After a decade of strong capital markets conditions, commercial real estate is set to slow while prices drop, according to panelists at the CRE Finance Council’s annual conference last week.
The CREFC conference took place as the stock market was plummeting and interest rates were soaring to multi-year highs, which heightened the negative tone. The Federal Reserve raised policy rates this week by 75 basis points, the biggest one-day jump in 28 years, in a bid to cool surging inflation. The consumer price index rose to 8.6% year-over-year in May, led by spiraling housing and energy costs. The 10-year Treasury yield has increased nearly 200 basis points and topped 3.40% this week, its highest level since January 2011.
Although commercial property fundamentals remain healthy in most sectors, the worrisome economic news increases the likelihood of a recession in coming quarters and is likely to put the industry in a holding pattern. “It’s been a while since we last discussed stagflation,” said CREFC executive director Lisa Pendergast. “No doubt, rising rates will impact mortgage and cap rates negatively, and recession can have a deleterious effect on property-level cash flows.”
CMBS Spreads Jump
Lenders and borrowers have been hit with a double whammy. Not only are interest rates rising but risk spreads are widening, as well. For example, the spread of senior 10-year triple-A CMBS has increased by more than 80 basis points over the past year, with that class priced to yield 145 basis points over Treasuries in a deal issued this week. The combination of rising rates and higher-risk spreads increased the cost of mortgage debt by 200-250 basis points since the beginning of the year. That creates ripple effects throughout the industry, including:
- Acquisition yields have increased, which erodes pricing. Anecdotally, property values are down 10-15%, but the decline could extend further if the capital markets continue to erode.
- Transaction activity will plummet. “The market is going to slow while people digest what’s going on in the world,” said one CREFC panelist.
- Mortgage activity is dropping. “All-in rates have gone up so much so fast that borrowers are looking at the rate (offered) and saying, ‘No, thank you,’” said a CREFC panelist.
- The increase in rates has the biggest impact on securitization programs, because their origination quotes are directly tied to bond spreads. “Investors don’t want to be in a position where they buy a bond and the next day spreads are wider,” said a CREFC speaker.
- There will also be a deleterious effect on refinancing maturing loans that were originated when rates were lower. Borrowers may be refinancing with less leverage and higher rates, leading to an increase in defaults and/or maturity extensions.
Headed for a Downturn?
The new capital markets environment has even impacted government-sponsored enterprises Fannie Mae and Freddie Mac, which have raised rates and “are not as competitive as other capital sources,” according to multifamily loan executives.
Not every source of mortgage debt will be on the sidelines, though. Portfolio lenders do not have the same mark-to-market constraints and hedging risks of securitized lenders.
Many of the participants at the CREFC event—which hit an all-time-high attendance record of 1,424—forecast that market activity will slow dramatically at least through the end of the summer. Whether the dip extends beyond then will depend on how the economy performs in the second half of the year and the Fed’s ability to slow inflation without creating a sharp recession.