The era of low rates has ended. As a result, the economics of the commercial real-estate industry are changing.
Aggressive rate increases from the Federal Reserve have decreased commercial real estate (CRE) lending to its lowest point in nearly a decade. As Treasury bonds rise, as they have since early August, creditors have slowed their lending activity. The reason: higher bond yields can lead to a higher capitalization rate which is the expected return from the income a property generates. Capitalization rates are inversely related to property prices. This means that a higher capitalization rate will push prices down.
This development has led to a total commercial property debt market that has increased by less than 1% in the second quarter of this year. This diminished growth represents the smallest quarterly rise since early 2014. Put simply, the fundamentals of the market are changing.
Here, we aim to bring clarity to those changes by offering an overview of:
- Historical trends in commercial real estate lending
- The impact of rate fluctuations
- How credit unions are navigating the setting and what they can do next
Historical Trends in Commercial Real Estate Lending
High interest rates are discouraging investors from buying or developing property. In fact, commercial property purchases declined 53% in the third quarter of 2023 compared to the same period just last year according to data from MSCI Real Assets. This drop might explain why market analytics firm Capital Economics forecasts that office values will fall 35% by the end of 2025.
But this decline wasn’t always the case.
U.S. CRE construction starts, as measured by square footage, were on a steady ascent rising about 111% from 2013 to 2022 based on numbers from Dodge Construction Network. During this period, construction starts increased every year with the exception of a dip in 2020 amid the global pandemic.
Therefore, it’s not surprising that the amount of CRE loans from all commercial banks rose by just over 100% between January of 2013 and December of 2022 according to economic data from the St. Louis Fed. Just last year, new CRE development and the operations of existing commercial properties added a record $2.3 trillion to the U.S. GDP according to NAIOP. Many of these rising numbers over the last decade were due to a consistent increase in office, retail, and industrial occupancy rates over the same period.
During this time, banks were, and remain, the dominant lending force in the CRE space owning over half of CRE loans outstanding. Insurance companies, pensions, and commercial mortgage-backed securities represent the bulk of the remaining portion. Over the long-term, commercial properties offer a return between approximately 6% and 12% with many resources citing 9.5% as the average.
The Impact of Rate Fluctuations on Commercial Real Estate Lending
Risks Associated with Floating Rates
Interest rate changes represent the largest influence over commercial real estate lending because the CRE industry in the U.S. has become more reliant on floating-rate debt over the last 12 years. This means that an increasing portion of commercial mortgage-backed securities (CMBS) are tied to a benchmark that changes. When central banks increase interest rates, as they have in recent months, this debt becomes more expensive. In 2012, floating rate mortgages represented roughly 12% of CMBS issuance. In 2022, this figure climbed to about 43% based on data from Goldman Sachs.
A High Level of Debt Coming Due
Adding to this pressure is an impending wall of debt that is coming due in the CRE market over the next three years in the form of interest-only loans. With these loans the borrower is only responsible for making interest payments throughout the life of the loan. The full principal is not due until the end. Those who hold these loans often do so with plans to obtain a new loan at the end or sell the real estate.
CRE Loans Are Widespread
Rising rates have complicated these plans. Rising borrowing costs and more hesitance from lenders who might otherwise refinance these loans means that default risks are rising. Moreover, this strategy has become popular in recent years which adds to the scope of the challenge. The portion of new commercial mortgage-backed securities issuance represented by these loans increased to 88% in 2021, up from 51% in 2013 according to the WSJ. As Richard Mack, CEO of Mack Real Estate Credit Strategies recently remarked, “If you’re an alternative lender and you don’t have new capital, you’re not making many new loans until you see more pay offs.”
While these challenges are significant, they remain far more manageable than the fallout experienced during the global financial crisis. Liquidity remains available, albeit at higher prices. Though credit standards have risen, and regulators are bringing more scrutiny to their monitoring of CRE loan quality, the market is still fluid.
Turning to The Fed for Clues
In the meantime, it is likely that borrowers and lenders alike are continuing to look for clues from Federal Reserve Chairman Jerome Powell regarding future rate moves. Recently he decided to keep short-term interest rates unchanged for a second straight policy meeting. Many welcome this news as an indication that the Fed is getting close to the end of its rate-hiking run.
Breaking Down CRE by Type
In the present, however, “higher for longer” rates continue to influence commercial property valuations across three main sectors:
Research from EY shows that before COVID-19, a 300,000-square-foot office tower located at 350 California Street in downtown San Francisco went to market with an asking price of about $300 million. Following this, the anchor tenant vacated the building. Today, it has an estimated value of just 20% of the initial asking price. This story of declining values is similar to that of other major U.S. cities that suffered amid the double-hit of remote work and rising interest rates which led to an office-vacancy rate of about 18%, a 30-year high based on data from CBRE.
While San Francisco’s office market was hit harder than any other in the country since 2020, there are some signs that the situation may be improving. This year investors have purchased or are planning to purchase at least five major office towers in the area. This is the most commercial real estate activity seen in San Francisco since 2019.
Retail is largely remaining resilient as net new stores for 2023 approaches 1,000. This growth is possible mostly because the 2008 global financial crisis forced brick-and-mortar retail to scale back. As a result, the industry became lean. Today, businesses are turning back to retail space to develop a more tangible connection with consumers who would otherwise only have a digital engagement with their brand.
The expansion of retail CRE is in stark contrast to office buildings as seen by the plummeting availability of retail space to just 4.8% which is the lowest it has been in 18 years according to analytics from CBRE. Many businesses like Macy’s, Nordstrom, and Kohl’s have all been successful in growing their physical retail space using small-footprint stores that are only 30,000-50,000 square feet which is only about one-fifth the size of their traditional locations.
The development of supply chain centers, distribution facilities, and warehouses have all slowed amid rising rates. From the start of 2023 through the end of May industrial real estate sales reached $16.3 billion compared to $31.2 billion over the same period in 2022 according to research from Commercial Observer.
However, there are reasons to believe that the picture will improve. A host of legislative initiatives funneling more than $1 trillion in funding and tax credits towards infrastructure investment will likely boost the sector. Additionally, as online retail continues to grow, industry is likely to grow with it given the increased need for warehouse space holding merchandise.
How Credit Unions Can Navigate the Setting
Credit Unions will need to proceed cautiously in this environment because their CRE loan balances grew about three times the rate of the national average in the first nine months of last year alone. This trend holds true for community banks and regional banks which own about two-thirds of loans associated with office buildings, hotels, retail stores and warehouses. Currently, utilization of US offices is down by 51% nationwide in comparison to levels prior to the global pandemic.
Adding to this challenge is the fact that deposits at small banks have fallen by roughly $250 billion since January 2023 according to data from Goldman Sachs. Consequently, many of these banks will need to reduce their CRE lending activity. Credit Unions need to become more strategic in this setting which is also characterized by rising vacancy rates, declining rent growth, and higher labor and materials costs.
- Credit unions are holding a substantial amount of CRE loans. As of March 31, credit unions held $118.8 billion in CRE loans representing 8% of total loans up from 6.4% in March 2019.
- As the National Credit Union Administration (NCUA) Chair Todd Harper remarked “The high levels of interest rate risk we are seeing can also increase a credit union’s liquidity risks.”
- Liquidity constraints are rising for credit unions leaving them exposed to heightened risk.
- To better manage interest rate fluctuations on lending portfolios, credit unions should consider:
- Reducing rate reset timelines
- Offering variable rate loans
- Using rate floors during the underwriting process
- Relying swaps as a hedge against the rising interest rate risk
- Execute comprehensive reviews for existing loans
- Diversify the CRE portfolio geographically to reduce risks
- Stress test the CRE portfolio
- Take the opportunity to develop new, more valuable depositor relationships in today’s relatively uncompetitive market.
- Consider CRE opportunities in self-storage and medical offices which tend to perform well, from a macroeconomic perspective, in recessions.
- Consider offering short-term loan accommodations where appropriate.
- To better manage interest rate fluctuations on lending portfolios, credit unions should consider:
Explore the Future of Commercial Real Estate Lending with AVANA CUSO
Navigating the dynamic world of commercial real estate lending requires expertise and insight, especially in an era of fluctuating interest rates and evolving market trends. At AVANA CUSO, we’re dedicated to guiding credit unions through these changes with innovative and collaborative lending solutions.
Whether you’re adjusting to the new economic landscape, exploring diverse lending opportunities, or seeking to understand the impact of rate fluctuations on your portfolio, we’re here to help. Our decades of experience, coupled with a deep understanding of the commercial real estate sector, empower us to offer strategic guidance and robust support.
Don’t let the shifting tides of the market hold you back. Connect with us to discuss how we can assist in steering your credit union towards success in these challenging times. Contact AVANA CUSO today, and let’s chart a path forward together.
About AVANA CUSO
Founded in 1998 and based in Simi Valley, CA, AVANA CUSO stands as one of America’s leading credit union service organization specializing in commercial real estate lending, including SBA 504 loans. We’re proud to be a key part of the AVANA Family of Companies, committed to fostering growth and success across credit unions nationwide.