As inflation continues to pressure property markets and the broader economy, questions are swirling in industry circles about whether the cost to finance commercial real estate will tick up.
US commercial mortgages originated last year showed an average 3.7% coupon rate for 7/10-year fixed rate products, according to data from Real Capital Analytics. As of March 2022, the rate had ticked up to 4.3%, a 60 basis point increase. And “increases in other rate instruments could foretell further commercial rate increases if traditional relationships hold moving forward,” RCA’s Jim Costello writes in a new analysis.
The 30-year fixed rate residential average from Freddie Mac was 5% in April, up from 3% in 2021. But Costello notes that the number fell much more than commercial rates during the height of the pandemic, and says it’s not clear that commercial mortgage rates will increase to the same extent in the future.
“This said, over the years commercial mortgage rates have averaged 55 bps higher than this residential mortgage rate,” Costello writes. “If this relationship simply returned to normal trends, the 5.0% read for April would imply commercial mortgage rates jumping to 5.5% or 5.6%. Again, not enough data is available yet to make that call, but conversations with industry professionals in recent weeks suggest that commercial debt costs are going up, particularly for the riskiest product. ”
Costello opines that property values would be challenged if mortgage rates tick up due to inflation, raising a hypothetical example of a logistics asset purchased at a 4% cap rate with short-term debt last year at a 3.7% coupon rate.
“That 30 bps of spread between the cap rate and the mortgage rate does leave some room for free cash flow outside of debt service,” he says. “Into 2023 as such a short-term loan reaches maturity, what happens when that 3.7% coupon rate is pushed up to 5.5%? Will there be a next buyer willing to pay at the same low cap rates when mortgage rates are higher? ”
Ultimately, Costello says “the relative aggressiveness and dependence” on the income growth assumptions investors are underwriting will be a “key point to survival” as mortgage costs increase.
In April, the Mortgage Bankers Association released figures predicting a holding pattern for commercial mortgage borrowing and lending this yearbut said they expect borrowing and lending to pick back up in 2023. Multifamily lending alone is expected to decline 11 percent in 2022 from last year’s estimated record of $ 470 billion.
In prepared remarks, Jamie Woodwell, MBA’s vice president for commercial real estate research, said the interest rate and economic outlook has shifted since MBA’s updated its commercial real estate finance forecast in February.
“The rapid rise in interest rates is expected to take some wind out of the sails of new lending activity, but healthy property fundamentals and strong property values should support the markets and keep commercial real estate mortgage demand at strong levels,” Woodwell said.