Real Estate Capital USA: Commercial real estate grapples with a ‘higher for longer’ rate environment

By Samantha Rowan and Randy Plavajka | Real Estate Capital USA

The Federal Reserve is expected to continue to raise interest rates to slow the US economy and temper inflation. Here is what higher rates for longer could mean for the commercial real estate market – and when it could end.

Transaction activity has slowed substantially in recent months as rising rates have created a gulf between buyer and seller and lender and borrower expectations. Transaction volume has declined about 22 percent year-on-year, per MSCI, while the 10-year Treasury is has risen more than 200 basis points since the start of the year. This is expected to continue, at least until there is more clarity on valuations.

“As the market navigates through the current disruption, we are all trying to figure out where the bottom is,” says Paul Rahimian, founder of Los Angeles-based construction lender Parkview Financial. “As rates go up, valuations go down and the lingering question is, ‘How much will valuations go down?’ And because no one knows when the Fed will stop raising rates, the market is frozen.”

Ghosts of the past

What is happening today is in some ways the opposite of global financial crisis, says Bill Sexton, chief executive of Atlanta-based Trimont.

In 2008, the Federal Reserve significantly reduced interest rates, unemployment was rising and liquidity was non-existent. “Today, interest rates are rapidly rising and are now higher than they have been for an entire cycle, unemployment remains low but is going to come under pressure and real estate debt and equity managers are sitting on– but not yet deploying – substantial amounts of dry powder,” Sexton says.

The action of central banks is also very different. Sexton says: “In 2008, central banks were trying to stimulate the economy. Today, we have central banks around the world turning off the tap in the on-going fight against inflation. This is an acknowledgement that embedded high levels of inflation will do more damage over the long-term than higher interest rates in the near term.”

One bright spot is the sense that the ghosts of the GFC and other previous recessions – along with more stringent regulations – have informed activity in the lending market over the past 15 years, market participants say.

“The GFC was a difficult recession and valuations dropped substantially. But everyone who was patient and had the ability to hold onto their real estate came out stronger because valuations did increase,” Rahimian says. “When everyone looks back historically, they remember that as bad as 2008 was, the market came back stronger.”

This time next year

The conventional wisdom is that transaction activity is unlikely to reboot until the end of Q1 2023 or later, depending on the pace and scale of future rate hikes. And as investment sales and lending activity picks up, the market will see a broad normalization of pricing at levels that are anywhere from 10 to 30 percent below where they are today.

“Deals are requiring more equity upfront because of the higher rates associated with the transaction and looking at the exits down the road,” says Troy Marek, managing director and group head of real estate capital markets project finance at Birmingham, Alabama-based Regions Bank.

At this point, it is a game of wait and- see, market participants say. But there is no near-term expectation that transaction activity will pick up again before the end of Q1.

“We will see how long rates continue to be at this level or go higher,” Marek says. “Higher rates right now are just driving everything, I do not think that is going to really change as we get over the next quarter or two.”

By Samantha Rowan and Randy Plavajka

Real Estate Capital USA