Why Overcoming Current CRE Financing Challenges Hinge on More than Interest Rates

Interest rates are currently at their highest level in over two decades, yet inflation persists. Though many had hoped interest rate cuts were on the horizon as early as June, the Federal Reserve hasn’t been comfortable doing so just yet, with analysts expecting it to be September before the first cut.

The current climate has commercial real estate owners, occupiers, investors, and developers sidelined and anxiously awaiting news that inflation has been tamed and the economy is stabilizing. But it may not all hinge on interest rates coming down.

The higher cost of funds along with several other market challenges could impact lending for longer than expected.

A Perfect Storm

“Over the past year, we’ve felt the impact of the enormous influx of capital that was injected into the economy during the pandemic,” said Travis McIntyre, vice president at Park National Bank.

The issuance of Paycheck Protection Program (PPP) loans during the pandemic, and subsequently Economic Injury Disaster Loans (EIDL) intended to save businesses from the immediate impact of the pandemic, allowed many small businesses to pay down existing pre-pandemic loans early, and in some instances, stop turning to banks for new loans.

These loans were issued through 2022, and offered businesses a deferred payment with a fixed rate of 3.75% which made it difficult for banks to compete and decreased bank revenue, explained McIntyre.

Simultaneously, the interest rate for banks, known as the federal funds rate which banks used to fund short-term loan growth, sat at 0%. When the overnight federal funds interest rates began to climb, so did the cost of those funds to the banks. This meant that banks were now paying up to 5.25%, resulting in compressed margins. This change resulted in banks competing for deposits to fund necessary loan growth and tightened lending as banks didn’t want to jeopardize their capital liquidity ratios.

While the low, key lending rate had its advantages for borrowers, it wasn’t advantageous for those who were saving, which also had an adverse impact.

For roughly 15 years, those planning their retirement were unable to earn a return on the money held in their savings and money market accounts and began investing their retirements in risk-to-market areas such as the stock market, REITs, and real estate, explained McIntrye.

This phenomenon was felt nationally, but its pairing with the regional climate of unprecedented growth and the announcement of Intel created a microcosm in Central Ohio. Prices rose and stayed high as a result.

In addition, demand continued to outweigh supply, explains Matt Gregory, executive managing director at NAI Ohio Equities.

“As construction costs for new buildings continue to rise, it’s propping up the cost of existing buildings. This combined with lender’s increased underwriting requirements began to price out small businesses and the average investor,” added Gregory.

“Those who wanted in on the market began paying for assets based on their equity instead of their income,” explained McIntyre.

As a result, commercial real estate prices have risen and constrained lending.

“Buyers seeking financing now must put down as much as 40 – 45% and sometimes even 50% to cover the bank’s required debt service coverage ratio,” he continued.

Market Indicators

At the same time, core indicators that are traditionally indicative of a downturn aren’t affecting the market as they historically would.

“Consumer credit card balances are higher and bankruptcy filings have increased, which indicates a lack of personal cash flow for the consumer,” explained McIntyre.

However, the Dow Jones Industrial Average crossed 40,000 points for the first time in May and day traders have been undeterred. The stock market, which has historically reacted to these metrics, is being fueled by AI and tech stocks.

“Core indicators we once used to help understand the market have been inconsistent and less impactful,” explained McIntyre. “Inflation isn’t coming down as quickly as expected and the consumer price index has increased,” he explained.

These indicators, which the Federal Reserve would traditionally use as a barometer for the effectiveness of its rate hikes, aren’t reflecting the current market climate, causing a delay in rate reductions.

Will Lending Remain Impacted?

“We’re in a transitionary period. It’s difficult to know what the future will bring,” said McIntyre.

Solid banks will continue to lend, though some may not lend as aggressively as in recent years. Institutions that have focused on a specific asset class over the past five to seven years may need to divest if they have become too concentrated. Those institutions that have retreated from certain asset classes or ceased lending may find it more challenging to return to a robust lending model, he explained.

Banks with long-standing, long-term relationships and a strong customer base are well positioned to continue a model of controlled growth, he said.