As the commercial real estate industry assesses the impact of today’s 75 basis-point interest-rate increase by the Federal Reserve, experts are offering varied predictions on how the series of hikes will affect investment and the capital markets.
Wednesday’s hike, the second 75 basis-point increase in two months, pushes the fed funds rate to a range of 2.25 percent to 2.5 percent. That range was last seen in late 2018, well before the COVID-19 pandemic hit in early 2020 and began what economist Hugh Kelly refers to as a series of earthquakes and aftershocks to the economy that is now teetering on the brink of recession. The Fed began increasing rates in March with a 25-basis-point hike followed by a 50-basis-point increase in May and the three-quarter percentage point increase in June, the largest since 1994.
Wednesday’s increase, which was announced at the conclusion of the central bank’s Open Market Committee meeting, is expected to precede several more hikes later this year. The Fed’s goal is to raise the federal funds rate to about 3.25 percent as a tool to fight inflation.
Richard Barkham, CBRE global chief economist and head of global and Americas research, said the most recent inflation number of 9.1 percent means the Fed still has to bring demand in the economy in line with supply. Noting it will take some time to get inflation back within normal bounds of 2 to 3 percent, Barkham said he anticipates the Fed may continue some hikes into next year before bringing them down quickly thereafter.
JLL Chief Economist Ryan Severino, who expects another 75-basis-point increase, said he thinks inflation is at its high-water mark for the year and should start to come down.
“The economy is starting to slow. They really are messaging to the market they are serious,” Severino said of the Fed’s actions.
In the meantime, Kelly said real estate investors should be shock-proofing their business plans to deal with those ongoing aftershocks.
“It means flexibility in your contracts. It means a long-term assessment of where the risk is greater and where it is less,” Kelly said.
Lee Menifee, PGIM Real Estate’s Head of Americas Investment Research, said he is also among those anticipating another rate increase of 75 basis points today but noted the long-term picture and the impact on commercial real estate for the second half of the year is less clear.
“U.S. real estate investors have largely priced in this round of interest rate rises so the overall market should be relatively unmoved by the Fed’s upcoming decision. But that does not mean volatility is going away. Real estate sentiment is at the whim of underlying worries about a recession and wider factors, like the war in Ukraine, that are far out of the Fed’s control,” Menifee said.
Menifee said the wider question is whether this interest rate cycle will change the long-term outlook for U.S. real estate.
“We doubt it. Demographics is going to remain the defining force shaping the U.S. real estate market in the decades to come,” Menifee said. “The U.S. population is aging, and will spend less as they do, while growth in the labor market will continue to slow. These are powerful disinflationary forces that will prevail beyond this market cycle.”
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CRE impacts felt
The economic uncertainty, rising interest rates, decreasing prices and lower loan-to-value levels are already impacting the commercial real estate world as the costs of borrowing increase and cause a lot of capital to retreat to the sidelines amid a high degree of caution, Barkham said.
“I would call it a moderate slowdown in capital markets activity that reflects the higher cost of capital and more nervousness about the economy,” he told CPE. “But deals are taking place and there is a lot in the pipeline.”
Barkham said retail, which has a higher cap rate, has been active, particularly for suburban assets as more people are living and shopping in the suburbs since the pandemic began.
“Office really surged in the first quarter, but demand has eased back a bit,” Barkham said. “What we’re seeing in office is a flight to quality.”
Industrial, which still has strong fundamentals including very low vacancy rates, is also seeing investor interest, though properties that have long-term leases locked in may be seeing less activity as investors seek value-add deals with more lease turnover and rent increases. He said demand for multifamily and life sciences properties continues because of robust fundamentals.
However, increasing cost of both equity and debt financing along with rising interest rates has caused multifamily sales volume to drop for July, according to the National Multifamily Housing Council’s Quarterly Survey of Apartment Market Conditions.
NMHC Chief Economist Mark Obrinsky said in prepared remarks higher rates have cut into investor proceeds. He said many sellers are reluctant to lower prices leading to a sharp drop in sales volume. The survey’s sales volume index came in at 10, well below the break-even level of 50, indicating lower sales volume than the previous quarter. A vast majority of respondents, 83 percent, reported lower sales volume.
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The Mortgage Bankers Association has updated its baseline forecast for the second half of 2022 and is projecting an 18 percent decline in total commercial and multifamily mortgage borrowing and lending to $733 billion, a decrease from record 2021 totals of $891 billion. Multifamily lending alone is expected to decrease 10 percent to $436 billion from last year’s record of $487 billion. However, Jamie Woodwell, MBA’s vice president for commercial real estate research, said he expects borrowing and lending to rebound in 2023 to $872 billion in total commercial real estate lending and $454 billion in multifamily lending.
He noted that even with the lower levels of volume anticipated this year, 2022 will still be the strongest year for commercial and multifamily borrowing and lending since 2021.
Woodwell said the Fed rate hikes are affecting the short-term adjustable loans more than those that would be refinanced through longer-term rates.
“When you look at what’s coming due maturity-wise this year and the coming year, it does tend to be shorter-term adjustable rate loans. Those will be a lot of CMBS, SASB (single-asset, single-borrower) loans and loans made by inventory-driven lenders like debt firms and mortgage REITs,” Woodwell said.
“When you go to underwrite them, it’s going to be a very different situation than it was two years ago,” he told CPE.
Brian Stoffers, global president of debt & structured finance at CBRE, called the current financing market “choppy.” He said debt financing is still available, but lenders are underwriting more conservatively and at higher rates.
“Underwriting standards have tightened across the board for all asset classes,” Stoffers told CPE. “Underwriting for office, particularly suburban and B and C class offices, is particularly difficult at the moment given some uncertainties around the return-to-work topic.”
Stoffers said tumult in credit spreads has led to a considerable slowdown in CMBS and SASB financing. He also noted many debt funds have also become less competitive. But borrowers still have options available for construction and acquisition financing.
“Regional and local banks appear to be taking market share from larger banks who have slowed their demand for commercial and construction. Life companies continue to lend on commercial and multifamily projects but have tapered recently given the higher relative value currently found in fixed income and private placement investments. The GSEs, Freddie Mac and Fannie Mae, are likely to increase activity the balance of the year given the death of other multifamily lending sources,” Stoffers said.