Understanding Current Challenges and Potential Opportunities in the CRE Market

Understandably, real estate investors may feel cautious about the commercial real estate market as a result of all that’s been occurring over the past few months. The Federal Reserve has raised its key rate at the fastest rate in more than forty years to fight stubbornly high inflation, cool the economy, and slow spending. Subsequently, the pace at which the Federal Reserve has increased rates has put stress on the banking system and has shown a light on the workings of the CRE and banking system relationship. It is difficult not to be alarmed by CRE headlines, however sector challenges may also create distressed asset opportunities for investors.

The Federal Reserve announced a pause in its rate hike cycle at its most recent meeting on June 14, 2023, providing relief to the CRE industry, and the decision has been met with both optimism and caution by the sector as investors carefully follow the interest rate market and recognize how rates might affect the future of their real estate investments. The Federal Reserve announced its benchmark interest rate would remain unchanged at 5-5.25%.3 Above-target inflation still leaves room for additional hikes, and many within the industry anticipate another rate hike in July as inflation has not yet leveled off to the Fed’s goal of 2%.

Interest rate hikes are changes to the Federal Reserve’s target for the federal funds rate, which is the rate at which banks lend money to each other. When the Fed raises rates, it can make borrowing more expensive and can slow economic growth. The rise in borrowing costs resulting from higher interest rates can be an impediment to potential investors’ motivations to buy, hold, or refinance real estate assets. As such, the pause in rate hikes may provide some relief for some investors looking to act as well as allow them to assess the longer-term impact of the previous rate hikes.

Banks have largely pulled back on lending amid uncertainty about how high rates would get. Transaction volume has slowed significantly since the start of the Fed’s rate hike, contracting 62% year-over-year as of Q1 2023.2 As interest rates increase, so does the cost of capital, ultimately eroding asset values. Additionally, banks are incorporating stricter lending standards following the recent turmoil in the banking sector, and tighter borrowing conditions are expected to further reduce transaction activity. More than two-thirds of banks reported tightening of standards for CRE loan applicants. However, CRE is far better positioned today compared to the GFC because of healthier underwriting principles and faster responses by policy makers, and we expect transaction activity to gain momentum again as the Fed’s plan for future rate activity becomes clearer in 2023 and beyond.

As banks pull back from CRE exposure, opportunities from other sources of capital may arise as well as distressed asset opportunities. Commercial banks’ reduced appetite for CRE loans may open up an opportunity to non-bank lenders such as private credit, rescue capital, and other private equity alternatives who may benefit from more deal flow, higher rates and less competition in the short term. Market dislocation and cost of capital may also provide liquid investors the ability to capitalize on potential new and distressed opportunities at a significant discount to their intrinsic value and potentially take advantage of changing market conditions.

Certainly, more stable rates will bring warmer sentiments towards the CRE market, provide clarity on underwriting assumptions, and help investors achieve better cost of capital, but we will ultimately need to assess the longer-term impact of the Fed’s rapid rate hike and realize where longer-term capital trends are headed.

1 “The Federal Reserve just raised interest rates again, its fastest stream of hikes in 40 years. 2 important money moves to make now.” Market Watch, May 2023
2 https://irei.com/wp-content/uploads/2023/05/2023-05-US-Real-Estate-Faces-Challenges-But-Opportunities-Exist.pdf, May 2023
3 https://www.federalreserve.gov/newsevents/pressreleases/monetary20230614a1.htm
4 https://www.federalreserve.gov/newsevents/pressreleases/monetary20230322a.htm
5 https://www.federalreserve.gov/data/sloos/sloos-202304.htm