Commercial Real Estate Faces a Cash Flow Crisis

Commercial real estate lending is dwindling to historically low levels, posing a risk of increased defaults on maturing debt and a significant drop in new construction for various property types, including warehouses and apartments.

The decline in lending can be attributed to banks, insurance companies, and other commercial property lenders reducing their exposure since the first half of 2022 when the Federal Reserve initiated interest rate hikes and concerns about a recession intensified. Moreover, rising Treasury bond yields have made lenders even more hesitant to issue new loans.

The majority of commercial real estate loans are linked to short-term rates, which meant the surge in Treasury rates exacerbated concerns about property valuations. The total volume of commercial real estate loans held by banks, the primary source of debt financing, decreased during the first two weeks of October. This decline was analyzed using Federal Reserve data by Trepp, a data provider. Bank commercial property lending has experienced a decline only twice since 2014. Other lenders have also reduced their activities.

Commercial mortgage-backed securities conversion saw only $28.2 billion in loans issued this year, the lowest since 2011. Furthermore, the largest mortgage REITs suspended loans to new borrowers in the first half of the year. The overall commercial property debt market, encompassing banks, commercial mortgage securities, nonbank lenders, and others, saw a growth of less than 1% in the second quarter, the lowest since the first quarter of 2014.

The most affected parties have been office owners who had to refinance loans at much higher rates. However, the scarcity of financing has also impacted other commercial borrowers, such as those for apartment buildings and warehouses. Despite being favored by investors for years, they have encountered challenges.

The recent increase in 10-year interest rates has made many in the marketplace apprehensive. According to Michael Levy, CEO of Crow Holdings, capital market uncertainty is affecting everyone. Private debt funds are struggling to raise capital and are primarily dealing with existing borrowers having difficulties refinancing low-interest-rate loans.

While loans are still available today, they come from fewer lenders and are more expensive. Although liquidity exists, it is likely to come at a higher cost, lower leverage, and from different lenders, as explained by James Muhlfeld, Managing Director at Eastdil Secured.

The decline in lending is partly due to diminished demand from investors who are uninterested in acquiring or developing property with high-interest rates. Furthermore, many lenders have lost their appetite for new deals, particularly small and regional banks that have been cautious about commercial property since the failures of Silicon Valley Bank, Signature Bank, and First Republic.

Regional banks are also experiencing an increase in problem loans. PNC Financial Group reported that nonperforming commercial real estate loans increased to $723 million in the third quarter, more than double the $350 million in the second quarter. This was attributed to the pressures anticipated within the commercial real estate office sector.

Construction loans have seen a particularly sharp decline, with forecasts predicting a 17% drop in commercial property construction starts this year, the most significant annual decline since 2009.

Projects like The Dream Las Vegas, a $650 million hotel and casino, have been delayed or altered due to financing issues. Developer Shopoff Realty ceased work earlier this year but is working on securing new financing.

The challenging financing environment has led to numerous projects across the country being placed on hold or pushed back. According to Mark Thigpen, the head of global real estate for law firm King & Spalding, the financing challenges have impacted numerous commercial projects throughout the country, and there’s no market that’s insulated from this.