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Why A Rise In Interest Rates May Not Spell Disaster For CRE

The U.S. Treasury Department

Interest rates are likely to start climbing again after hitting historic lows during the onset of the coronavirus pandemic, and some commercial real estate owners see storm clouds gathering. 

Interest rate hikes are often viewed as a harbinger of lower performance for real estate. Because CRE is by nature a leveraged asset class, rising rates make loans more difficult to pay back. When a property is more expensive to refinance, it can eat at an owner’s asset-level returns. 

Many analysts have pointed out that incremental changes to interest rates are typically offset by overall growth in the economy and more demand for commercial real estate in general. But on the most recent Walker Webcast, Morgan Stanley Managing Director Richard Hill made the case that commercial real estate is going to be insulated from the risk of rising interest rates for a different reason.

“There is a sea change happening in commercial real estate where it is becoming increasingly attractive for long-term permanent capital,” said Hill, who is Morgan Stanley’s head of U.S. CRE research for equity and debt. “When I speak to institutional investors, they’re largely telling me that their allocations in CRE are going higher. There’s a lot of reasons to suggest that CRE can do a lot better than what we were expecting two years ago.”

Part of the reason for this transformation is an industry-wide cooling on bonds and fixed-income instruments that have flirted with negative yields throughout the last few years. Hill said he expects that private equity and active managers will likely start turning more to commercial real estate investments as a surrogate for chunks of fixed-income portfolios. 

Even with trillions of dollars of CRE debt coming to maturity in the next five years, Hill was bullish on REITs and commercial assets, which he said had far outperformed expectations in early 2021. And as the economy recovers, discount rates for commercial real estate risk will also likely fall, boosting investor returns. 

“Two years ago, I would have told you that a rising interest rate environment was going to be a big challenge for CRE,” Hill said. “But REITs are actually doing very well in a rising interest rate environment. They’re up around 8% year-to-date, which is what we were projecting for a full-year return just five months ago.” 

Clockwise from top left: Morgan Stanley Head of U.S. CRE Research Richard Hill, Walker & Dunlop CEO Willy Walker and JPMorgan Head of Consumer and Specialty Finance Research Rick Shane on the Walker Webcast.

In Hill’s view, those kinds of returns suggest the growth of a long-term investment paradigm. The value driver for real estate would not be the prospect of refinancing a property more cheaply, but more capital expenditure in the properties.

One of the only reasons CRE can be having this conversation is that the mass sell-off of real estate assets predicted by many analysts at the outset of the pandemic has not materialized. A flood of distressed assets would likely have placed the industry back in a similar state to directly after the Great Financial Crisis. But rather than the adversarial tones of 2007 and 2008, many lenders and borrowers have been able to work out cooperative payment plans.

“There was an element of blamelessness to what occurred last year,” JPMorgan Head of Consumer and Specialty Finance Research Rick Shane told Walker & Dunlop CEO Willy Walker. “Because no one saw the other party as at fault for the situation, it was easier for them to choose to collaborate and be thoughtful in their responses.”

Shane was also complimentary of the way the federal government was able to provide funding to keep businesses afloat and debt markets solvent. The playbook that the government learned in 2007 was put to use with great effect in 2020, he said, mentioning how stability across asset classes — from steady real estate payments to low delinquencies on credit card payments — has shored up weaknesses within the financial system. 

Walker pointed out how he and many of his colleagues in the real estate industry had lobbied the federal government to set up a facility to start processing mass requests for loan forbearance and had been rebuffed. Ultimately, though, the facility wasn’t needed, because requests for forbearance were isolated rather than widespread. 

Still, the pandemic may force a kind of reckoning for the CRE industry. Trends that have been brewing for years, from the rise of e-commerce to millennials moving out from the urban core, have now come to a head. Lenders may be more likely to look skeptically at optimistic underwriting from deal sponsors.

“I am a steadfast believer that Covid-19 was a really good thing for CRE,” Hill said. “CRE has been overdeveloped and overbuilt for decades. The pandemic is requiring the market to do some rationalization around real estate, take our medicine earlier and inject capex into our properties. It’s not going to be easy, but I think the asset class comes out of this stronger in one year or three years much stronger, because the weaker aspects of the asset class will effectively be pruned.”

On March 31, Walker will host Russell Dubner, president and CEO of Edelman US. Register here for the event.

This article was produced in collaboration between Walker & Dunlop and Studio B. Bisnow news staff was not involved in the production of this content.

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