Challenges with managing CRE debt in North America

How high CRE debt costs became the norm?

Commercial real estate participants that have enjoyed a long run of abundant low-cost capital are now facing a new reality. Owners, investment managers and developers across North America are reeling from a shifting landscape where debt financing is more expensive and more difficult to source.

Central banks around the world began hiking key benchmark borrowing rates in 2022 in an attempt to cool high inflation. In the US, the Fed moved aggressively, raising rates 11 consecutive times over the span of 17 months. The result was a seismic shift in the federal funds rate from near zero to between 5.25 and 5.50 percent at the end of July 2023. The Bank of Canada has been on a similar pace with a series of increases since March 2022 that have raised its key interest rate to 5 percent.

The challenge of higher debt costs has been compounded by banks pulling back on lending. With the failure of Silicon Valley Bank, Credit Suisse and others early in 2023, US banks are coming to terms with the potential credit quality deterioration that could come with a potential recession, expectations of more stringent capital requirements from the Fed, or the unanticipated exposure from CRE loans they would have considered to be stable a year ago. According to Oxford Economics, banks that have begun to sell off loans over the past several months are an indicator of the impact from tighter credit conditions and concerns about the CRE concentration risk within their loan portfolios which represent about 40% of the commercial and multifamily mortgages in the US. The firm’s economists believe there could be a stronger pullback in CRE lending in the second half of 2023.

Managing higher CRE debt costs

CRE industry participants are now dealing with the pressures of higher capital costs and tighter liquidity in managing existing portfolios and sourcing capital for acquisition and development strategies. Altus recently surveyed several CRE finance professionals to hear more about the specific financing challenges they’re facing, and how they’re adapting to market conditions.

Cost of carry taking a big bite out of returns

A significant challenge for CRE firms is maintaining portfolio performance in a higher interest rate environment while managing exposure to other market risks. According to one CRE Managing Director, "Lately, our main obstacle has been ensuring that our portfolio meets the targets set for our investors, especially with the rise in interest rates over the past year… It's been a large challenge in the general steepness of the yield curve, and the cost of carry for the portfolio has not helped either. So, while our investments have performed, we've lost a significant amount of return."

To mitigate the risks associated with higher interest rates, CRE firms are exploring various strategies to enhance performance. By analyzing market scenarios and sensitivity at different levels of the portfolio, financing teams are getting a better understanding of how interest rate fluctuations and other market risks affect their investments. This data-driven approach allows them to make more informed decisions, adjust their debt management strategies proactively, and optimize financing.

Weathering floating rate debt

CRE firms that have a high proportion of their portfolio financed by floating rate debt have taken a bigger hit from rising rates, especially if they did not have interest rate caps in place or their rate caps expired. "We're refinancing a fair bit of our floating rate debt when spreads have widened up or the Canadian prime lending rate is up. But it's becoming increasingly difficult to secure no matter what type of loan, although we can pursue numerous avenues. So, I think the challenge of dealing with those maturities is weighing," said one EVP of Finance at a large CRE firm in Canada.

CRE firms are now keeping a closer eye on the balance between fixed-rate and floating-rate debt in their investment portfolios to lessen the impact of increasing interest rates. By strategically managing the mix of fixed and floating rate debt, they can mitigate their vulnerability to interest rate fluctuations. This approach is crucial in safeguarding the portfolio's performance and financial stability during dynamic market conditions.

Refinancing maturing debt

The ability to refinance maturing debt is a growing concern. Some industry research estimates that a staggering $1.5 trillion of US commercial and multifamily debt matures before the end of 2025. “Our biggest challenges as it relates to debt management from a holistic, high-level perspective is refinancing maturing debt that is coming due in the near term given the volatility that we've seen in the capital markets and the rising interest rate environment,” said one Senior Corporate Finance Director.

During uncertain recession forecasts on a macro level, it becomes even more challenging to find lenders and secure refinancing options. For the CRE firm, an additional hurdle is that some of its secured debt is backed by properties that haven't fully recovered from the pandemic. The executive added, "We're limited to a certain extent, working with our existing relationship banks to understand what's out there from a fixed and floating rate perspective, balance sheet lending, securitized lending, and then also looking to tap the high yield institutional markets from a corporate level."

To tackle these challenges, some CRE firms are calculating benchmark rates for their debt portfolio. This helps them figure out the ideal approach for refinancing their debt as it reaches maturity. By comparing their rates to relevant indicators and market trends, they can assess their funding options more efficiently and make informed choices about the most appropriate financing structures. This ultimately enables them to better navigate the punishing debt management landscape.

CRE sector searches for solutions to manage new debt financing challenges

In an interest rate environment where every basis point can move the needle on returns. CRE owners, developers and investment managers are trying to proactively manage debt by seeking new funding avenues, exploring various financing structures, and staying vigilant about market conditions. These crucial steps are helping CRE loan borrowers to survive and thrive in these dynamic and ever-changing market conditions.