Inflation and high-interest rates increase the cost of capital; that’s a given. But in commercial real estate, a “transaction” encompasses much more than a straightforward purchase or sale with a single funding source. Changes to the lending climate affect every piece of the puzzle separately, and when those pieces come together, the impact multiplies.
How have you seen the effects of today’s volatile lending environment play out this year—beyond basic buying and selling, and across different asset classes and transaction types?
1. Office buildings
Financial modeling for office buildings has changed significantly in the current lending climate. Traditionally, lenders have based their income approach valuation on a standard 5% vacancy rate, even when the property is full.
But in the current landscape, some lenders are factoring in higher vacancy percentages for stabilized properties. Borrowers are seeing up to 30% vacancy rates for fully occupied buildings. This change in underwriting has huge repercussions in lending—especially for refinancing. Owners are having to modify pro forma projections for office buildings. Couple this with increased interest rates, and refinancing may no longer be viable. This environment has led many owners to make some tough decisions.
To keep these office assets, many owners will be faced with altering their loan structure or adding significant amounts of cash. If they do not have the necessary capital available to do that, they will have to sell. And if the property doesn’t sell for more than the loan balance amount, in more extreme cases, the lender may take back the asset.
“The rate goes up, debt service coverage ratios go up, and you have to come to the table with a meaningful amount of cash,” says Director Matt Bassist. “Or you say ‘here are the keys.’ And that’s going to continue to happen a lot.”
2. Tenant improvements
The changing lending environment also affects commercial leasing and the funds needed for tenant improvements. Historically, you could amortize tenant improvements at stable rates of 7-8%. But now we’re seeing rates around 9% or higher. The question for many brokers has become, how much of a premium should I encourage clients to pursue given the increased cost of funds?
And that depends, Bassist says. Before entering into any agreement, tenants should weigh how motivated they are to lease the space, and they should consider factors such as the length of the lease, the financial health of the involved parties; and whether the lease is secured by a guarantor. Increasingly, tenants are finding spaces that can be occupied with minimal tenant improvements—new paint and carpet—and owners with built-out space are reaping the benefits of this trend.
“A landlord likely isn’t going to loan a million dollars on a space that could be used by another group without spending that money,” Bassist says. “They might come down on the rate if it’s a building that needs substantial improvements. But more than anything else, it depends on liquidity: Does the landlord have the financial health to be able to finance that difference, versus getting a bank to do it?”
3. Retail financing
And what about retail transactions? Director Gary Litvin has seen the lending environment affect his clients both locally and across the country.
“I have a retail client that’s a national franchise using big, expensive equipment, and interest rates have gone up so much they have two parts to their financing now,” he says. “First, they have to finance an equipment package. The equipment costs about $700,000, and the distributor will finance it. Then they have the build-out, which adds approximately $400,000.”
Litvin says franchisees were going to their local banks and taking out small business administration (SBA) loans for the $400,000 build-out cost. But now that SBA rates are sitting at a higher rate, the franchisor is recommending for those funds to be in cash.
“They’re saying, we don’t want you to be underwater with your sales once you have to pay that kind of interest to SBA or to your local bank.
We agree—especially for a trend that’s being observed on a national scale.
And yet, Litvin says, the franchise has kept expanding: “That’s the thing—plenty of people have the cash. The qualifications have gone up significantly, and yet there new franchisees are entering into the business aggressively. It’s all about the quality and earning potential of the franchise.”
Last month, we talked about how the people who make up the commercial real estate industry seem to be factoring in all the unknowns of inflation, interest rates and political anxiety, and pushing ahead anyway. And in these conversations with our brokers, we heard many of the same themes: The current may be slow, its course may be unclear and its obstacles may be significant, but we’re still moving forward.
