Canceled Contracts Pile Up As Real Estate Buyers, Lenders Reckon With Rising Rates
Some commercial real estate deals are falling apart across the country as the market reels from the highest interest rate environment in over a decade and clouds of economic uncertainty are gathering.
As borrowing costs rise, the prices for everything from out-of-favor assets like office buildings and retail to warehouses and apartments are declining as buyers get nervous about future values.
“No one's immune,” said Eddie Lorin, an affordable, workforce and mixed-income housing developer who co-founded California-based Alliant Strategic Development. "Everybody is getting repriced."
The Federal Reserve Bank officially increased interest rates by three-quarters of a point Wednesday, the second hike in as many months of that size, as policymakers attempt to combat inflation. That puts the Fed's benchmark rate between 2.25% and 2.5%.
Green Street's Commercial Property Price Index, a measure of current unleveraged U.S. property values, declined by 3.7% in June and is down nearly 5% since March. Total commercial and multifamily mortgage borrowing and lending is projected to drop 18% to $733B this year, down from $891B in 2021, according to the Mortgage Bankers Association.
“Buyers are going into contracts knowing full well where the increased interest rates are going to be, but increasingly investors are unsure about where the market is heading and that lack of confidence while under contract is what’s leading buyers to cancel contracts,” Chicago-based Greenstone Partners Managing Partner Jason St. John told Bisnow via email. “Many buyers are speculating that there may be better deals if they hold off and wait for pricing to come down.”
Lorin said he is seeing anywhere from 5% to 10% drops in apartment pricing as a result of economic uncertainty and the Fed's coming rate hike.
“That's on everybody's mind right now. There's a disconnect between the buyer and a disconnect between the seller on what the values are for properties today. And that probably won't be fixed for a few months,” Old Capital National Underwriter Paul Peebles said. “I told a lot of people to take the summer off, because this is not going to get any better.”
Peebles said a deal on which he was working saw the buyer walk away from a $700K deposit on a $40M apartment deal under contract in Texas. After the June rate hike, the buyer asked to shave $5M from the purchase price, Peebles said, but the seller balked.
The examples of collapsing real estate transactions over pricing uncertainty, increased borrowing costs and recession worries have been mounting all summer.
Boston-based TA Realty recently put a 5M SF industrial portfolio up for sale — with warehouses in Dallas, Southern California, Baltimore, Chicago and Phoenix — hoping to get more than $1B. Eastdil and CBRE were marketing the portfolio, which only received one offer for $800M, and advised TA to pull the offering from the market, sources familiar with the process told Bisnow.
Spokespeople from Eastdil and CBRE declined to comment. TA officials didn't return emails seeking comment.
Maria King, a multifamily broker and vice president with Bull Realty in Atlanta, said she had two apartment deals fall apart over the past summer, including one buyer walking away from a 50-unit, $12M deal because of rising interest rates.
“That offer still might stand at $10M,” King said. “The money, the amount they were borrowing before, is not the same as interest rates have gone up. They're not penciling out anymore.”
Rosalie Manansala, the founder of DOT Capital Advisors, an investment consultant, said she has seen a rise in the number of properties that had to adjust the agreed-upon purchase price due to rising interest rates. On top of that, capitalization rates across property types are on the rise.
“I feel that there are going to be more price adjustments in the marketplace,” Manansala said. "To what extent, I'm not sure."
Those seeking floating-rate financing, whether for new construction or purchases, are experiencing the impacts with the rise in the Secured Overnight Financing Rate, a measure of the cost that banks are charged to borrow overnight cash, collateralized by Treasury securities. SOFR has largely replaced Libor as the benchmark rate for determining the interest rate on floating debt.
According to Pensford Financial, a financial consulting firm that tracks and predicts where SOFR rates will be in the future, the one-month SOFR term is expected to rise from 2.32% this month to 2.9% by Sept. 26. Pensford is projecting one-month SOFR terms to exceed 3% starting in late October and continuing through next summer.
Banks will usually charge a percent premium over SOFR for floating commercial real estate loans, especially construction lending. Peebles said nearly 90% of the multifamily loans his firm originated over the past two years have been with floating debt. While this allowed borrowers to obtain cheaper debt, floating rates open them up to more volatility and risk.
The interest rate question mark is only exacerbated by high construction costs, which is cooling demand for development financing, ACRES Capital CEO Mark Fogel said. Last year, the firm did $2.4B in lending. This year, he expects that to drop to $2B as it shies away from more aggressive deals.
“As a construction lender, we've been affected by the fact it's really hard to price construction materials,” Fogel said. "Things are moving all over the place, and it's really hard to underwrite deals in a marketplace where that is not tamed."
ACRES was in the underwriting process on a deal for a D.C.-area development four months ago, but as the SOFR rate went up, ACRES pulled out of the deal, Fogel said.
“When we as lenders look at deals, we're thinking about how to get refinanced out of the deals,” he said. “People just can't get a real feel where these properties are going to be two three, years down the road” from a cash flow and valuation standpoint.
Years of cheap debt fueled by historically low interest rates have made for a consistent financing environment for many new development projects across the country, but that has changed in a matter of months.
“Everything you believed over the last couple of years doesn't necessarily hold these days," Fogel said.
Inflation's effects on commercial rents have historically mitigated valuation concerns, Lorin said, especially in the apartment sector. But banks are becoming more gun-shy to risk, forcing developers to seek multiple avenues to finance deals.
Lorin said his firm, Alliant, was in talks with one bank for a $300M loan to develop four mixed-income apartment projects in Los Angeles. As rates rose, the bank got nervous. Instead, in a move Alliant rarely takes, Lorin brought in two more banks, each funding a portion of the loan.
“It's too much exposure. Lenders are nervous,” he said. “They're going to pull back and do structured deals.”
Some real estate investors, though, see the Fed's actions as an opportunity for property prices to return to earth.
“I think we end up going back to a pre-Covid world where Treasuries are 3[%] and cap rates are 3-ish to 4[%]. And that's fine. You can certainly do quite well and you're not going to destroy asset values in the resetting,” Bridge Logistics Properties CEO Jay Cornforth said. “This is a healthy correction. The last two years were incredibly ... unrealistic.”
CORRECTION, JULY 28, 1:50 P.M. ET: A previous version of this story incorrectly identified Eddie Lorin's company as SRH, which merged with Alliant Capital in 2019 to form Alliant Strategic Development. The story has been updated.