April 27, 2023

Show Me The (More Expensive) Money

Shawn Swenson


IT’S WELL PUBLICIZED HOW MUCH INTEREST RATES have increased over the past year. The Prime Rate has increased 4.25% and the 10-year US treasury has increased nearly 2.0% since early 2021. These rate increases have a direct impact on borrowers, and they’re impacting the Commercial Real Estate (“CRE”) market. We can all agree debt is more expensive. What about the availabil- ity of debt?


In conversations with lenders in late 2022, there was a very clear pattern: The larger the institution, the less lending on CRE. National lenders essentially stopped lending, regional banks were continuing to lend, but at a slower pace. Local and community banks remained the most active, but not to the level they were in early 2022. Most lending that occurred focused on existing properties with proven cash flow. Speculative deals and new developments were gener- ally out of the question.


There’s more to the story on interest rates for CRE borrowers. Given that lenders have less appetite for new loans, they’re increas- ing their profit margin. Adding a higher profit margin, which is some- times referred to as a loan spread, to a higher base rate has a dou- bling effect. This places additional stress on floating rate loans and maturing loans. Imagine a CRE borrower looking to refinance a matur- ing loan that was fixed at 3.5% with current rates at 7%. Depending on the project’s leverage, that presents a problem.


Today’s problems lead to tomorrow’s opportunities and often that opportunity must be funded with more of equity and less debt. While equity capital isn’t as robust as it was a year ago, most indus- try professionals believe there’s ample money “on the sidelines” waiting to be deployed. However, don’t expect this to happen in early 2023, as it takes time for loans to be earmarked as troubled. If rates remain high and debt capital is tight, the industry may even- tually be in a situation where lenders are willing to take a “haircut” to move a troubled loan.


The key to all of this is duration. How long do rates stay elevated and how long do lenders tread cautiously? The answer to these questions will have a significant impact on the CRE market in 2023.


During my time at the University of Wisconsin, a well-known Chi- cago developer came to speak to the real estate club. He told us there were three things we needed to remember from his presentation. Truth be told, I can only remember one: You must have access to cap- ital. In my defense, he did say that was the most important one. We will all see how important that is in 2023.