How to adjust in commercial real estate to higher rates

Not many real estate people sent holiday wishes to Board Chair Jerome Powell in 2022 as the Federal Reserve ratcheted rates higher at almost every meeting. But as Chrissie Hynde and The Pretenders sang in their 1979 hit, it is time for everyone in commercial real estate to “Stop Your Sobbing.” Now, as we jump into the unknown of 2023, it’s time to adjust to the new higher rate environment and carry on.

About the only groups in commercial real estate that weren’t crying as rates rose were banks and title companies. The banks, which have been sitting on zero rate deposits for many years, finally got to cash in on hefty profit margins in the last six months of 2022. As rates spiraled upward to over 6%, depositor returns remained near 0%, which created a windfall for banks that isn’t likely to continue in 2023.

Title companies, which for many years have relied on fees to survive, now also have the prospect of earning a respectable return on float. That’s the cash that sits in their bank accounts cost free for a short period of time. For the past 15 years, title companies were earning nothing on float; now they can earn greater than 2% in many cases.

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The rising rate environment for most in commercial real estate, however, was costly. The shock of rising rates ground transaction activity to a near standstill in the last quarter of the year, and tremendous uncertainty still hangs over the market. Many economists are indicating the risk of a recession is greater than a 50% probability in 2023. Recession or no recession, activity has slowed.

Various surveys of commercial real estate participants indicate that lenders and investors alike expect less transactional volume in 2023 than was booked in 2022, and in 2022, there was less investment volume than 2021. Commercial mortgage-backed securities originated in 2022 were down more than 33 % from 2021, and the expectations are even lower for 2023. Insurance company lenders are also expecting to put less money out in 2023.

For institutional investors, the so-called denominator effect is also likely to reduce the amount of new money that goes into real estate and other alternative investments. When allocating investment dollars, institutional investors look at their current portfolio and try to rebalance to maintain certain percentages in each category of investment. Because stock and bond portfolios suffered in 2022, the denominator, or overall investment dollars, is lower, and that means real estate is probably overweighted. So, to get portfolio allocations back in line, less money will flow into real estate in 2023.

The good news is, in the first few weeks of 2023, relative stability has returned to the market and rates are lower than they have been in three or four months. Commercial mortgage rates range from 5.25% to 5.75% for five- to 10-year loans on conservatively leveraged properties. Floating rate loans are priced higher because the benchmark Secured Overnight Financing Rate is .75% higher than the 10-year Treasury yield.

Here in Richmond, the biggest challenge is getting new projects financed. At current construction loan rates, it is still difficult to underwrite loan proceeds that exceed 60% to 65% loan-to-cost on development projects. The combination of less leverage, uncertain exit cap rates and inflated costs is putting many projects on temporary pause.

John B. Levy & Co. partner and investment banker Andrew Little can be reached at [email protected]