After a dark year for commercial real estate lending, the sun began to peek out from behind the clouds in mid-December.
While 2023 has been largely dominated by uncertainty about how much the Federal Reserve will raise interest rates, the commercial real estate market rallied after the central bank signaled on Dec. 13 that its hawkish inflation-fighting strategy is over and that multiple rate cuts are on the table for 2024.
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The Fed cut short-term interest rates to a 22-year high of 5.25% to 5.5% and, given current economic conditions, projects them to be 4.6% by the end of 2024, 3.6% in the second half of 2025, and 2.9% by the end of 2026.
The Federal Reserve implemented 11 interest rate hikes between March 2022 and July 2023. The subsequent pause in rate hikes and the expectation of rate cuts was good news for commercial real estate lenders and borrowers.
The commercial mortgage-backed securities (CMBS) market was already beginning to show signs of improving lending conditions ahead of the Fed's final meeting of the year, driven by a decline in the 10-year Treasury yield, which is expected to fall from 4.37% in late November to 3.91% by December 15.
Last month was the most active December for conduit loan activity in four years, said Stephen Caldwell, head of large loan origination at Barclays (BCS). Most of the activity was driven by borrowers looking to take advantage of an improving interest rate environment for deals they were initially looking to bring to market in mid-2023. Caldwell said the Fed's announcement on Dec. 13 reinforces the improved lending conditions seen before the meeting and bodes well for origination volume to begin sooner next year than previously expected.
“I think this is definitely moving the calendar forward,” Caldwell said. “A lot of the end-of-year optimism that we saw was driven by the expectation that interest rates were going to eventually come down.”
Caldwell noted that the CMBS market is also getting a boost from the prospect of lower interest rates, as well as the ongoing “stalemate” as borrowers opt for conduit loans to generate needed liquidity for projects.Caldwell said Burleys prices 15 to 20 percent of the office loans in each pool with a fixed-rate structure, typically for a five-year term.
Barclays was one of the few banks to start offering five-year-only fixed-rate conduit pools in late 2022, a move that played a key role in providing liquidity to a constrained market for short-term owner-occupied real estate, said Larry Kravetz, head of CMBS finance at the investment bank. He said five-year fixed-rate loans will remain an attractive financing tool despite expectations of lower interest rates. That depends on how costly it is to buy into the interest rate cap on floating-rate deals tied to the Secured Overnight Financing Rate (SOFR).
“Some of the five-year fixed rate debt would have been given to non-bank lenders as floaters,” Kravetz said, “but because of how expensive the shape of the yield curve and the cap costs associated with SOFR were, some of it got moved to the five-year fixed, making it an option for people who aren't long-term holders.”
Caldwell said conduit loans are expected to become more common in the CMBS space heading into 2024, while single-asset, single-borrower (SASB) transactions are also expected to become more important as interest rates become less uncertain. The majority of Barclays' SASB transactions have focused on hotels and shopping malls, but Caldwell said he has seen more market activity recently for industrial and data center refinancing transactions. The average size SASB deal is down about 30% from four years ago.
One uncertainty for 2024 is whether loans will start flowing again from the big banks and smaller banks that were on the sidelines for much of 2023. As interest rates began to spike in 2022, regional banks began filling the gap left by the larger banks. But many regional banks also fell back last year after the regional banking crisis erupted in March, leading to the closure of Silicon Valley Bank and Signature Bank.
Banks face a significant CRE-related burden heading into 2024, as evidenced by a December report from the National Bureau of Economic Research that showed loan default rates of 10% to 20%. These defaults could equate to losses of $80 billion to $160 billion.
Chris Coiley, head of commercial real estate for the New York and New Jersey market at Valley National Bank, said the Fed's Dec. 13 meeting should provide ample confirmation that interest rates are stable, paving the way for more deals. He warned that regional banks will likely be more selective in their lending and prioritize existing customers as rising energy and insurance costs continue to pressure property owners.
“Banks are going to be very cautious and take care of their customers,” Coiley said. “Knowing who they're doing business with, what borrowers and asset classes they're investing in will be their number one focus. I don't think banks are going to do deals just for growth.”
Coily said many regional banks are looking to improve their commercial real estate risk exposure by stress-testing the fundamentals of the loans they could potentially make, such as interest rates, cap rates and cash flow, and taking a hard look at their portfolio performance. He added that regional banks are well-positioned to fill a significant lending gap in 2024 as larger banks are still working to shore up their balance sheets and reduce their real estate holdings while also dealing with increased regulation.
Debt funds may also step into this void in a bigger way in 2024, injecting significant capital for property owners.
Some of the challenges limiting banks' lending volume are likely to persist for a long time, according to Warren de Haan, chief executive officer of Acore Capital, which could open up more opportunities for alternative lenders to make acquisitions or refinance looming maturities.
“If you're a lender in our position, the first half of 2024 will be the start of probably the strongest period of lending in my career, and I don't see it being short-lived,” said de Haan, who has more than 20 years of experience in CRE capital markets. “I think it's going to be a multi-year opportunity because there are structural nuances that need to be worked out over time and impacts from regulators through bank balance sheets and so on.”
If lower interest rates boost investment sales activity, Acore will see a significant increase in lending in 2024, since about 75% of the company's business is focused on acquisition loans, de Haan said. He added that there are also “selective” refinancing opportunities in 2024, given that there is about $1 trillion in CRE loans maturing by the end of the year.
Beneath the optimism about loan volumes in 2024 is the realization that increases are likely to be modest. Indeed, the Fed gave the industry a boost by stabilizing interest rates in the second half of 2023. Lumento CEO Jim Flynn said that will still only lead to a modest increase in loan volumes in 2024. But Flynn sees particularly positive signs in the multifamily sector, where Lumento is very active in lending. A recent Lumento survey of 300 mid-sized multifamily owners found that the majority plan to make net sales this year.
“We have a few owners who are waiting on the sidelines to wait for the dust to settle and for interest rates to stabilize,” Flynn said. “This will allow them to really make long-term plans, whether to hold onto assets or exit, or sell parts of their portfolios and move them into new assets.”
Andrew Coen can be reached at acoen@commercialobserver.com.