Landlords Facing Challenges Refinancing Amid Rolling Bank Loans
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CRE Market Insight: Refinancing
January 2024
By Meghan Liddy, Sr. Vice President, Capital Markets
In response to the unprecedented challenges posed by the COVID-19 pandemic, the U.S. Federal Reserve introduced a historic fiscal stimulus package, infusing the economy with vast amounts of capital. This initiative helped stave off an economic contraction that many economists feared, but it also gave rise to a unique set of new challenges.
The Inflation Conundrum
One of the immediate consequences of the massive fiscal stimulus package was a surge in inflation rates. Armed with money pumped into their savings accounts, consumers went on a buying spree. However, the availability of goods was limited due to global supply chain disruptions. This imbalance of high demand and limited supply caused the inflation rate to peak at 9.06% in the second quarter of 2022. Price shocks began to subside thereafter, but rising wages driven by surging demand for labor kept inflationary pressures high for the next 12 months.
To tame inflation, the Federal Reserve implemented a series of eleven interest rate hikes between the first quarter of 2022 and the third quarter of 2023. During this time, interest rates soared from 0.25% to 5.50 and inflation decreased.
By the close of 2023, inflation had eased to 3.35%, although it still lingered above the central bank’s target of 2%.
The Impact of Rising Interest Rates
The deliberate series of interest rate hikes embarked upon by the Federal Reserve was not without its ramifications. These measures were instrumental in tempering overall U.S. economic activity, but they came at a cost. Increased borrowing costs left consumers with less money to spend. Businesses felt the pinch, too. Demand for their products and services lessened at the same time as the wages they paid their workers increased. As profits decreased, financial resources for investment and growth diminished.
This economic contraction significantly impacted the commercial real estate industry. Businesses became increasingly circumspect about expanding their real estate footprint. A decline in demand led to a surge in vacancy rates across virtually all types of properties, including industrial parks, retail stores, office buildings, and biopharma laboratories.
In the Metro Boston area, office space availability expanded to a staggering 24.5% during the fourth quarter of 2023, according to data from Newmark. And lab space availability surged to a 11.7% rate, according to Colliers.
This surplus of available commercial space has exerted downward pressure on rental rates. With lower rental income and mounting operating costs—attributable to factors such as escalating building material prices, labor expenses, and surging energy costs—landlords have seen their net operating incomes significantly constrained.
Debt Maturities Coinciding with Higher Borrowing Costs and Declining Property Values
This downturn in business has created a host of challenges for property owners and investors. Financing new real estate deals or refinancing existing loans became an increasingly expensive endeavor, resulting in a noticeable reduction in investment across the sector. With fewer investors actively pursuing commercial real estate properties, property valuations have experienced a noticeable downturn.
In many cases, landlords are finding themselves at a crossroads as their debt maturities coincide with a period of elevated borrowing costs, declining property values, and risk-averse lenders. This confluence of factors has made the process of refinancing difficult.
In an environment marked by elevated risk and uncertainty, most real estate lenders will require borrowers to inject additional capital into their loans as a prerequisite for refinancing. This mandatory requirement, while aimed at safeguarding lenders against defaults, poses a significant challenge for property owners. Some may find themselves unwilling or unable to meet these stringent prerequisites.
Moody’s Analytics reported that only one out of every three securitized office mortgages that matured during the first nine months of 2023 managed to be paid off by the end of September. This trend underscored a broader freeze in the lending market specifically for office buildings.
In the face of these formidable challenges, the need for banks and landlords to work together to find common ground has never been more important.
Banks do not want to take back real estate if they can avoid it. They would much rather hammer out a strategy with landlords so a mutually beneficial solution could be achieved.
Such strategies invariably will involve thinner debt coverage and higher leverage than normal. The alternative for banks is to take losses through discounted note sales or property foreclosure. It is more beneficial for both parties to negotiate and ultimately extend loan terms as the headwinds discussed stabilize.
Navigating the Road Ahead
Moving forward, broad market sentiment suggests that interest rates have likely reached their peak. Market participants anticipate a gradual softening, with the central bank expected to pivot by the end of 2024.
Until this anticipated shift materializes, banks and landlords must maintain close collaboration to navigate the complex financing landscape and identify commercial real estate property solutions that align with the current economic realities.
Interviews with landlords by Kelleher & Sadowsky confirm the view that closely working together with their lenders is essential. In this challenging market, it’s the only way that financial resources can be paired with the unique opportunities presented.
Leasing Activity in the Office Sector
Despite the challenges, there have been pockets of leasing activity in the office sector, particularly involving smaller space requirements. Workers are returning to the office and finding spaces that have evolved to the times. Landlords who adapt best will have the best chance to secure tenants.
Dynamics in the Industrial Sector
The industrial sector, while witnessing slower leasing activity for large blocks of space, continues to see demand for smaller space requirements. These smaller spaces cater to businesses with evolving logistics and warehousing needs, reflecting the changing dynamics of supply chains.
Multi-Family Sector: A Bright Spot
The multi-family sector remains a bright spot on the real estate horizon in the coming year. The persistent shortage of housing in the region positions multi-family properties as a compelling investment option – and one that banks are willing to finance.
Retail Sector: Quality and Location Matter
In 2023, the retail landscape witnessed a noteworthy shift with more store openings than closures. The expectation for 2024 is that the more robust (and creditworthy) retailers will continue to absorb and display weaker competitors.
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