Is the Worst Yet to Come?
-by Brandon Michaels and Chris Adnams
Notwithstanding the running debate on whether the U.S. economy will experience a hard or soft landing, commercial real estate markets are currently in a recession."
-Boston Properties CEO Owen Thomas.
The 2023 commercial real estate landscape is expected to be challenged by a significant slowdown in transactions and potential reduction in property values brought on by the unparalleled raising of interest rates by the Federal Reserve. In anticipation of the coming Federal Reserve meetings and review of how commercial real estate sales and values have reacted to interest rate increases thus far, it begs the question: have we seen the worst, or is the worst yet to come?
Federal Funds Rate Increases in 2022:
2022 was a year of unprecedented increases to the Federal Funds Rate. Starting the year, the rate was held to a range of 0.00% to 0.25%. Over the course of seven meetings, the Federal Reserve raised its namesake rate 25 basis points, 50 basis points, 75 basis points in four consecutive meetings, and one final 50 basis point increase in December. In the most recent meeting on January 31st and February 1st of 2023, the Federal Reserve continued its efforts against combating inflation, increasing the Federal Funds Rate by an additional 25 basis points, setting the current Federal Funds target rate to 4.50%-4.75%.
What Is the Federal Funds Rate?
The federal funds rate is the borrowing rate between banks used to meet daily reserve requirements. These loans are short term, often just overnight, and are unsecured. They are effectively an “IOU” between major depository institutions. The Federal Reserve sets a target rate determined during its Federal Open Market Committee meetings as a guideline with negotiations between the banks themselves determining the actual lending rate, referred to as the effective federal funds rate (EFFR).
Connection to Commercial Real Estate Lending Rates:
Commercial real estate loans are often tied to indexes influenced, in some part, by the effective federal funds rate. For real estate loans involving a property that is fully stabilized, such as a core or core + investment, the effective federal funds rate is typically not a crucial factor. Conventional financing is often based off the United States Treasuries. In reviewing the 10-year treasury yields throughout 2022, treasuries have increased, but not at the same pace as the Federal Funds Rate. In some instances, following a federal funds rate increase, US Treasury yields have briefly fallen, leading to relatively lower and more stable lending.
That being said, not all commercial loans encumber properties that are fully stabilized. In these cases, such as a value-add or opportunistic investments, the PRIME rate or Secured Overnight Financing Rate (SOFR) with the addition of a ‘spread’ determines the prevailing interest rate for a commercial real estate loan. These indexes are incredibly sensitive to rate increases, thus, as the Federal Funds Rate increases, PRIME and SOFR move in kind. This direct correlation has made financing these types of properties challenging or, in some instances, unattainable, putting Buyers for these types of assets at a significant disadvantage or taking them completely out of the marketplace.
What is the Impact on Rising Interest Rates to the Commercial Real Estate Market?
The effect of this sensitivity to interest rates can be seen when looking at recent sales volume and transaction data. Taking into account the four major asset classes, multifamily, industrial, retail and office throughout the continental United States, sales volume fell $85 billion in 2022 relative to 2021, representing a 9% reduction. The decrease is further accentuated looking at the total number of transactions, which fell from 253,623 to 226,261, representing an 11% decline.
These reductions, though impactful, do not represent the entire story, considering much of 2022 still enjoyed relatively low interest rates. In review the number of transactions that occurred in January of 2023 compared to January of 2022, the number of transactions fell from 18,229 to 10,597, a 42% reduction. Furthermore, sales volume in this same time frame was reduced from $58 billion to $23 billion, a 60% reduction (data sourced from Costar Analytics).
