CRE lending outlook remains stormy amid rising interest rates, recessionary fears

The commercial real estate lending outlook for the next 12 months is shrouded in the same uncertainty that the broader economy faces: Rising interest rates, stubbornly high inflation readings and recessionary fears. 

Tom Hosier

The forecast, however, isn’t entirely pessimistic. Tom Hosier, chief lending officer at St. Cloud, Minn.-based Stearns Bank, is “cautiously optimistic” that most core CRE segments will recover by the end of this year. The single-tenant retail sector remains strong, Hosier noted, and workforce housing developers still see short- and long-term growth opportunities. 

The $2 billion Stearns Bank still has significant capital levels and “plenty of opportunities” to grow through its diversified portfolio in equipment financing, short-term construction and bridge lending as well as loans backed by the Small Business Administration and U.S. Department of Agriculture. Section 42 Low-Income Housing Tax Credit lending will be a major part of the bank’s growth this year, Hosier noted. “Every article and statistic I have seen shows that homebuilding is in some level of a correction phase right now and probably will remain there until the benchmark 30-year loan yields return to the low 5 percent range,” he added. 

Though optimistic, Hosier says his outlook could change depending on how many more interest rate hikes the Federal Reserve Open Market Committee approves and the impact from the permanent markets’ coming absorption of an estimated $900 billion in loans expected to come due in the next couple of years.

The FOMC had already raised interest rates seven times over the course of 2022 before adding another 25-basis-point increase at its January meeting, bringing its target from near-zero to 4.50 to 4.75 percent. That is the smallest increase since last March, however. Stearns Bank has already been impacted by the rising rates, experiencing what Hosier called a “significant slowdown” in several lending areas, especially single-family residential.   

“Speculative construction in the industrial sector also tailed off significantly by the tail end of last year,” he noted. “Most developers who were already underwriting the inflationary pressures for materials and manpower as well as slower-than-normal responses and approvals from the various municipalities had to now adjust for the dramatically increasing rates. Some decided to shelve the project for the foreseeable future, a trend we expect to see going forward for at least the next few months.” 

Other CRE uncertainties pertain to long-term trends. Though firms could once construct a large building with the expectation that it would eventually be filled, that is no longer always the case. The number of employees consistently working from an in-person setting, though higher than the first stages of the pandemic, has not fully recovered. The tight labor market is also impacting CRE lending and growth. Unemployment remains low — at approximately 3.5 percent in December 2022 — as the labor force participation rate improves but remains below pre-pandemic averages after millions of workers retired early over the last three years.

To adjust, Stearns Bank has adjusted its underwriting metrics by keeping a close eye on real-time CRE market information, including submarket trends, while closely analyzing the project itself. Lenders review default rates in certain segments of the potential lender and any additional volatility in permanent markets. 

Rising interest rates have especially impacted the commercial residential real estate market. Thirty-year fixed mortgage rates have doubled from under 3 percent in the fall of 2021 to more than 6 percent. Existing home sales have fallen 30 percent from their peak and mortgage lending has faltered as well.

 The amount by which market asset ask prices exceed bid prices has also widened to between 8 and 20 percent, causing more office and self-storage deals to falter, noted Brian Bailey, an industry expert with the Federal Reserve Bank of Atlanta. The multi-family real estate market remains robust, but much of that is geared toward the high-end luxury space. Supply is starting to exceed demand, which Bailey expects will reduce price pressures. 

Part of the interest rate uncertainty stems from a lack of clarity in the Fed’s next steps. 

Federal Reserve Bank of St. Louis President and CEO James Bullard predicted in January that the FOMC will raise interest rates to higher than 5 percent to ensure that inflation returns to the Fed’s long-term 2 percent target. Federal Reserve Bank of Dallas President Lorie Logan said later that month that the Fed should not lock into a maximum interest rate and must instead adjust the target to the most current economic outlook.

The personal savings rate has fallen due to decades-high inflation readings. Consumers have responded by paring back on discretionary spending, which could adversely impact hospitality, retail and industrial CRE. Bailey said real estate taxes, insurance, utilities and labor costs will all likely see double-digit increases this year. Higher operating costs could lead to an erosion in business net operating income and impact CRE valuations, Bailey added. He expects companies with larger physical footprints will find it easier to consolidate their space than smaller businesses which only have a few thousand square feet of space. 

The potential downturn follows a period of rising CRE prices due to low inventory and a substantial rise in demand following numerous pandemic-era stimulus payments and years of low interest rates. NAI Iowa Realty Commercial Manager Kevin Crowley noted that residential real estate inventory had fallen to a record low over the last two years in the Des Moines market. 

 Though some NAI Iowa brokerage clients are still signing long-term business office leases, they are not undertaking large expansion projects en masse. Banks will need to adjust to these trends. “[Banks are] going to have to really understand the company’’s business plan, or if a developer owns a multi-tenant office space, they’re going to have to understand who their tenants are, or what their credits are, to really underwrite what’s going on there,” Crowley said. 

In the Kansas City Fed region, CRE subleasing increased late last year as more space once occupied by tech businesses became available. Prices fell, and terms became more favorable for new tenants. 

“Contacts reported they expect further acceleration in the amount of office space that will be offered on secondary markets in coming months,” the Federal Reserve stated in its January Beige Book. “Although credit quality remained stable in recent weeks, contacts reported deterioration in the next six months as higher interest rates impair property valuations and borrowers’ ability to generate sufficient cash flow for debt service, particularly in the CRE space.”

Crowley doesn’t expect any CRE downturn to begin until the third quarter of this year, noting that states with ag-based economies such as Iowa and Minnesota could see “more of a glancing blow” compared to previous recessions as business financials remain strong and ag land values continue to soar.

He predicted that the highest quality residential real estate inventory, labeled ‘Multifamily Class A,’ will continue to have low capitalization rates, while rates for Class B and Class C multifamily sectors will revert back to “market-sensible rates” as interest rates continue to rise. Crowley doesn’t expect the Fed will begin reducing interest rates until unemployment increases and economic growth falls to a more sustainable level. He predicted that the severity of the impact will depend on the flexibility regulators provide banks with on loan terms.  

“The interest rate bumps we’ve had from the Fed will have an impact on some of the transactions that have been done with interest-only loans,” he said. “People who are just up for a renewal are going to be in for maybe a shock when the bank is going to require additional equity in the deals and there’s just going to be some pain. Some people will be able to, some won’t.”

Despite the market challenges, pandemic-era predictions of the downfall of brick-and-mortar CRE were overstated and the market has stabilized, Bailey said. Crowley also sees positive signs in the market. Companies headquartered in the Midwest are shifting their industrial footprints from having smaller, more numerous distribution centers to using more centralized, larger spaces. Though speculation abounds that the industrial sector will slow in the near-future, Crowley noted that demand remains high and supply chain kinks are being worked out.    

The CRE services and investment firm CBRE Group, Inc., was more pessimistic in its outlook for this year, predicting a challenging 12 months for CRE lending due to high interest rates and recessionary predictions. Even as inflation fell last year, it remained at more than 7 percent, and the firm expects the FOMC to continue hiking rates until inflation falls to near the committee’s 2-percent long-term target. “Weakening fundamentals and higher cost of capital will generally lower asset values,” CBRE said.

Still, any recession is expected to be shallow as corporate finances remain healthy and employers avoid mass layoffs amid worker shortages. “While consumer confidence is highly subdued, average household debt is low compared with the onset of previous recessions,” CBRE Group stated. “These factors suggest a moderate downturn, with unemployment unlikely to breach the 6 percent level. Inflation will be significantly lower by the second half of 2023, setting the stage for falling interest rates and the beginning of a new cycle that will last to the 2030s.”  

Those trends come against the backdrop of banks facing more competition for CRE lending. According to CBRE Group, banks still had the largest share of CRE loan closings in the second quarter of 2022 at 38.1 percent, 10 percentage points higher than the year-prior. Alternative lenders such as debt funds and mortgage real estate investment trusts were the second-most active lending group with 32.2 percent of loan closings, a 10-percent drop from the year prior as bridge lending slowed. Though Bailey said non-banks provide less transparency than banks, their market share has still grown through providing borrowers with higher loan-to-value ratios.