Respondents shared that the current credit environment is on the tighter side of that range.
FEDERAL FUNDS EFFECTIVE RATE, JULY 2003 TO JULY 2023
Image Source: Fred Economic Data | St. Louis Fed
Impact of Credit Tightening on CRE
In a tighter lending environment, banks reserve their loans for only the most credit-worthy borrowers, seeking to underwrite less risky loans. A challenge here is that the refinancing options become constrained. Investors may need to inject more capital into their assets to complete a refinance, and they may be forced to sell assets to accomplish this.
These forced asset sales can lead to transactional evidence for price declines, perpetuating the cycle of negative market growth.
Price discovery has been a widely discussed topic in this first half of 2023, as both the dollar and transaction volume of CRE sales has experienced a marked decline year over year. Of course, the first half of 2022 still carried noteworthy deal momentum as investors scrambled to allocate excess liquidity while interest rates were still near historic lows. The volume of these sales and elevated property valuations do exacerbate the year-over-year declines we are currently witnessing.
Still, the upcoming wave of loan maturities for CRE (an estimated $1.5 trillion over the next three years, according to Trepp) combined with the likelihood of constrained credit, is a concern to many market participants. Because commercial real estate mortgages often have an amortization period longer than the life of the loan, borrowers primarily pay interest during the loan term and must make a larger payment (a balloon payment) at its end to cover most of the loan principal. In a weakened economy with declining property values, maturing loans can cause a significant burden on CRE property owners who have a lack of liquid capital and an outstanding loan balance greater than the current market value of their property.
While CRE transactions have slowed across the board, their decline is most acute for Class A commercial assets. These are typically purchased by institutional investors rather than private investors, and these investors have been taking a wait-and-see approach as the Fed continues to raise its rates in response to inflation.
Private investors have increased their share of overall transaction volume in the first half of the year and will likely be keeping an eye on opportunities in the emergence of distressed assets when so many enter refinancing negotiations.
In its latest meeting, the Fed neither foreshadowed upcoming increases nor indicated they would dispense with the increases in their remaining meetings this year, saying instead that they would be looking to the data to determine their next moves.
Should the Fed enter a holding pattern, investor and consumer sentiment would likely be positive, and it may signal less need for increased credit tightening over the last half of 2023, bringing some stability to CRE markets nationwide. If not, and credit continues to tighten, it will pose continued challenges for the CRE market, particularly in the face of the upcoming loan maturities.
Investors, appraisers, and other market participants will continue to keep an eye on CRE transactional data and economic metrics, such as inflation and employment, as we assess the changes in the market.
With such highly variable market conditions, there is both great challenge and opportunity at play—placing an even greater emphasis on data-driven decisions.