Rising Interest Rates: Challenges and Opportunities in Commercial Real Estate

As we navigate through a landscape marked by significant shifts in lending practices and economic uncertainties, you will need to be both informed and adaptable in order to find success in financing real estate.   

Investors and owner-users may be familiar with financing based on their experiences with current banking relationships. However, the current lending environment presents unique challenges and opportunities that demand a broader perspective.

High interest rates and bank liquidity issues, partly stemming from events like the Q1 collapse of Silicon Valley Bank, have reshaped the lending landscape. Banks are now cautious, focusing primarily on maintaining and monitoring their existing portfolios. This shift resulted in stricter lending criteria.

Despite these headwinds, there are silver linings.

Key Financing Headwinds in the Current Market

Navigating the commercial real estate market today means confronting a series of significant financing headwinds.  Here are 3 you need to be aware of.

High Interest Rate Environment 

A primary challenge is the high-interest rate environment. As banks grapple with increased borrowing costs, these heightened rates are inevitably passed on to clients, affecting the affordability and feasibility of new investments.

Bank Liquidity and Portfolio Reviews Will Drive Their Appetite To Lend

The Q1 collapse of Silicon Valley Bank was noted as the third largest bank failure in US history and the largest since the 2007-2008 financial crisis. The collapse rippled through the media creating significant fear amongst banking clients, beginning a shift in deposits from banks into other holdings such as treasuries, stocks and bonds.  

The movement of liquidity has created an imbalance in many regional or local banks’ loan-to-deposit ratios. Credit officers are required to balance a loan-to-deposit ratio for each institution, with both internal and Federally mandated guidelines. When liquidity (aka deposits) move from their accounts, it lowers the available funds they have to lend. Combine the lower liquidity available by banks, with the need to remain fiscally responsible and you find a much lower lending appetite by many institutions.

In the environment of uncertain economic conditions, banks are often scaling back their loan commitments to focus on maintaining and monitoring their existing portfolio.  Lenders tend to shift their approval guidelines in these times, which may include requiring more available global discretionary income for borrowers or higher debt service coverage ratio requirements. 

Seller Expectations 

Seller expectations can also be a contributing headwind in financing a property.  Sellers may have a specific price or value for their property in mind based on market conditions from the last few years.  This may create a scenario where the Seller insists on selling the property at a certain price, but rising interest rates directly affect deal velocity and typically result in higher capitalization rates, driving values down. 

But all obstacles create opportunities. 

Turning Headwinds into Opportunities

In the face of the current financing challenges, there are unique opportunities for savvy commercial real estate agents and investors. One significant shift is the rise in seller financing. 

In 2023, the share of transactions involving seller financing in commercial real estate saw a notable increase. Specifically, this form of financing accounted for 1.9% of all commercial real estate lending in the first half of 2023, up from 0.5% of all originations in the first half of 2022. This shift indicates a growing preference for seller financing in the commercial real estate market during this period​​.

Financing Structure Will Depend on The Type of Property and Buyer.  

Here are a couple of recent example:

• A recent downtown property prime for redevelopment: 

Seller carried 50% of the purchase price with a note and trust deed. The buyer is a known developer in the commercial real estate community and the seller was willing to agree to subordinate to a construction loan after closing.  

• Multi-use property, including existing/operating restaurant:

Seller is carrying two land sale contracts. One parcel will be redeveloped soon after closing and can be paid off at any time. Seller doesn’t want to realize all capital gains in the same year, so the other land sale contract cannot be paid off in the same year as the other in order to spread the gains into different tax years for the seller. 

Strength in Numbers – Partnership Opportunities

In the current commercial real estate market, there’s a notable trend towards harnessing the power of partnerships. These collaborative ventures offer a strategic way to navigate the financing landscape, particularly in light of the increased capital contribution requirements from banks. By pooling resources, partners can share the financial burden, making it more feasible to undertake significant investments that might be challenging for an individual investor. 

However, it’s crucial to approach these partnerships with a clear understanding and alignment of goals, as well as a thorough vetting process. 

Cash is King – Greater Opportunities to Purchase

In an environment where financing is more challenging, having liquid assets is a significant advantage. Cash buyers are in a strong position to negotiate and close deals more quickly, often at better terms. This is particularly true in the current market, where sellers might be more inclined to accept lower offers for the assurance of a swift and secure transaction.

Investors with readily available cash can leverage this advantage to acquire properties at competitive prices.

Strong Commercial Lending Relationships

In today’s complex financing environment, the importance of strong relationships with commercial lenders cannot be overstated. These relationships can be a critical factor in successfully navigating the current market’s challenges. Lenders who have a deep understanding of their clients’ business models and investment strategies are more likely to work collaboratively to find viable financing solutions. 

In a landscape marked by cautious lending practices, having a lender who trusts and understands your business can mean the difference between securing funding for a promising opportunity and missing out. 

Question for you:

How do you see financing options change as we move into 2024?

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