Rising interest rates have scrambled the plans of many real estate investors and finance leaders. No one knows how much more interest rates will rise, how much property prices will fall, or whether the U.S. economy will dive into a recession, a mild downturn, or even continue to grow.

All this uncertainty drives potential buyers away from deals, while potential sellers hesitate and many lenders make smaller loans—if they are lending at all. The capital markets for real estate have ground almost to a halt.

“It’s a capital markets recession for real estate,” says Ken Rosen, chairman of Rosen Consulting Group, based in Berkeley, California. He spoke at the 29th annual ULI/McCoy Symposium on Real Estate Finance, a  gathering of real estate leaders held on December 9 in New York City, and named after real estate legend Bowen “Buzz” McCoy. “Money is, all of a sudden, not available or it is available at a very costly rate,” continued Rosen.

Demand for many types of real estate is still high, particularly apartments and industrial space. But the real estate experts at the Symposium were not talking about opportunities to invest. Instead, most of the conversation focused on the challenge of adapting to high interest rates.

“The fear of missing out has been replaced by the fear of making a mistake,” says Roy March, CEO of Eastdil Secured, headquartered in New York City, who also presented at the Symposium.

Federal Reserve Still Aggressive

Since the beginning of 2022, Federal Reserve officials raised their benchmark interest rates over and over again, pushing interest rates for all types of loans up several percentage points. A few days after the Symposium, the latest increase left the Fed’s top target rate at 4.50 percent. That’s up from just 0.25 percent at the beginning of the year. Most economists and investors expect at least one more increase of at least 25 basis points in January 2023.

Federal Reserve officials raised their interest rates in an effort to fight rising prices, throwing cold water on an overheated economy. At the Symposium, some experts hoped the Fed’s fight against inflation may be almost finished as prices seem to be growing less quickly.

“A lot of people are hoping that interest rates will come back down,” says Rosen. The yield on 10-year U.S. Treasury bonds already dropped to 3.5 percent in early December, down from over 4 percent in October. Meanwhile, the Fed continued to hike its Fed Funds rate, which was almost 80 basis points above the yield on 10-year Treasuries in early December.

“I don’t think that will hold—it’s very hard to have an inverted yield curve for very long,” says Rosen. “Every single time that’s happened there has been a pretty substantial recession.” Bond investors may be betting that such a substantial recession could motivate Federal Reserve officials to cut their interest rates to some degree.

“I assured them that I don’t expect rates to ever be where they were during the pandemic,” says Rosen. “That was a one-time event—a mistake, I felt.” 

A ‘Soft Landing’ Would Avoid Recession

Real estate experts should also prepare for the possibility long-term interest rates creep up to match or exceed short-term rates. That could happen if the Federal Reserve becomes satisfied with moderating inflation and pauses its rate hikes.

“People are still hoping that we avoid a recession,” says Rosen. “The general view is fundamentals, the economy, job growth… are all still excellent.”

Most types of commercial real estate property have also performed very well during the recovery from the pandemic.

“There has been limited overbuilding,” says March. In the recovery from the pandemic, supply chain problems and a labor shortage pushed up the replacement cost of properties. Strong demand pushed rents higher—especially with apartments and industrial space. 

Many real estate properties also carry relatively little debt, compared with past recessions. “We had less leverage in the system this time around than we had historically,” says March. In past decades, the average property carried debt equal to about 70 percent of its value. In 2022 that burden of debt was lighter—closer to 55 percent.

Troubled Deals Need More Equity

However, some properties still have problems—particularly if they have mature loans they must refinance at the new, higher interest rates. “The cost of refinancing has gone up. There is going to have to be more equity put in,” says Rosen. “That is going to be… a problem.”

Investors may also be stressed by how fast interest rates have increased.

“It’s unprecedented,” says March. Fed officials have raised their rates several times to slow inflation—but not this much or this quickly in recent decades. During the housing boom, for example, the Federal Reserve also raised its interest rates more than 400 basis points, but it took more than twice as long: 24 months. “The rate of increasing rates is probably the biggest issue,” says March.

Properties with floating-rate debt may face particular challenges for example. The cost of interest rate caps has risen to 229 basis points for a two-year cap from just 12 basis points during the pandemic. “It’s become increasingly expensive even to function within the floating rate market,” says March.

Eventually, real estate investors are likely to adapt. “These rates are not high,” says Rosen “They are just high compared to the last three years when they were incredibly low—free money because of COVID.” The Fed Funds rate is now just a percentage point higher than in 2018, for example. “I think we can live with this environment, but we have to adjust to it.”

Many lenders began in 2022 to add more spread over benchmark rates to the interest rates they charge borrowers. CMBS lenders have to charge much wider spreads, because they raise capital by selling bonds which are also commanding higher yields. Other lenders may be more conscious of risk and feel less motivation to compete by offering low spreads.

The Federal Reserve’s fight against inflation has also widened spreads. During the coronavirus crisis, the Federal Reserve bought hundreds of billions of dollars in bonds—including CMBS—to help keep longer-term interest rates low, too. That “quantitative easing” effort has come to an end and the Federal Reserve is now selling billions of dollars in bonds every month, pushing spreads higher.

Finally, federal regulation is discouraging many banks from lending more to commercial real estate properties. Regulators are strictly demanding that commercial banks hold enough capital on their balance sheets to cover the full risk of investments in real estate.

“The banks’ stress tests—they have really been put under the microscope,” says Rosen. “The banking industry is lending very little to real estate right now. Also, the debt funds can’t make deals work without the senior loans available from the banks.”

Cap Rates Are Up; Prices Are Down

It’s still too early to measure how much the prices of commercial real estate properties have shrunk because interest rates have increased. Not enough sales have been negotiated and closed since interest rates began to rise to show the change. Dealmakers report investors are much less willing to pay high prices because borrowing has become more expensive for them.

Few sellers are willing to deeply cut their prices, however. “The market has a big bid-ask spread,” says Rosen. “There’s so much uncertainty that people are frozen.”

In the past, higher interest rates have always hurt property prices—especially at first. “Every time that Fed Funds rate has gone up there’s been a decrease in real estate values,” says March. “Values have come down substantially.”

The shrinking prices of real estate property can already be seen in the prices Wall Street investors are willing to pay for stock in real estate investment trusts (REITs). The prices of those stocks fell quickly as interest rates began to rise. The index of the National Association of Real Estate Investment Trusts (NAREIT) lost roughly a third of its value since the beginning of the year. That change provides an advance warning of how much the prices of real estate properties are likely to fall on the private market.

“The public market has already adjusted 30 to 40 percent,” says Rosen. “That’s telling us that the private market properties will adjust 10 to 20 percent.”

The outlook is not all grim. In the past, real estate values quickly began to recover from the shock of rising interest rates—much more quickly than other types of assets. “In rising rate environments, real estate has historically outperformed,” says March. In past three-year periods as the Fed raised rates, REIT stocks provided a significantly better total return than stocks focused on finance, technology industry or the S&P 500 overall, according to a comparison between the NAREIT index and other equities.

Private equity funds may also be able to help fill holes left in property budgets by rising interest rates and falling property values. There is currently $388 billion in “dry powder” held by private equity funds targeting opportunistic or value-added investments—though those funds have typically promised very high yields to their investors. However, another $330 billion has been raised by infrastructure funds targeting lower yield “core” investment strategies that might cross over to real estate investments.

Of course, these plans will only work if the Federal Reserve’s interest rates don’t rise so much that the holes in project budgets become too big to fill.

“Watching the Fed is still very important,” says March.