Changing Interest Rates and CRE Financing: Implications for Investors and Deal Structures

The landscape of commercial real estate (CRE) is always changing, and one of the key elements influencing the sector right now is the environment of shifting interest rates. Investors and developers need to modify their strategy as we move through 2024 to take these shifts into account, as well as how they will affect financing alternatives and deal structures.

Current Interest Rate Environment

The Federal Reserve has hinted that rate cuts may be coming after a period of strong rate hikes. In the CRE market, there are opportunities as well as obstacles because interest rates are still much higher now than they were a few years ago.

Impact on Refinancing

The challenge that many property owners have when refinancing their current loans is one of the most noticeable consequences of rising interest rates. This problem is especially urgent because there are over $2.75 trillion in commercial mortgage loans that are scheduled to mature between 2023 and 2027. Many debtors who previously obtained debt at cheaper interest rates are now faced with refinancing at considerably higher expenses, which could result in:

* The need for additional capital injection to meet new loan terms

* Increased risk of distress or foreclosure, especially for CMBS loans

* A surge in "dual track" strategies, where owners simultaneously explore refinancing and sale options.

Valuation Challenges

Property values across a range of asset sectors have been under pressure to decline due to rising interest rates. According to the Commercial Property Price Index, the price of commercial real estate fell by 22% by the end of 2023 compared to its peak in March 2022. Due to the drop in valuations, borrowers may find it difficult to get loans big enough to completely pay off their current debt, which would need making extra equity contributions.

Shifts in Lending Strategies

Lenders are adapting to the new environment by:

* Becoming more selective in their underwriting processes

* Focusing on higher-quality assets and experienced sponsors

* Offering creative financing solutions to address the gap between existing loan balances and current property values.

Opportunities for Well-Capitalized Investors

While the current environment presents challenges, it also creates opportunities for investors with strong capital positions. These include:

* Acquiring distressed assets at discounted prices

* Providing mezzanine financing or preferred equity to fill capital gaps

* Exploring value-add strategies to improve property performance and increase valuations

Deal Structure Innovations

To navigate the changing landscape, investors and lenders are getting creative with deal structures:

* Extension options: Many borrowers are looking to exercise built-in extension options on existing loans, hoping for improved market conditions in the future.

* Partial prepayments: Some loans allow borrowers to make partial prepayments to meet financial metrics required for extensions.

* Joint ventures: Partnering with equity providers to inject additional capital and meet new lending requirements.

* Bridge financing: Short-term loans to provide time for property improvements or market stabilization before seeking long-term financing.

Sector-Specific Considerations

The impact of changing interest rates varies across different CRE sectors:

* Office: Already facing challenges due to remote work trends, higher financing costs are further complicating the outlook for this sector.

* Multifamily: While generally more resilient, even this sector is seeing some pressure on cap rates and valuations.

* Industrial: Continues to perform well, but investors may need to adjust return expectations in light of higher borrowing costs.

* Retail: Mixed performance, with some subsectors (e.g., grocery-anchored centers) faring better than others.

Looking Ahead

As we move through 2024, the CRE market will likely continue to adjust to the new interest rate environment. Investors should:

* Stay informed about potential rate changes and their impact on different property types and markets

* Maintain flexibility in investment strategies and deal structures

* Focus on properties with strong fundamentals and value-add potential

* Build relationships with diverse capital sources to ensure access to financing options

Although there are difficulties with the current interest rate environment, astute investors who can modify their approaches and take use of innovative financing options can also benefit from it. CRE professionals may effectively manage these shifts and position themselves for long-term success in the changing market by remaining knowledgeable and adaptable.

If you need more information or assistance in sailing through these challenging times of commercial real estate, don’t hesitate, contact us at 310-943-8530 or info@cbicommercial.com