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  • Writer's pictureJason Tuvia

Softer Rate Hike Outlook Potentially Clears Some Hurdles for Investors

Banking shock prompts Fed to take a more measured approach. At its March 22 meeting, the Federal Open Market Committee raised the federal funds rate for the ninth time in 12 months. The 25-basis-point hike matches the margin from February and lifts the lending rate’s lower bound to 4.75 percent. The FOMC cited still-too-high inflation and a persistently tight labor market as reasons for necessitating the increase, which is nevertheless below what was anticipated by the market just a few weeks prior. The recent seizures of Silicon Valley Bank and Signature Bank, while due to unique challenges and quickly contained by regulators, have prompted more caution around the banking sector. The resulting tightening to credit conditions is likely to complement the Federal Reserve’s goal of reducing inflation and softening employment, allowing for a smaller policy rate adjustment.

Further rate hikes are less likely. The combined 50-basis-point increase so far this year marks a much more deliberate pace compared to 2022, when the overnight lending rate was raised by more than four times that amount in a similar time span. Moving forward, the Fed is likely to be equally measured, if not more so. To assess the full impact of the recent banking shock, the FOMC has retracted previous statements indicating ongoing rate hikes and has instead suggested that some policy tightening may be necessary. A more stable federal funds rate will greatly assist commercial real estate lending by allowing capital providers to more easily establish terms and determine valuations.

A clearer near-term rate outlook will benefit the investment landscape, giving financiers and borrowers more time to agree on terms. While the bank closures are likely to prompt short-term lender caution, leading to tighter underwriting, the recent downward pressure on the 10-year Treasury, coupled with reduced rate uncertainty, could result in slightly lower interest rates for commercial real estate borrowers. Despite an overall increase in capital costs over the past year, investors will still need to take on less leverage going forward. However, for well-performing properties, the demand for assets should outweigh these concerns. Most property sectors are in strong long-term positions, even if certain asset classes, such as downtown offices, face challenges.

A wave of distress is still unlikely. The rapid rise in interest rates over the past year has raised concerns about distress among properties with upcoming debt maturities. Currently, distress levels are low, accounting for only about 1 percent of recent sales, well below the 20 percent peak observed following the Global Financial Crisis. Whether this trend will change in the future largely depends on property performance. Owners of well-performing properties are unlikely to resort to distressed sales solely due to higher capital costs from refinancing. The situation may be different for underperforming assets, which could be more prevalent among urban-core office towers and outdated retail floor plans.

Commercial real estate is not a risk factor for banks. Concerns about commercial property distress spreading to the banking sector are also unlikely. Chairman Powell stated that banks with concentrations of commercial real estate (CRE) debt are not comparable to SVB. Much of the debt maturing in 2023 is backed by CMBS (Commercial Mortgage-Backed Securities), while more bank debt is maturing after 2024, when the interest rate environment could be very different.

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