This is a perfect storm for the commercial real estate lending industry. Rising interest rates have slowed the economy and made loans prohibitively expensive. Falling property prices and liquidity worries have caused banks to slow or stop lending to commercial real estate. And with seller expectations still high, transactions have fallen to a fraction of pre-pandemic levels.
All of this has combined to send commercial lending stagnate. Second-quarter figures from the National Association of Mortgage Brokers showed commercial and multifamily mortgage lending volumes down an incredible 54 percent from a year ago. It's hard to think of any industry that could survive seeing more than half of its revenue dry up in less than a year.
So how has the industry adapted to this systemic shock? The first change is that new types of lenders have stepped in to fill the void left by regional banks. Unlike banks, these lenders are not bound by Dodd-Frank regulations and don't have to worry about deposit runs. These non-bank lenders charge higher interest rates than banks, but the gap between the two is narrowing. Plus, many owners have no other choice. But while these lenders have been able to provide much-needed liquidity to the lending market, not all are created equal. “Some debt funds originate loans and buy bonds from other institutions,” said Tim Milazzo, founder of StackSource, an online marketplace for commercial real estate debt and equity.
The distinction is important because funds that also buy loans are slowing down lending to preserve capital for acquisitions. “Banks don't want to hold bad loans on their balance sheets, so nonbank lenders know they can buy up these bonds for a fraction of the money when they default,” Milazzo said. So while debt funds that originate loans are still lending, funds that also buy loan portfolios are slowing down lending to preserve capital to buy up when more bad loans start to come up for sale.
When lending conditions worsen, large construction loans are often the first to be cut. Not only are these loans expensive for borrowers (the longer it takes for a building to stabilize, the more expensive the loan is), but they also pose an administrative burden for lenders. Construction loans are paid back in “installments” that are timed to the completion of certain milestones. Inspecting each piece of a project to make these payments can mean more work for construction lenders and an increased risk of error.
As with commercial mortgages, the construction loan market is seeing increased activity from non-bank lenders. With a few exceptions, such as New York City, the majority of construction loans come from local banks, which have all but dried up since the bank shutdowns earlier this year. “As bank lending has all but dried up in some cities, we've seen a big increase in lending from other institutions. Even life insurance companies, which typically only buy developed properties, are leaning more toward development lending,” said Riley Thomas, senior vice president of markets at Built Technology, a construction finance technology platform.
If high interest rates have made non-bank lenders more competitive, you'd think that lower rates would diminish their competitive advantage. But that might not be the case. “The shadow banking system will likely continue to expand even if interest rates fall,” Thomas says. “These organizations are much less regulated and are designed to be more agile than banks, which could be a big advantage for them if banks ever make a comeback.”
While interest rates are certainly an important consideration for commercial real estate borrowers, they are not the only one. Other factors such as down payments, repayment terms, and speed of underwriting can also make certain loans more attractive, even at higher interest rates. The continued growth of debt funds and non-bank lenders is good news for the commercial real estate industry. If the Federal Reserve finally decides to lower interest rates, it will do so in a gradual manner, just as it did when it raised them. This means that while there will be a period when interest rates will start to fall, the positive effects of lower interest rates on real estate valuations have yet to be felt. The more commercial real estate lending is made, the less competitive it will be, since demand for loans will likely increase ahead of supply. High interest rates and bank failures have already changed the commercial real estate lending landscape. Hopefully, these changes will serve the industry well after this lending crisis has passed.