Commercial real estate transaction activity is likely to increase due to economic uncertainty and rising interest rates, which have led to a sharp rise in mortgage rates, according to panellists at the CRE Financial Council‘s annual conference this week.

The conference took place at a time of turmoil in the financial markets. The Federal Reserve hiked interest rates by 75 basis points, the largest one-day jump in 28 years, to cool rising inflation. The consumer price index rose to 8.6 percent year-on-year in May, led by rising housing and energy costs.

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After peaking at 36,585 in early January, the Dow Jones industrial index is down more than 20 percent and was below 30,000 this week. And even more critically for commercial real estate, the 10-year Treasury yield is up nearly 200 basis points, topping 3.40 percent this week, the highest since January 2011.

Although commercial real estate fundamentals remain healthy across most sectors, the worrying economic news increases the likelihood of a recession in the coming quarters and is likely to put the industry on hold. “It’s been a while since we last talked about stagflation,” said CREFC executive director Lisa Pendergast. “There is no doubt that rising interest rates will negatively impact mortgage and cap rates, and a recession can be detrimental to property-level cash flows.”

weakening of the capital markets

The commercial real estate market got off to a good start to the year as transaction volumes and property values ​​hit all-time highs in 2021, a trend that continued into the first quarter of 2022. However, persistent inflation prompted a reassessment of Fed policy. Not only are interest rates rising, risk spreads are also widening.

For example, the proliferation of senior 10-year triple-A CMBS is up more than 80 basis points over the past year, with the class priced 145 basis points above government bonds in a deal issued this week. The combination of rising interest rates and higher risk premiums has increased the cost of mortgage debt by 200 to 250 basis points year-to-date. This creates ripple effects across the industry, including:

• Increased acquisition yields that undermine prices. The average multi-family cap was about 4.5 percent in 2021, but now mortgage rates for most properties are 5.5 percent or higher. Even assuming rents will rise, as they are in some real estate segments, there are few deals that make sense when borrowing costs are higher than cap rates. Anecdotally, property values ​​have fallen 10 to 15 percent, but the decline could extend further if capital markets continue to erode.
• Transaction activity will plummet. Many institutions have stopped bidding, and buyers are pulling out of deals when they can. Sellers unwilling to accept the new lower price environment are taking properties off the market. “The market will slow down as people digest what’s going on in the world,” said a CREFC panelist.
• Mortgage activity will fall. The cost of both fixed and floating rate debt has increased dramatically in a short space of time. “Borrowers who don’t need to borrow will be left out,” said a CREFC panelist. Another said, “All-in interest rates have gone up so fast that borrowers are looking at the (offered) rate and saying, ‘No thanks.'”
• The increase in interest rates has the greatest impact on securitization programs because their origination rates are directly linked to bond spreads. Not only CMBS and secured credit obligation (CLO), spreads have widened but investors are becoming more selective about the property types in the collateral. Many investors avoid asset classes such as office, retail and hotel, which have long-term demand issues. “Investors don’t want to be in a position where they buy a bond and the next day the spreads are wider,” said a CREFC spokesman.
• It will also have an adverse effect on refinancing maturing loans that have been granted at lower interest rates. Although operating income has generally increased in recent years due to strong rental growth, borrowers may be refinancing with less leverage and higher interest rates. This could result in an increase in outages and/or runtime extensions.

Temporary weakness or beginning of a downturn?

The new capital market environment has even had an impact on state-sponsored companies Fanny Mae and Freddie Mac, which have raised interest rates and “are not as competitive as other sources of capital,” according to multifamily lending executives. For the first time in many years, GSEs are at risk of not meeting their full annual allocations, which the Federal Housing Finance Agency has set at $78 billion for 2022.

Not every source of mortgage debt will stay on the sidelines. Portfolio lenders are not subject to the same mark-to-market constraints and hedging risks as securitized lenders, so they will continue to do business that meets their quality and return requirements. However, debt sources that still lend are putting a new focus on debt service coverage and exit rate ceiling assumptions. Strong debt service coverage means loans must have enough cash flow to make payments even if income deteriorates. Conservative exit cap assumptions reduce the overly optimistic growth assumptions that have fueled aggressive lending in past cycles.

Many of the attendees at the CREFC event – which drew a record all-time attendance of 1,424 – are predicting that market activity will slow dramatically at least until the end of the summer. Whether the decline will continue beyond that depends on how the economy develops in the second half of the year and whether the Fed manages to rein in inflation without triggering a sharp recession.