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Higher Interest Rates Weigh on Real Estate Values

admin  /   March 2023

Elevated Debt Service Forcing Lower Leverage

Real Estate owners facing debt maturities are at a crossroads. They must decide whether to sell their property in a market with softening demand or to refinance and reduce their loan amount. While property price appreciation and principal paydown have cushioned most owners, not all loans are expected to transition smoothly when they come due.

Between 2019 and 2021, commercial mortgage-backed securities originated in the office sector averaged $7.6 billion per quarter, with annual debt issuance remaining steady. However, the market slowed in 2022 as the Federal Reserve raised its policy rate by 400 basis points between May and December.

For office owners, obtaining purchase offers in a softening market or right-sizing the loan may be ahead. In the former scenario, bid-ask spreads are widening. In the latter setup, refinancing discussions must address the relationship between the total amount of debt and the monthly payments required to service that debt. A “cash-in” refinance may be necessary to satisfy debt service requirements and underwriting metrics that have significantly changed since the loan origination.

Debt service coverage ratios, or the borrower’s ability to satisfy debt payments from cash flow, have been directly affected as interest rates rose to new cycle highs. Borrowers must inject more equity to secure new debt since cash flows from operations are failing to keep pace. As their primary loan-sizing metric, lenders require borrowers’ cash flow to stay between 1.25 and 1.4 times the property’s debt payments to provide a cushion for unexpected operational changes. Therefore, as borrowers’ debt payments rise faster than cash flow, they now find terms at 55%-65% loan-to-value compared to the 65%-75% loan-to-value terms available last year.

As sophisticated investors are aware, when all underwriting metrics are held constant, there is a correlation between interest rates and leverage. Specifically, maintaining the coverage ratio with higher rates requires lower leverage. In the hypothetical office case study illustrated in the chart above, for every 50-basis point increase in the interest rate, the loan-to-value decreases by two percentage points to meet the debt service requirements. So, for example, when the interest rate rose to 7%, the loan-to-value fell to 58%, resulting in a 9.4% drop in the property’s value when holding the investor’s return steady.

Higher interest rates also impact the quality of the underlying cash flows that support commercial real estate values. Further, economic uncertainty and the potential for slowing earnings are becoming more plausible to investors. Therefore, increased levered return requirements are the logical next step in response to higher risk in the system. As a result, implications for property values suggest office capitalization rates will rise by 100 to 150 basis points from those seen in early 2022.