How rising interest rates are affecting the real estate industry

Commercial Mortgages

It is not likely that Jim Morrison and the Doors were singing about real estate investors in their classic "Riders on the Storm," but it describes the situation today for just about anyone involved in the industry.

Lenders have plenty of money, but pricing is all over the map. Developers have projects in varying stages of planning but are trying to ignore the storm clouds of high costs and spiking interest rates. Buyers, brokers and sellers are struggling to find common ground for deal-making as swirling interest rates make it difficult.

The industry is adjusting to a new paradigm of lower values because of higher interest rates, and the adjustment is causing waves that affect just about everyone. Take multifamily, the darling of the real estate industry. Many value-added multifamily transactions over the past several years have been structured with high-leverage floating-rate debt and aggressive rental growth and exit cap rates. Even if the developers executed their business plans perfectly - no cost overruns, timely completion, rents increased according to proforma - no one underwrote the dramatic rise in interest rates, which is putting stress on these deals even if they are 100% occupied.

According to the latest John B. Levy Commercial Mortgage Survey, five- and 10-year loans are pricing in the 5.75% to 6.25% range for lower leverage deals. Floating-rate non-recourse transactions are pricing in the 7.75% to 8.25% range, but that could easily be .50% higher before summer as the Secured Overnight Financing Rate, or SOFR, adjusts upward.

As a comparison, longer-term fixed rates ranged from 3.25%% to 3.50% at this time both last year and in 2021. Floating rates were as low as 3.50%.

With rates increasing so rapidly, it is not difficult to understand that things are not what they were. The problem for most in the market is trying to understand valuations.

The edge of the storm is currently hovering over office markets in larger cities. Several stories have emerged where large and capable borrowers are handing properties back to lenders to let them deal with falling values. Uncertainty related to tenants downsizing combined with higher interest rates have conspired to force a reckoning, and the implications for the overall market are still unclear. At the least, this will make new loans more difficult as some lenders turn their focus to loan workouts.

In a smaller market like Richmond, the problem emerging in office properties is not as pronounced. According to data from Cushman & Wakefield| Thalhimer, the overall office vacancy rate closed out 2022 at 8.2% (Colliers was higher at 12.2%). National data from CBRE indicated that the vacancy rate for offices across the country averages 17.3%, making Richmond look relatively good.

More important for office owners, several sales and leases at the end of 2022 in the Richmond area were positive and supportive. Genworth leased/subleased approximately 175,000 square feet at 11011 and 11013 W. Broad St. in Innsbrook, and Lingerfelt sold a portfolio of Innsbrook office buildings for approximately $165 per square foot.

The other transaction showing a floor price per square foot for vacant buildings was the BHE purchase of two vacant office buildings at 10700 and 10750 Wheat First Drive for over $100 per square foot.

While the storm kicks up and the industry adjusts, some markets will fare better than others.

John B. Levy & Co. partner and investment banker Andrew Little can be reached at alittle@ jblevyco.com.<!--p:BC TAG Body Copy Tagline-->