3 Trends Impacting Commercial Real Estate Lending Today

The famous real estate investor that once planned to tear down Carnegie Hall and replace it with a rather boring, but most likely profitable 40-story building once said, “The best investment on earth is earth.”  Many would have said that would not have been true during the pandemic, as “work from home” and “shelter in place” was the mode from many CRE residents.

The easing of Covid-19 restrictions, coupled with a gradual return to the office, has invigorated urban markets previously dampened by the 2020 pandemic and started to lead to a robust driving of dollars and investments. On a trailing-four-quarter basis, New York was the top market for investment volume, attracting $67 billion. Los Angeles came in second, bringing in $65 billion in investment volume. In fact, according to CBRE, Commercial Real Estate (CRE) investments were basically giving a 10% year over year investment, with acceptable risk.

But as we come to the end of an interesting economic year, some key trends are going to impact how we look at CRE and how we make it a part of our loan portfolio. In this three-part blog from Baker Hill, a leader in loan origination and loan portfolio monitoring, along with business data experts, Equifax, we will explore these CRE trends and the risks associated with CRE lending.

Let’s look at some of the trends and why you should be focused on these CRE considerations:

Interest Rates and Inflation

Unfortunately, most bankers have never been in an environment like we find ourselves today.  Inflation is running at more than a 40-year high and in an effort to stem the tide the Federal Reserve (along with most global banks) responded aggressively with consecutive interest rate hikes (some of them being the largest hikes in decades). The more rates rise, and the longer inflation stays elevated, the greater the fear of a recession.

These higher rates have radically changed the cost of capital. Just like we have seen in the cooling home mortgage market, these higher costs of capital shut some borrowers out of the CRE market. According to MSCI, the overall commercial real estate deal making at midyear reflected a decline of 29% (in terms of number of properties) compared to the first half of 2021.  Most bankers that we talk with expect that CRE transactions in the first part of 2023 to continue the cooling trend as buyers pull out of deals due to higher borrowing costs.

CRE Valuations

With the “office first” concepts varying across the nation, we are seeing the office sector being rewritten as companies renegotiate rents and consider the redesign of their office footprint with a post-pandemic workforce. This is dramatically changing the valuations of those properties based on their rents.  The retail sector is a mixed bag of subtypes and geographies with varying risk profiles and the servicing of those CRE occupants and their workers. The strongest lending opportunities are in retail conversions as obsolete properties are either renovated to meet the demands of today’s consumer or repurposed into entirely new uses. What we are also seeing is that many CRE investors are holding off in the event property prices fall as valuations catch up with changing market dynamics driven by inflation pressures and the cost of capital based on the increased interest rates.

Increased Power of Tenants

Lastly, changes in lease agreements and the make-up of tenants are dramatically impacting the risks associated with CRE opportunities.  The National Association of Realtors showed that coming out of 2021, vacancy rates hit over 12 percent. This new normal in vacancy made it so that tenants are now negotiating shorter rental agreements, with lower rates, and looking to have conditions that support a hybrid workforce. These new tenants and the power that they hold (along with the risk they bring) make CRE lending and investment more challenging than ever.

Join in the conversation  as we look next at how we can review the risks associated with tenants and how you can monitor and keep a sound CRE loan portfolio.  Also, in the meantime if you want to have us reach out to you, please contact us here.

Other blogs in this series:

“Not Knowing” About Commercial Real Estate Tenants Is Not an Option

Meatloaf Would Do Anything For Love But Never Did CRE Lending

Author Bio

With more than 25 years of experience in the financial services industry, Mike Horrocks possesses a unique and extensive blend of financial expertise, technology skills, process redesign abilities and solution management experience. Horrocks’ background enables him to create go-to-market strategies for new solutions, help clients convert strategies into revenue generating initiatives and forecast market direction.

As the Vice-President of Product Management at Baker Hill, Horrocks’ responsibilities include the identification and development of new market opportunities in the business of lending, risk management, and analytics for financial institutions. Mike holds a MBA both in International Finance and Venture Technology Management from Indiana University and a B.S in International Finance from Brigham Young University.

Before joining Baker Hill, he held executive positions within several other organizations, including Experian, Profit Technologies, SAIC, Broadway and Seymour (FIS), Zions First National Bank and Zions Data Corporation.

Horrocks is a member of many associations including the Risk Management Association and Bankers Without Borders. In his free time, he enjoys traveling internationally with his wife and five children.