What a rise in commercial mortgage rates could mean for CRE

As inflation continues to put pressure on real estate markets and the broader economy, questions are swirling in industry circles about whether the cost of financing commercial real estate will rise.

U.S. commercial mortgages issued last year posted an average coupon rate of 3.7% for 7/10-year fixed rate products, according to data from Real Capital Analytics. By March 2022, the rate had reached 4.3%, an increase of 60 basis points. And “increases in other rate instruments could predict further increases in commercial rates if traditional relationships continue,” RCA’s Jim Costello writes in new analysis.

Freddie Mac’s 30-year fixed-rate residential average was 5% in April, down from 3% in 2021. But Costello notes the number fell far more than commercial rates at the height of the pandemic, and says that it is not clear that commercial mortgage rates will rise to the same extent in the future.

“That said, over the years, commercial mortgage rates have averaged 55 basis points above this residential mortgage rate,” Costello writes. “If this relationship were to simply return to normal trends, the 5.0% read for April would imply a jump in commercial mortgage rates to 5.5% or 5.6%. Again, there isn’t enough data available yet to make this call, but conversations with industry professionals over the past few weeks suggest that trade debt costs are rising, particularly for the product. the most risky.

Costello believes property values ​​would come into question if mortgage rates rise due to inflation, pointing to a hypothetical example of a logistics asset purchased at a 4% cap rate with short-term debt last year. at a coupon rate of 3.7%.

“That 30 basis point spread between the cap rate and the mortgage rate leaves some room for free cash flow outside of debt service,” he says. “In 2023, when such a short-term loan matures, what happens when that coupon rate of 3.7% is increased to 5.5%? Will there be a next buyer willing to pay at the same low cap rates when mortgage rates are higher?”

Ultimately, Costello says the “relative aggressiveness and dependence” on the revenue growth assumptions that investors subscribe to will be a “key point for survival” as mortgage costs rise.

In April, the Mortgage Bankers Association released figures predict a waiting pattern for borrowing and commercial mortgages this yearbut said they expect borrowing and lending to pick up in 2023. Multifamily lending alone is expected to fall 11% in 2022 from last year’s estimated record of $470 billion.

In prepared remarks, Jamie Woodwell, MBA’s vice president for commercial real estate research, said interest rates and the economic outlook have changed since MBA updated its investment forecast. commercial real estate in February.

“Rapidly rising interest rates should dampen the sails of new lending activity, but healthy real estate fundamentals and solid real estate values ​​should support markets and keep demand for commercial real estate loans at high levels,” said Woodwell.

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