The long road to 2023
As we settle into the new year, players in the commercial real estate space are reflecting on 2022 and beginning to execute their strategies for 2023. Although real estate has been heavily – and many say negatively – impacted by economic variables and the resulting market cycles of widening credit spreads and rising interest rates, great opportunities continue to exist for lenders, experienced asset managers and patient investors. However, it is essential for these players to comprehend that the key to success and returns on real estate investment this year will depend on navigating the current market cycle and having an understanding of how we got here.
The overarching umbrella that is impacting the commercial real estate market and the economy, is that with high inflation, interest rates have continued to increase aggressively. Last year, starting in March, the Bank of Canada increased its short-term policy rate at eight of its scheduled meetings, bringing the rate up from 0.25% to 4.5% as of January. The U.S. Federal Reserve Board similarly started off with an interest rate of 0.25% in March 2022, and it has since increased to 4.5%-4.75% starting this month. These hikes have impacted residential sales and slowed commercial real estate transaction activity during Q4 2022 in Canada to less than one-third of the strong pace set a year earlier in Q4 2021. Despite this decline, transaction activity remains above quarterly lows registered during the initial phase of the pandemic in 2020. The U.S. was not much different, with Q4 2022 transactions down 62% compared to the year prior.
These aggregate variables have created wide bid-ask spreads and has put the commercial sales market in a period of price discovery, with sellers reluctant to discount to lower prices from leveraged buyers, who face much higher financing costs to meet required returns. In both Canadian and U.S. commercial real estate markets, the wide spreads have ultimately led to a decrease in liquidity in commercial mortgage markets.
What’s happening today
It’s important to note that amidst all of this, deals continue to close as asset managers have capital to deploy. What has changed is that the relationship between lenders and borrowers have become much more conservative and complex due to the instability in the factors impacting the commercial market such as rising interest rates. The average loan-to-value on permanent fixed-rate commercial loans have declined by 4.2% over the past year to 55.1% as of Q4 2022. As well, senior lenders have become more selective, underwriting to higher debt yields and cap rates.
So, what does this mean for the current market and the times ahead for the commercial real estate market? Foremost, it’s important to note that any future rate increases are projected to be tempered by the central banks’ concerns that past hikes will lead to a contraction in economic activity in 2023. With the current rates, lenders have become growingly conservative and selective in 2023.
Opportunities amid the turmoil in 2023
Despite what may seem like a bleak outlook, strong opportunities are expected to emerge for experienced private lenders and patient investors due to higher mortgage rates and market dislocation, coupled with the continued growth in need for residential properties in key regions in both Canada and the U.S., due to continued population and job growth.
The market is showing that there is currently a gap in project refinancing amongst borrowers and their lenders. Borrowers in need of refinancing are likely to face lower proceeds on new senior loans due to higher rates and more conservative underwriting which will provide opportunities for private lenders to provide mezzanine or bridge lending to cover shortfalls in new senior loan proceeds. With regulatory scrutiny of capital requirements and concerns of their exposure to commercial real estate, banks are likely to restrict construction financing. This will allow more opportunities for non-bank alternative lenders to surface.
Opportunities also exist due to the demand balance in commercial markets remaining healthy, particularly in the residential multi-family and apartment sectors. Among the uncertainty, great opportunities exist particularly in the Sunbelt region of the U.S., where there is low taxation, stronger pro-business environments which are driving exceptional job growth which in turn is driving continued population growth.
The silver lining is that for patient investors, there are still strong investments to be made in the commercial real estate market. This is especially true for experienced private lenders, like Trez Capital that deeply understands and successfully executes institutional-grade underwriting, strong investment strategies, and fosters deep relationships with borrowers and experienced developers.