Monday Morning Scoop - Borrowers Adjust to a Higher Cost of Capital in 2023

Borrowers Adjust to a Higher Cost of Capital in 2023

Borrowers can breathe a sigh of relief: there is no liquidity crunch coming in 2023. Lenders are actively lending, and there is plenty of capital available to fund deals. That’s the good news. The bad news: interest rates have increased at a historically fast pace and are predicated to continue to increase in the first half of 2023.

“There isn’t a liquidity problem. There is a cost-of-capital problem,” says capital markets expert Ronald Davis, First Vice President at Matthews Real Estate Investment Services. Multifamily mortgages are above 6%, and commercial mortgage coupons are at levels not seen in over a decade. Despite this Davis says money for lending on commercial real estate is still available, but with an important caveat: “We have to adjust to the fact that it is more expensive.”

Rates Will Increase Through the First Half of the Year

The Fed has signaled plans to ease its aggressive monetary strategy, which authorized seven consecutive interest rate increases last year. The run-up in interest rates has been unprecedented, with the Fed Funds rate swinging from 0.5% to 4.5% in a mere six months. “No one predicted that,” says Davis. He expects another two or three 25-basis point increases in the first half of the year. By the midyear, the upward push will wane, and borrowers could see rates inch down.

That will bring some respite to borrowers, but Davis warns that the zero-interest rate lending environment has likely gone extinct. “The days of zero interest rates and free money is over,” he says. “It was an anomaly in the capital markets, and we are never going to go back to that. We are just going to have to deal with the paradigm shift.”

High Costs Drive Lending Slowdown

Interest rates are driving a dramatic slowdown in transaction volumes, to the upset of lenders. In November and December, Davis received several calls from banks looking for deals because they had capital left to allocate before the end of the year.

In the near-term, property owners that need to refinance will have the hardest time adjusting to the higher interest-rate environment. As Davis notes, underwriting refinance deals is tough, with some owners anticipating a 5% to 5.5% interest rate, when the market is dictating rates in excess of 7%. “We are having a hard time taking out some existing loans because of the cost of capital,” says Davis, who has gotten creative in structuring re-finance deals to get them across the finish line.

It will take some time, but investors have to transact, whether because a loan term is coming due, or because they have investment capital to place, or because they have a 1031 exchange. In the first half of the year, the market will work through these changes and an adjustment in cap rates. “Once we get comfortable with the new cost of capital,” Davis assures, “there will be a return to normalcy.”

By: Kelsi Maree Borland
Source: GlobeStreet