CREFC January 2024: Great Expectations

With characteristic optimism, the commercial and multifamily finance industry gathered in South Beach for the Commercial Real Estate Finance Council’s annual outlook on the lending market. In the worst of times this is an enthusiastic group, and this year was no different. Most felt there was nowhere to go but up after 2023 and they are justifiably confident that interest rates have peaked and have nowhere to go but down. A fall in rates could make real estate deals work again, improving transaction volume and allowing the industry to earn its keep.

So much of the discussion was about interest rates the conference could have been called “Rate Cuts 2024.” Interest rate specialists were brought in to discuss the possible paths of rates, all of whom (of course) had different opinions. There was general consensus that short-term rates would fall at some point in 2024 but a lack of faith that the ten-year Treasury rate would move that much. Both timing and magnitude remain elusive. Nonetheless, one panelist encouraged the more than 2,000 people at the conference to “jump in now;” believing we’ve hit bottom and price discounts will quickly evaporate as capital rushes into the market.

The direction of rates is extremely important to borrowers who have struggled to refinance loans and hedge floating rates. A number of people believed borrowers were far more willing to transact at a 4% rather than a 5% ten-year Treasury. During the last 18 months many borrowers changed their lending habits, moving from short-term, floating rate loans with prepayment flexibility or the typical ten-year fixed rate loan to five-year fixed rate loans. That pattern is starting to reverse as borrowers use floating rate debt to ride down rates and get out of under-performing properties when the market provides a reasonable bid.

While at last year’s January conference participants were hoping for a recession and a steep decline in rates, by now it has sunk in that rates won’t return to pre-2022 levels any time soon. Even if SOFR falls 100 basis points it will still be a lot higher than what the industry has grown accustomed to. Both lenders and borrowers will have to navigate this new reality. No one wanted to discuss the other major component of our new reality: property values. The word wasn’t mentioned through a good portion of the conference and initially simply referred to as the ”V” word. It will take more time for owners and lenders alike to discover where values land and how that will impact the ability of borrowers to finance and refinance their investments.

Unfortunately, those borrowers have less lender choices than in the past. There is less liquidity for senior debt even when there seems to be excess liquidity for mezzanine debt and preferred equity. Panelists believed banks will continue to pull back from commercial real estate and described CMBS as the lender of last resort. For borrowers, CMBS deals are too complex, too uncertain of the mortgage rate until just before closing, and too difficult if there is a problem. Alternative lenders are flush, but the high rates they charge are painful.

The other topic everyone tried to avoid but kept coming back to was office distress. Uncharacteristically, there was little hope in the room for an office recovery, except by a few office brokers. And there was concern that distress was building in other corners of the market:

• Further slowing of rent growth and property cash flow erosion,
• The fate of value-add multifamily deals with near-term maturities in CRE CLO pools,
• The drop in appraised value since origination in resolved loans and its impact on loss severities,
• The growing number of incidents of warehouse lenders foreclosing on bridge lenders,
• The increasing concern by master servicers about the recoverability of their advances, and
• Higher insurance costs as the properties prove vulnerable to more frequent incidents of catastrophic climate events.

Despite these risks, industry participates are looking for the clarity and stability that capital needs to come back into the real estate market. Many were looking for the Fed to “do the right thing,” which doesn’t seem like a reliable business strategy. But a clear signal that rates are moving downward and the yield curve is steepening would encourage new transactions and allow loan extensions to get some borrowers out of trouble. That picture might look like a 3.5% SOFR and a 4% ten-year Treasury by CREFC January 2025. The real question to be answered in the next twelve months may be whether the lowering of rates will reveal a longer-term deterioration of commercial mortgage credit or improving property performance and valuations.