In a New Interest-Rate World, Owners and Lenders Must Work Together

The end of the zero-interest rate period has brought significant shocks to the commercial real estate industry. The initial increases brought a rush to lock in financing, but as the rates continued to rise, the market found itself in a lengthy state of paralysis. With the Fed looking likely to keep interest rates in their current zone for longer than the market originally expected, a new and unfamiliar normal is settling over the industry.

Incumbent commercial banks remain sidelined, reluctant to lend to all but the largest and least risky borrowers. Regional, community, and smaller banks are eager to lend to their local borrowers but may not have the capital to take on much more risk. More than ever, institutional borrowers are turning to alternative, non-bank providers like credit funds and lenders such as iBorrow to fill the gap.

If there was any doubt that private lenders are here to stay, that is gone. Fifteen years ago, private credit was barely part of the market, but today we are seeing long-standing institutional borrowers tap into private lending sources for the first time. However, as the industry gets used to living with higher interest rates, the long-term success of the industry during this period of challenging economics will depend on borrowers working together with their lenders.

Yardi estimates that over $60 billion worth of multifamily loans are maturing this year. The industry believes that about $21 billion of those loans are underwater. After the pandemic, some owners took for granted that people could pay more rent. Rent as a percentage of income jumped from 30-35 percent to 50-55 percent, and that is not sustainable. As rent growth ends, cash flow and exit NOI will make those properties even less viable for the owners as they look for refinancing, resulting in more distressed sales. The second half of 2024 will see more distressed activity with an acceleration in 2025, as another $84 billion in loans mature next year.

What in the cards?

The next 24 months will bring many opportunities for both buyers and lenders. Prospective buyers, however, need to show their lenders their plan for making the assets profitable amidst the higher interest rates. Additionally, lenders are looking at factors which in recent years they took for granted. For example, rent growth assumptions are likely to be flat or negative and a lender’s exit strategy is now an active consideration. Forecasts within presented business models need to be much more conservative. Still, entrepreneurial-oriented borrowers who have a solid plan for their investment, and can make the numbers pencil out, will find interested lenders. Regardless of type, every borrower needs to come to their lender as a responsible sponsor with an excellent track record and a well-thought-out plan.

During this period, we expect buying opportunities will be available across the board. Investors in value-add assets will find attractive assets particularly in resilient markets, including pockets of California and Texas. Affordable housing remains a very high-demand segment. On the development side, there is demand for rescue capital on mature projects where developers may otherwise have to pull back from construction activity due to the higher-for-longer interest rates and increased material and labor costs. However, on the positive side, new construction starts have significantly slowed overall, which, in the long term, will allow for many currently poorly performing assets to recover under their new owners.

Commercial real estate is a dynamic industry. The extended low-interest rate period changed how borrowers and lenders did business with each other. Now with the zero-interest rate period firmly in the rearview mirror, there will be new changes. Private lenders will continue to grow as a go-to source for financing, while the traditional lenders remain on the sidelines as bank retrenchment takes time to ease.

Borrowers who waited for interest rates to drop now face the reality that they have no other option but to sell or seek refinancing. Well-capitalized lenders will have an advantage in serving borrowers in the coming months. There will be more opportunities to acquire both distressed loans and properties as the markets bottom out, with the following caveat: lenders expect borrowers to clearly demonstrate the viability of their project. Capital is available, particularly from alternative sources. Lenders, like iBorrow, are eager to finance great ideas from high quality borrowers with creative business plans that show they are worth taking a risk on.

Brian Good is managing partner of iBorrow, a nationwide direct lender that provides short-term bridge financing to commercial and multifamily property owners.