Executive Summary
While some financial pundits predict near-term interest rate cuts, others, such as Sam Millette, director at Commonwealth Financial Network, believe “the May [2024] estimate is likely to prove to be too early and a first cut in the second half of the year is more probable.” Raphael Bostic, president of the Atlanta Federal Reserve, expects rates to stay elevated until at least late 2024. Source: Money. Rates may have stabilized somewhat, but the damage has been done and continues to plague CRE, Commercial Real Estate leaders.
Deloitte’s 2024 Commercial Real Estate Outlook paints the industry as one trying to find terra firma, firm ground). Deloitte’s writers use a floating piece of commercial real estate to depict an industry floating rudderless and airborne, looking for a direction and a place to land. Financial concerns are but one of the industry’s many challenges.
Rising interest rates increase foreclosures in several ways. Yet Commercial Real Estate leaders would be advised to look past the hard-to-predict numbers and embrace the trends pulling at the industry globally and in the U.S.
The formula for success: It’s still wise to heed interest rates and foreclosure numbers. But success in this industry may stem from being flexible, creative, and open to what is unknown in this post-pandemic Commercial Real Estate domain, which is still on shaky ground. The winners will find terra firma by recognizing and capitalizing on opportunities their competitors miss. Is foreclosure one?
Five Ways Higher Interest Rates Contribute to Foreclosures
Many forces can cause foreclosures in commercial real estate. The pandemic was one. While land, labor, and capital define the playing field in the CRE market, interest rates set the rules of the game. Here are five ways interest rates affect CRE. Number five is the most important of them all.
- Higher interest rates increase debt servicing costs relative to the property incomes that have not kept pace. When a property does not generate sufficient revenue to cover debt service costs, it may lead to default and eventual foreclosure. Even “hedging” products, such as interest rate protection agreements designed to protect the borrower, have skyrocketed in price. Reuters reports that the average cost to buy one such interest rate protection policy increased tenfold over a year ago. Mitigating risk itself is a risk to commercial real estate investors.
- Refinancing is often out of reach with rising interest rates. Even if a property owner has been making payments, there may come a time when the loan needs to be rewritten: the terms of the loan may require it. It could also be that the owner seeks refinancing to avoid default. If the lender cannot safely deliver a loan product, the corporation or investor/owner may be forced to sell the property or default on the loan. On the lender’s side, when they foreclose, they are stuck with a property they may not be able to sell. The spiral spins down.
- Diminished property values often result from higher interest rates. As the cost of money increases, the demand for commercial real estate weakens. The forces of supply and demand dictate that the property price will decrease as demand slides, lowering the property’s value in the marketplace. The LTV Loan-to-Value increases, and lenders are more exposed. They usually respond by protecting themselves with additional loan requirements, which borrowers may be unable to meet. If the borrower and lender cannot agree, default and foreclosure often ensue.
- Higher interest rates also affect the tenants in commercial real estate properties. From retailers in shopping malls to corporations in high rises, higher interest rates mean loans cost them more. If they face decreasing revenues as the economy contracts, they struggle to make ends meet. They leave the property. Vacancies, in turn, mean less rental income for CRE owners, who also strain to meet mortgage payments. The cycle twists out of control.
- Rising interest rates destroy investor confidence: The worst of it is that the reason for interest rates rising is the Fed’s attempt to cool the economy! Everyone feels it, from the mom-and-pop grocers to the rocket builders and their suppliers. The Deloitte report’s respondents pointed to “the cost of capital and capital availability as the weakest among real estate fundamentals.”
Opportunities for Savvy Investors
Rising interest rate clouds come with silver linings. While the negative impacts of rising interest rates challenge profits and reduce maneuverability in commercial real estate circles, the braver and more liquid players have an opportunity to scoop up properties at greatly reduced prices. It’s risky, but either way — whether in the office buildings sector, retail, industrial, residential, or hotel/entertainment industries—players in the commercial real estate markets have their work cut out for them.
Conclusion
Rising interest rates are one of the forces that are increasing foreclosures in the CRE marketplace. Increasingly, non-financial factors distract industry leaders. Of the top five macroeconomic elements from the Deloitte report, cyber risk and sustained high inflation count as two, whereas supply chain disruption is the next one on the list. Few outsiders would consider supply chain issues a major contribution to the CRE industry’s unease. We don’t know what we don’t know.
The suggestion for the CEOs at the top of the CRE management chains might be repeated in other industries. Deloitte recommends “proactive property portfolio structuring and risk mitigation, value creation through green and decarbonization initiatives and tax incentives, and by transforming operations and technology.” Creative. Proactive. Green. Transformation. Technology. These words can be applied universally in our post-pandemic world.
Heed rising interest rates, of course. Foreclosure, in large numbers, is a symptom of a marketplace needing terra firma to be sure. However, investors with vision and cash to spare could find a silver lining in the depressed foreclosure property prices.