Marc Perkowski

Commercial real estate has generally performed well throughout 2022. Apartments are full, warehouses are renting at record rates, and malls and hotels are rebounding from the impact of COVID closures. Despite the good performance, CRE owners find the debt market to be increasingly constrained and costly. Factors within the broader capital markets, such as Fed policy, the corporate bond market, and savings account balances, affect the lending terms CRE capital providers can offer. Here are some of the most important factors.

Monetary center banks

The largest US banks are subject to Fed reserve requirements, which are determined by annual stress tests. The measures applied for the hypothetical 2022 scenario were particularly severe, with the model assuming a 10% unemployment rate, a 40% drop in the value of commercial real estate and a 55% drop in stock prices. Although the 34 banks designated as “big banks” by the Federal Reserve passed the test, some then had to take steps to ensure they could withstand such a doomsday (albeit unlikely) hypothetical scenario. This forced banks to cut lending and tighten credit standards, which not only had an immediate impact on the biggest borrowers – such as REITs, pension funds and debt funds – but also had a ripple effect on the entire commercial real estate industry by increasing the cost of capital for all borrowers.

Insurance companies

Insurance companies take a very long-term approach to investing and lending. They invest the premiums in a diversified set of assets, including stocks, corporate bonds, government bonds and commercial mortgages. The investment team evaluates investment options based on relative value and modifies allocations based on performance metrics. Their CRE mortgage rates are directly impacted by corporate bond market rates. Corporate bond spreads widened in the first half of 2022 as the market pivoted towards a more “risk-free” investment thesis. This has caused insurance companies to raise commercial mortgage rates to match the returns they can get on corporate bonds.

The good news for borrowers is that many insurance companies are reluctant to stop lending altogether. It takes time to create a pipeline of good loan opportunities, and insurance companies want to remain an active and available source of capital for their best customers. Many lenders will write loans at sub-optimal rates (for a short period) in order to maintain relationships with long-term borrowers and mortgage bankers.

Community banks and credit unions

The primary source of capital for local banks and credit unions is their deposit base. During a recession, savings levels tend to decline; Northwestern Mutual 2022 Planning and Progress Study reports that the average personal savings of Americans fell 15% between 2021 and 2022. This diminishes the lending capacity of community banks and credit unions, prompting them to tighten standards and raise rates. This leads to natural loan volume attrition while simultaneously improving credit quality and increasing performance metrics.

In times of economic uncertainty, banks and credit unions are more likely to lend to regular borrowers with long-standing relationships. They are also attracted to loans that generate deposits, ideally 10-20% of the loan amount. This means that C&I (operating business) loans and CRE loans with an operating component become more favored by local lenders in times of recession. Examples include owner-occupied industrial buildings, self-storage facilities, and high net worth borrowers who are willing to store personal deposits with the lender.

CMBS Lenders and debt funds

CMBS lenders and debt funds are strongly affected by fluctuations in the capital market. CMBS lenders temporarily store the loans on their balance sheet until they are bundled with other loans and sold to bond buyers. Debt funds also securitize loans or borrow from large monetary central banks using their loan portfolio as collateral, allowing them to maximize the return on their equity investment.

Stock market volatility this year has led to a rapid decline in demand for securitized bonds, causing spreads to rise. Spreads in the higher tranches were about 70 basis points higher this summer compared to the fourth quarter of 2021. Some lenders had to sell their loans at a loss (i.e. pay bond buyers a higher interest rate than the underlying loan) just to get them off their balance sheet. In response, CMBS and debt fund lenders raised their prices to hedge against continued market deterioration.

There may be light at the end of the tunnel, however. Spreads have recently come down from their highs and the market appears to be stabilizing. Although a higher rate environment is likely to continue, prices will stabilize as lenders gain confidence in their ability to offload loans into the secondary market.

Behind-the-scenes factors like Fed policy, bond rates, and consumer savings rates have a powerful effect on the amount and cost of capital for commercial real estate. Lenders have become much more cautious in 2022, for now reducing CRE bets or setting higher prices for loans. But capital is still available for a price, and while 2021’s relative free flow of capital has diminished, lenders will continue to seek out good opportunities that complement their loan portfolio.