CRE Loans’ Structures Shape Up Differently in Higher Interest Rate Environment


What a difference 11 rate hikes in 20 months can make.

The architecture of commercial real estate loans and deals has changed drastically in the last two years since origination levels reached record levels in 2021 at near zero borrowing conditions. Market conditions today have resulted in far more boxes to be checked to bring deals across the finish line.

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CRE lending reached an all-time high of $891 billion in 2021, just before the Federal Reserve began aggressively hiking interest rates to combat inflation in March 2022, leading to an 8 percent decrease in loan volume last year, according to the Mortgage Bankers Association (MBA). Borrowing levels for 2023 are far more severely impacted, however, and projected to fall 46 percent to $442 billion in 2023 based on the most updated baseline forecast released by MBA on Oct. 19. 

“We’ve all had a little bit of a gut check. We’re resetting valuations and going back to the fundamental real estate analysis of what is the right value of a property, and what we should be lending against that value,” said Kyle Jeffers senior managing director and co-head of originations at Acore Capital. 

Uncertainty about how high interest rates will go — and for how long — have limited the number of property transactions, thus creating a lack of price discovery within the market. This has led to increased lender competition for acquisition loans with fewer deals in play, according to David Perlman, managing director and head of the New York office at Thorofare Capital. Thorofare has done fewer acquisition financings this year than normal, with the lender’s deal flow shifting more to refinancings. 

Longer hold periods for investors is another new reality facing CRE market participants in 2023 given the higher cap rate climate since interest rates have been elevated, according to Perlman. 

“Short-term debt is not the most optimal if you’re trying to flip the property in five years,” Perlman said. “On the acquisition side, people will have to hold the property longer in order to get equity appreciation on the deal.” 

Dramatic changes to interest rates compared with early 2022 coupled with economic uncertainty have spurred tighter lending standards, including lower loan-to-value ratios. Debt service coverage ratios (DSCR) are also drawing more scrutiny from lenders as sponsors struggle more to have rental incomes keep pace with debt service standards imposed by underwriters. 

“The underwriting standards have become stricter and we’re a little bit more careful about what revenues we’re underwriting and what vacancies we’re underwriting and what expenses are, and then the debt service coverage ratio has become more of a concern,” Jeffers said. 

With more stringent lending standards, borrowers are increasingly seeking equity partners  to add to deals to help the financing pencil out. Jeffers said leverage levels for sponsors in today’s market is typically about 5 to 10 percent lower than 2021, often in the 60 to 65 percent loan-to-value range. 

Melissa Farrell, head of debt originations at PGIM Real Estate, noted that loans in its core lending strategy when interest rates were far lower in 2021 typically involved minimum debt yields of 7 to 8 percent depending on property type. Today by comparison, PGIM’s DSCR is around 1.25 times on a 30-year amortization for industrial and multifamily loans, which translates into a 9.5 percent to 10 percent debt yield, according to Farrell. 

“This has pushed our leverage down, and LTV is not typically coming into play given where actual debt service coverage is,” Farrell said. “However, there is a lot of uncertainty around market cap rates and values. Our standard underwriting approach in our core strategy is to use a cap rate that allows for positive leverage.” 

Farrell said rising interest rates have spurred shorter loan-term requests, with the most being five-year fixed-rate debt with some prepay flexibility offered in the last one to two years of the loan. While there was also a “dramatic increase” in fixed-rate requests in the last year, Farrell said the run-up in Treasury yields in October led to some borrowers reconsidering taking on floating-rate debt if they needed maximum flexibility. 

Preferred equity and mezzanine loan requests have also been commonplace, particularly in construction loans where available leverage has sometimes dropped below 55 percent, according to Farrell. She said many developers are seeking total leverage of 65 percent to 80 percent, and PGIM has been finding opportunities to deploy both mezzanine debt and preferred equity behind first-mortgage lenders to help achieve this goal. 

Lenders typically require interest rate caps for deals involving floating-rate borrowing, and several borrowers have been burned in the past two years by those caps resetting in the higher environment. Jeffers said in a lower-rate environment Acore would conduct deals with springing interest rate caps that required the borrower to purchase a cap if the index rate for the loan exceeded a certain threshold, but that is less of a factor today.

“We really needed them back then but now when rates are five, five and a quarter you’re buying a rate at six, six and a quarter and the rates hopefully are not going to go up much higher,” Jeffers said. “We still require them, but they’re not as important as they were when we did them last round.” 

Affordable housing impact

The demand for affordable housing has remained high amid the market dislocation, and the sector has also benefited from forms of tax credit equity along with subsidies from government agencies. Ensuring that affordable housing sponsors have adequate reserves is crucial to get deals across the finish line without a major slowdown when grappling with elevated rising interest rates, according to Maria Barry, community development banking national executive at Bank of America (BAC).

“We already have a reduced debt profile for affordable housing, so there’s really not a lot of shifting with how the deals get done except if more equity is needed,” Barry said. “It’s also more important now to really protect the deal with adequate reserves so that it can continue to go along if it hits a little bump in the road.” 

Looking ahead to 2024 and beyond, lenders are gearing up for a bounce back in volume as transaction volume picks up when sponsors have a better gauge on the peak for interest rates even if they are higher for longer. 

“If we know where values are, we know where we can lend. And if we know where we can lend, then we can know how to price the risk associated with that value,” Jeffers said. “We think the next few years are going to be really good lending opportunities.” 

Jeffers added that less competition for deals, with  banks largely on the sidelines, has led to increased negotiating power around  deal structure for those lenders still in the game. While there have been fewer transactions, Acore has still managed to find some “robust” deals through its debt fund platform in 2023, according to Jeffers. 

While interest rates are far higher than early 2022, Perlman stressed that borrowing levels are still far less expensive from a historical perspective compared to when interest rates reached the high teens in the 1980s. Perlman said reality will soon set in on the new interest rate universe. 

“At the end of the day, there’s still capital interested in real estate, and I think people are going to still be interested in investing in this space both on the equity and debt side. It’s just a different valuation point and maybe a different hold period,” Perlman said. 

“I think people that are just sitting on the sidelines for this past year are probably going to come back in for 2024 and start lending again, which is just going to increase the competition for loans, which will help the overall market because there will be more debt players.”