January 16, 2023
As 2022 has drawn to a close, we can reflect on the events that have led us to the current market environment. After a strong 2021 and promising start to 2022, commercial real estate finance’s good fortunes quickly shifted with the start of the Ukraine-Russia conflict, widening credit spreads, and rising interest rates and ultimately disturbing supply-chain balances. Opportunities still exist for experienced managers and patient investors. The cornerstone for returns on real estate will be the understanding of the current market cycle.
With persistently high inflation, the Bank of Canada and the Federal Reserve moved aggressively to raise interest rates to slow economic activity and quell rising inflation expectations. The increase in rates has been quite dramatic: starting in March, the Bank of Canada increased its short-term policy rate at seven of its scheduled meetings, bringing up the rate from 0.25% to 4.25% as of this December. The U.S. Federal Reserve Board also commenced a series of increases in March, increasing the Federal Funds target range from 0-0.25% to 4.25%-4.5% in December. While labour markets have continued to show signs of expansion in recent months, economic growth expectations for 2023 have been downshifted. A sharp increase in mortgage rates has begun to have a ripple effect on activity, especially in the residential and commercial real estate markets. As of Q3 2022, residential sales are down by 29% and 23.8% in Canada and the U.S. respectively on a year-over-year basis.[1] Commercial real estate transaction activity slowed in Canada during Q3 2022 to about one-third of the strong pace set a year earlier in Q3 2021. Despite this decline, transaction activity remains above quarterly lows registered during the initial phase of the pandemic in 2020. U.S. commercial real estate transaction volume has fared better, with Q3 2022 volumes down 18% from year-earlier levels. With higher mortgage rates, the commercial sales market has entered a period of price discovery, characterized by wide bid-ask spreads. Sellers remain reluctant to discount to lower prices from leveraged buyers, who face much higher financing costs to meet required returns.
In U.S. markets, CBRE notes that while there has been a general decline in commercial mortgage market liquidity, deals continue to close. Life companies and private equity debt funds have capital to deploy, while multi-family agency lending remains strong. However, lenders have become more selective and conservative, and have generally lowered loan proceeds due to coverage and leverage constraints. Lender sentiment is more subdued, as the CRE Finance Council (CREFC) reported its fifth consecutive quarterly decline in its Board of Governors Sentiment Index in Q3, reflecting a more negative outlook for commercial real estate fundamentals, trends in the Commercial Mortgage-Backed Securities (CMBS) and Collateralized Loan Obligation (CLO) markets, and the overall outlook for commercial real estate finance.[2]
Some key trends in U.S. commercial real estate debt markets are noted below:
Lower loan closings. The CBRE Lending Momentum index shows that loan closings were down 11% between Q2 and Q3, and 4.7% on a year-over-year basis. Until mortgage rates stabilize, and cap rates adjust, deal volume is likely to remain subdued into Q1 2023.
Mortgage rate Increases. Fixed-rate senior loan costs tracked by CBRE jumped sharply between Q1 and Q3, due to widening spreads and higher benchmark rates. The overall fixed mortgage coupon rate averaged 4.61% in Q3, up 116 basis-points (bps) from Q1. Spreads on 55-65% loan-to-value (LTV) commercial and multi-family loans have increased by 32 bps since Q1.
Shifting lender composition. Banks were the top non-agency lenders in Q3, despite growing regulatory headwinds and more conservative underwriting. Securitized markets have suffered from volatile markets and higher spreads, which has led to progressively lower CMBS issuance volume during the year. CMBS issuance started off the year strong at $29.2 billion, downshifting to $13.3 billion by Q3. The CLO market has demonstrated a similar slowing pattern, with issuance declining from $13.2 billion in Q1 to $3.39 billion in Q3. Several alternative lenders who have tapped the CLO market to term finance their acquisitions of floating rate bridge loans, have faced higher costs of CLO financing, while their borrowers have faced sharply rising premiums for floating rate interest caps on their loans.
More conservative underwriting. Average LTVs on permanent fixed-rate commercial loans have declined 3.5 percentage points over the past year to 55.8% as of Q3. As senior lenders have become more selective, underwritten debt yields and cap rates have increased.
Figure 1 – Benchmark interest rates rose sharply in 2022
Sources: Bank of Canada, Federal Reserve Bank of St. Louis
Looking toward peak rates
As lenders and borrowers navigate volatile markets, many question how much longer central banks will continue to tighten interest rates and when they might stabilize. Past cycles offer some insight into the length and the magnitude of increases. Since the early 1980s, the average Federal Reserve tightening cycle has lasted 21 months with Federal Funds having an increase of 3.02%. In Canada, the average Bank of Canada tightening cycle has lasted 18 months with an overnight rate increase of 1.94%%.[3] This would suggest the magnitude of the current tightening cycle has already surpassed recent historic averages within a relatively short time frame.
However, the current cycle is unique due to the conditions that led to higher inflation: a period of very accommodative monetary policy during the initial stages of the pandemic, the economic recovery following the relaxation of pandemic-related restrictions and the supply chain disruptions that ensued, and global energy supply issues that emerged because of the Russia-Ukraine conflict.
Stabilization of interest rates will be tied to progress in reducing inflation. While it appears that core price inflation has peaked in recent months, inflation remains well above central bank targets.[4] (Figure 2) Market participants anticipate additional rate hikes, but the size of future increases will likely be tempered by the central bank’s concerns that recent increases will lead to a contraction in economic activity in early 2023. After a 1% increase to the overnight rate in July, the Bank of Canada slowed the pace of increases to 50 bps in October and December. The Bank signaled that it may soon pause increases as it weighs their effect on economic activity. Meanwhile, the Federal Reserve reduced the size of its recent increase to 50 bps in December, following several 75 bps increases. It is suggested that central banks are likely to take a more cautious approach toward rate increases in 2023, increasing the likelihood of reaching “peak rates” in Q1 2023.[5] As market participants anticipate peak rates, the benefits in terms of additional lender participation and lower financing costs will become more apparent in the commercial mortgage markets. In recent weeks, floating interest rate cap premiums have begun to fall, a sign that markets anticipate a lower probability of higher future short-term rates.
Figure 2 – Core inflation has peaked, but remains elevated
Sources: Statistics Canada, U.S. Bureau of Labor Statistics
The silver lining – opportunities amid the turmoil
With signals that tightening may continue, there will likely be a period of relatively conservative underwriting and lender selectivity in early 2023 as rates stabilize. However, opportunities are expected to emerge because of higher mortgage rates and market dislocation.
Borrowers in need of refinancing are likely to face lower proceeds on new senior loans due to higher rates and more conservative underwriting. This “refinance gap” will provide opportunities for alternative lenders to provide mezzanine or bridge lending to cover shortfalls in new senior loan proceeds.
Asides from the office sector, the supply and demand balance in commercial markets remains healthy, particularly in the residential multi-family and apartment sectors. With regulatory scrutiny of capital requirements and concerns of their exposure to commercial real estate, banks are likely to restrict construction financing to focus on top customers, creating opportunities for non-bank alternative lenders.
Among the uncertainty, greater opportunities still exist in the Southern U.S. states with low taxation, population growth and warmer climates. Trez Capital remains well positioned to take advantage of these opportunities that are likely to result from the higher interest rate and more conservative lending environment.
[1] Sources: CREA and National Association of Realtors.
[2] See Bubny, Paul, “CREFC Survey Reports Fifth Consecutive Quarterly Drop in Sentiment”, at https://www.connectcre.com/stories/crefc-survey-reports-fifth-consecutive-quarterly-drop-in-sentiment/
[3] See https://www.chathamfinancial.com/insights/historical-interest-rate-tightening-cycles, Bank of Canada, Federal Reserve Board, and author’s calculations.
[4] The Bank of Canada has a 2% inflation target, the midpoint of a 1-3% target range. https://www.bankofcanada.ca/core-functions/monetary-policy/inflation/. The U.S. Federal Reserve has over recent history targeted 2% increase to the personal consumption expenditure price deflator, a slightly broader measure than the consumer price index, as part of its “dual mandate” of achieving full employment and price stability. See https://research.stlouisfed.org/publications/economic-synopses/2022/09/02/inflation-part-3-what-is-the-feds-current-goal-has-the-fed-met-its-inflation-mandate
[5] Oxford Economics Canada report 11/15/2022, and U.S. report 11/9/2022 at www.oxfordeconomics.com