The old saying about things getting worse before they get better could be applicable to commercial real estate. The industry is feeling mounting pressure from higher rates and tighter liquidity—with more pain ahead.

“If we’re peeling the onion back to see what’s going to make us cry in the second half of the year—it’s all capital,” says K.C. Conway, real estate economist at Red Shoe Economics. Everyone is addicted to really low debt costs, and when the Fed took that away, it created a capital crisis, he adds.

In a market where there are still plenty of divergent opinions, Conway admittedly has a “glass half empty” view on the outlook for the commercial real estate market. However, challenges are coming from high costs of capital and tighter liquidity rather than asset performance. Although there are some obvious exceptions in the office sector, fundamentals for many owners are still solid, notes Conway. “The problem is capital, and because commercial real estate is so capital intensive, if you turn the spigot off, it doesn’t take very long to have a really bad multi-car collision on the interstate,” says Conway. “And that’s what we’ve got.”

Click to zoom. CBRE Research, Q2 2023

Although deals are still getting done, it is a tough market to find capital to fund acquisitions and development, and the need to deleverage maturing loans in a higher rate environment is fueling concerns about rising commercial real estate loan stress. That challenging market is evident in slumping transaction activity. According to an updated baseline forecast released by the Mortgage Bankers Association (MBA), total commercial and multifamily mortgage borrowing and lending is expected to fall to $504 billion this year—a 38 percent drop compared to the $816 billion in originations in 2022.

Fed rate hikes have raised the federal funds rate from near zero to 5.25 percent in less than 18 months. Add in volatility and uncertainty and it has put a lot of industry participants—developers, investors, and lenders—on their heels, adds Drew Fletcher, head of Greystone Capital Advisors. “Whether they are on the debt side or the equity side, people are not deploying capital because of the uncertainty,” he says.  Interest rates have yet to settle on a plateau, and many in the industry are expecting that liquidity will likely tighten further before it starts to turn the corner. “I think we are looking at a 12- to 18-month window before we see meaningful improvement,” says Fletcher. 

Stress in the market is evident in rising delinquencies and loans that are moving to special servicers. According to Trepp, the special servicing rate climbed to 6.62 percent in July. Although that is up compared to 4.79 percent a year ago, it is still well below the all-time high of 13.4 percent recorded in May 2012. Among the $2.7 billion in loans that transferred to special servicers in July, 32.8 percent were in mixed-use, 29.6 percent in lodging, and 26.5 percent in office.  

Bank pullback has long reach

Banks that began tightening credit even before high-profile bank failures early in the year aren’t likely to loosen lending anytime soon. They’re worried about commercial real estate exposure risk in loan portfolios, deposit flight, and higher rates that are eating into their profitability and limiting lending capacity. Loan payoffs are down, and borrowers are extending loans because it’s difficult to refi in the current environment. As a result, bank balance sheets have ballooned, which triggers increased regulatory requirements.

Although the dust was beginning to settle from bank failures earlier in the year, Moody’s Investors Service reignited concerns with a fresh round of bank downgrades, citing stresses that included funding pressures, regulatory capital weaknesses, and commercial real estate exposure.

  • The banks that were downgraded include M&T Bank, Pinnacle Financial Partners, and Old National Bancorp.
  • Moody’s also revised its outlook to negative for some banks including Capital One, PNC Financial Services, and Fifth Third Bancorp.
  • Banks on review for downgrade are Bank of New York Mellon, U.S. Bancorp, State Street, Truist Financial, Cullen Frost, and Northern Trust.

“They basically said what was the truth—there is all kinds of liquidity risk here. They don’t know if they have sticky deposits to fund construction loans. And they haven’t recognized that CRE values for loans on their books are not worth at refinance what they thought they were when they underwrote them,” says Conway.

Another challenge for the banks is that CMBS issuance is down, which makes it difficult for banks to move construction loans out to permanent financing. During the first half of the year, CMBS conduit volume is down 43 percent while single-borrower transaction volume is nearly 80 percent behind last year, according to Trepp. If banks can’t move loans off their books, it means they can’t replenish the funds available to lend. 

The pullback in liquidity that originated within the banking sector is cascading into other segments of the debt market. Non-bank private capital that has been raised, including private equity debt funds, are still heavily reliant on the banks to provide A notes or senior leverage. So, the two markets are deeply interconnected, and non-bank lenders are no longer lending at the same leverage point. 

Other lenders also are tapping the brakes. According to the Wall Street Journal, the mortgage REITs Blackstone Mortgage Trust and KKR Real Estate Finance Trust have halted real estate loans to new borrowers to focus on their balance sheets. “What you have had is a confluence of different factors coming together at the same time, really impacting things,” says Fletcher.

Casting a wider net

To be clear, capital markets are still functioning. Accessing debt financing is simply more challenging with availability of capital that varies widely depending on the situation. “There is liquidity in the market, but it is asset specific, location specific and sponsor specific,” says Aaron Appel, senior managing director and co-head of New York capital markets at Walker & Dunlop.

And on top of higher interest rates, borrowers are facing bigger spreads from lenders and substantially lower leverage compared to where it has been historically. What that does is make the net cost of debt more expensive than it has been since the early 1980s, adds Appel. 

The current cost of capital doesn’t mirror the values that people have put on their assets or what they have paid for properties over the last few years. “It’s getting harder to refinance out that existing debt. So, it has created a bit of a credit freeze, and on top of that there is a substantial lack of liquidity from the commercial banks,” he says.

For example, Walker & Dunlop has a client that owns multifamily properties in New York. That client has traditionally borrowed from regional banks. Those banks have either merged or are no longer in existence. To borrow $50 million on four properties, the banks are asking the client to put between $10 million and $15 million in cash into the bank in order to get the credit. “That is historically well out of line with what a regional bank would require from a customer to borrower money,” says Appel.

Community banks are still lending, and borrowers are looking at a variety of non-bank options. Credit unions, private equity, and life insurance companies are providing capital, including funds for construction loans. However, credit unions have limits on lending and the higher return requirements of private equity lenders means they are lending money at double or triple the rate compared to a bank. 

Life companies also are offering fixed and floating-rate construction loans. “That helps, but it doesn’t make up for the loss of regional and national bank participation,” says Josh Bodin, senior vice president, securities trading at Berkadia. “Debt funds also are stepping in to fill the void, albeit at substantially higher costs,” he says. 

However, it remains a tough financing environment for developers across the board. For example, 18 months ago, Berkadia could take a construction loan opportunity for an apartment project out to maybe a dozen or so lenders and get a commitment fairly quickly. Today, that same opportunity will require the mortgage banker to cast a much wider net, sometimes approaching upwards of 50 lenders to find decent terms, notes Bodin. 

Haves vs have nots

The narrative is that liquidity is tightening, but it is not affecting everyone the same. “Banks have had to become hyper-selective in terms of who they will lend to, which is contributing to this market of haves and have-nots,” says Fletcher. The strongest sponsors with the longest track records are able to lean on relationships to get their deals done. Anyone else is in a position where they may not even be able to get a bid on financing for their next development project, which is resulting in developers putting projects on hold. 

The multifamily sector is better positioned because it does have Fannie Mae, Freddie Mac, and HUD as a backstop with a core mission to provide liquidity and stability to the mortgage market for multifamily properties. Fannie and Freddie each have a $75 billion cap on their lending volume for 2023. At mid-year, Freddie Mac had only financed $19 billion, while Fannie Mae had funded about $25 billion. Collectively, the GSEs (Government-Sponsored Enterprises) have ample capital to deploy in the second half of the year. “I do believe that the GSEs are both mission-focused and open for business when it comes to financing all types of multifamily properties,” says Bodin. 

Borrowers need to work harder to find an appropriate capital source for the deal, but capital is still available. For example, multifamily borrowers can still access 10-year GSE debt at 65 percent in a pricing range of 5.6 percent to 5.8 percent, notes Bodin. “The 10-year Treasury is where it should be in a normal monetary policy environment and the spreads can still be relatively attractive,” he says. “So recalibrating expectations is important when it comes to looking at the debt environment and the interest rate environment right now.” 

The office sector is taking the brunt of the pullback in capital due to the added challenges created by remote working. The higher rate environment also is a big problem for owners that have maturing debt, particularly short-term floating-rate loans that were financed in the low-rate environment that are now over-levered. There are a lot of gaps that borrowers are looking to fill with subordinate debt such as mezz or preferred equity to provide some additional runway until the market normalizes. “There is no easy, clean senior-mortgage only refi solution in the market. Everything, for the most part, needs some other capital to fill the gap and a more creative solution to make it work,” says Fletcher.

For many market participants, the solution is patience. It will take time for interest rates to stabilize and settle on a plateau. A better line of sight on where rates are headed will give investors confidence to start coming back to the market, and liquidity will improve.