CRE Sector Facing the Heat of a Financial Slow Down

David Cohn
Feb 10, 2023
Commercial Real Estate Lending

By the end of 2020, prices for industrial and residential properties worldwide have skyrocketed. The hardest hit sectors—retail and office spaces—are also starting to show signs of stabilization.

It's safe to say that after an initial downturn at the start of the pandemic, commercial real estate (CRE) properties have significantly recovered.

But there are signs that momentum is cautiously waning. Central banks have hiked interest rates, effectively tightening global financial conditions.

According to this chart published by the IMF in September 2022, average property prices within both industrial and residential sectors have slowed across different regions in the last few months of the year.

The devaluation of retail and office properties has risen significantly, too. Not only do tighter financial conditions raise the cost of obtaining financing to purchase or refinance commercial property—they also decrease investment in this sector.

Indirectly, these restrictive measures hinder economic activity, which diminishes the demand for commercial spaces such as restaurants, stores, and industrial warehouses. This further decreases the overall interest in CRE investments, leading to a price decline.

According to the same research from the IMF, monetary conditions are a critical factor in commercial real estate prices and help explain why different regions have experienced mixed results during the pandemic.

Economies with more accessible financing—including lower actual interest rates and other amiable market conditions—generally experienced a less severe decline in commercial property prices during the pandemic and sped up their recovery time.

Additionally, countries that took fewer restrictive steps to contain the virus spread along with offering larger fiscal support packages and higher vaccination numbers saw an increase in commercial property values.

Constricting financial conditions can make the CRE sector vulnerable, especially in regions with meager economic prospects.

Furthermore, additional stringent protocols implemented to contain new COVID-19 outbreaks would only further affect the industry even more adversely.

IMF's analysis likewise shows that remote work and online shopping (among other structural shifts encouraged by the pandemic) influence commercial real estate prices.

For example, increased teleworking tends to reduce demand for office space, while e-commerce adversely affects the price of retail CRE as consumers shop online.

There is considerable uncertainty surrounding the future pace and extent of such structural shifts in the coming years.

Still, tighter financial conditions could compound these effects and worsen downward price pressures in specific segments.

Disruptions in the commercial real estate sector could significantly affect global financial stability due to its close relationship with the banking system and macroeconomy.

Therefore, financial watchdogs must remain vigilant and take preventive action to reduce potential risks.

In regions where banks are the primary CRE lenders, it's essential to conduct stress testing for significant decreases in commercial real estate prices to determine if capital reserves are adequate enough for CRE exposures.

Banks should also thoroughly review their commercial real estate valuation assumptions to make sure that sufficient provisions are in place.

To reduce systemic risks in areas where nonbank financial institutions are critical players in commercial real estate funding, the IMF recommends that efforts be focused on extending macroprudential policies to cover these institutions.

How interest rate hikes affect multifamily CRE

Inflation has been a central theme of the American economic dialogue, and it's easy to see why. In 2022, the Federal Open Market Committee raised interest rates by as much as 75 basis points four times from June to November and another 50 basis points in December.

Despite a recent cooling, inflation still hovers around its highest in four decades. Along with tight labor markets that are pushing wages up, the economy is witnessing something unprecedented according to commercial banking experts at JPMorgan Chase.

Consequently, the Fed is strengthening monetary policy measures faster than ever. It's important to note that not all financing structures will be affected by rate hikes, so it is essential to assess your specific situation to understand the possible impacts.

For example, although an increase in interest rates could considerably affect short-term and adjustable-rate loans, longer-term fixed-rate ones may be less heavily impacted.

According to financial giant JPMorgan Chase, fixed rates could fluctuate depending on the economic circumstances after a hike. Therefore, keeping an eye on treasury yields is essential for investors with fixed-rate loans as they greatly influence mortgage rates.

The treasury yield is an indicator of investor outlook regarding the economy; market forces (rather than the Fed) dictate how they move.

As a result, they fluctuate based on market assumptions of the long-term effect of inflation and whether an economic recession may be forthcoming.

Yields are hovering on the low end of that range as of Dec 2022.Although there is potential for fluctuations in the coming months, there's unlikely to be significant increases.

How multifamily housing investors can cope with increasing interest rates

Housing activity is one of the economic sectors most sensitive to interest rate changes. So, unsurprisingly, it has weakened significantly in the last leg of 2022. However, multifamily housing demand has risen amid a low supply of affordable single-family homes.

The Federal Reserve predicts a continuation of interest rate hikes in early 2023. This may harm multifamily real estate owners and investors. Nonetheless, some benefits can be derived from the situation.

For example, if interest rates rise, many aspiring homeowners cannot purchase a single-family house and may have to remain renters for an extended period.

In addition, inflation, high costs, and construction delays may also cause rent in existing multifamily properties to go up.

Finally, multifamily real estate owners and investors with rock-solid financials can also take advantage of the current economic climate to expand their portfolios more cost-effectively.

Going beyond interest rates

Are you planning to invest in a multifamily home or refinance your current apartment building? There's more than just interest rates to take into consideration. Make sure that you also look at these two factors:

  • Shifts in demographics, supply, and demand - The shortage of housing, particularly affordable options, is an increasingly urgent issue. Demand has far outpaced supply, and more people have been relocating to the middle of the country, searching for workforce housing solutions (affordable dwellings for households whose earned income is not enough to acquire quality housing close to their workplace). As a result, investors should carefully consider the potential risks and rewards of moving their focus from suburbs to cities.
  • Local market - Real estate is inherently local, making it crucial to closely analyze the particulars of each particular market before buying or refinancing. Inspect every property individually--especially its capitalization rate, which typically rises when interest rates surge.

What lies ahead

Inflation will likely remain elevated in the short term, but we are already seeing signs that inflation is moderating, and this cooling will become more evident as time progresses.

The Federal Reserve expects interest rates to rise and fall following fluctuating economic trends. However, according to their estimations, these levels are expected to peak at 5.25% by 2023.

However, financial markets remain skeptical of this forecast, with futures pointing to a maximum 5.00% target by May.

Markets are expecting a shift by the end of the year, and once that occurs, there is potential for the Fed to loosen its policies to respond to a possible economic downturn.

The Fed itself does not predict such a move, expecting instead that higher rates will be required for an extended period to contain inflation.

Unexpected global political uncertainties can also create a domino effect of market volatility and interest rate instability worldwide.

The cost of financing and the fluctuations in market behaviors have certainly extended to multiple tiers across the capital structure. In addition, economic circumstances further complicate matters and cause bank balance sheet constraints.

The Federal Reserve's stress tests also dampen bank appetite for commercial real estate loans. On the upside, this means that nonbank mortgage investors can benefit from the lack of capital availability in the market.

If you're looking for CRE financing in 2023, it's best to cast your net wider and look beyond traditional lenders such as banks. Instead, start building relationships with private investors as early as now. Talk to Capital Investors Direct.

Capital Investors Direct is quickly becoming one of the nation's premier CRE loan placement and advisory firms.

We understand that every customer has unique goals, so we customize our services to meet each investment goal and objective.

As a result, you can count on a personalized approach tailored specifically to your needs. Whatever your loan needs—Bridge, Hard Money, Construction, Jumbo, Stated Income, or Permanent—we can help you get the funding you need.