How’s your capital stacking up these days?
The Federal Reserve has decided it’s time to start fighting the worst inflation since the 1970’s, by announcing on June 15, 2022, a 75-basis point increase in the Federal Funds Rate. This is the largest increase since 1994 and one that should not be overlooked. To give you additional historical perspective, the 10-year treasury is the standard to which most lenders in the commercial real estate industry peg their loan rates, and today this number stands at 3.25%, and has increased by 117% in 9 months. Here are a few indicators to provide insight as to where the industry is heading.
Negative leverage in commercial real estate
The single most important aspect of investing in commercial real estate is net positive cash flow. Negative leverage is when the capitalization rate is less than the interest rate assigned to the debt. This becomes an untenable situation for investors. If a buyer currently has a property under contract, and has yet to lock in an interest rate, they may have to trade down on the price, or walk away from the acquisition.
Possible Outcome 1: More properties coming back on the market at lower prices.
Commercial loan term cycles
As interest rates rise, and debt becomes more expensive, overzealous buyers who paid a premium at the top of the market, and leveraged with debt to excessively high levels, are now being forced back into an increasingly hostile debt market with tighter lending criteria and more expensive debt service. According to Trepp, an estimated $450 billion in CRE loans will mature in 2022, a new annual record.
Possible Outcome 2: More properties falling into default by lenders.
Small Business Defaults
Higher interest rates not only affect real estate markets. They affect small businesses that rely on debt to finance their business, from receivables, to equipment and leasehold improvements. According to Markus Lahrkamp, a managing director at advisory firm Alvarez & Marsal, “The first wave of real distress is probably going to hit us kind of mid-year. For the first ones, they might have too much leverage, they were not prepared, the companies were not operationally sound. And then from there, it will probably trigger into more and more.” When businesses don’t pay rent, commercial real estate suffers. Watch the Business Bankruptcy Meter to help determine the health of the overall CRE market.
Possible Outcome 3: Small business bankruptcies may cause more commercial real estate to default on loans.
The inflation tax is inescapable, and extremely hard on the poor and middle class, especially seniors who live off fixed income. We could argue who caused this inflationary environment, but I would rather talk about how to profit from predictable factors that may cause distress in the commercial real estate market.
Disruptions in the marketplace are when opportunities arise, and this may be one of the best times to start thinking about where and who to invest with in commercial real estate.