is under control. Borrowers are choosing this option because it affords them time until rates decrease. If most borrowers forecast interest rates will drop in two to three years after closing – and knowing there is a 12-month penalty-free open period at the end of the term – they expect to be able to sell or refinance these loans before maturity with minimal risk.
DEALS WILL GET DONE
This higher interest environment also puts pressure on the debt service coverage, which results in lower leverage on most loans. This is a double whammy for financing as valuations are lower due to higher cap rates, and leverage is lower due to lower debt-service-coverage ratio calculations. Capital markets will function normally, however, and the silver lining is there will be plenty of capital available for maturing and acquisition financing in the markets. These are the times when advisors, investment bankers, and intermediaries are more valuable than ever because of their relationships and pulse on the market.