The Effects of a Changing Debt Market in Commercial Real Estate

Real estate markets are dynamic environments influenced by a multitude of factors ranging from natural disasters to state and federal regulations. As such, the landscape of real estate is perpetually transforming, as we have seen firsthand with the changing of debt markets since COVID-19.

In April of 2020, as the cost of debt approached zero, we began to see unprecedented levels of demand for goods serviced via ecommerce. In turn, lease values on industrial properties reached all-time highs, as well as going-in cap rates for investment acquisitions. The following two-year rise in the economy was accompanied by rising interest rates, bringing an eventual halt and subsequent decline in the industrial sector. Product volumes slowed, lease rates began to fall as buildings became harder to fill, and values dropped with the rise of required cap rates from investors. Overall, the effects of rising debt within the industrial real estate sector, especially in New Jersey, were widely apparent. In the most recent 12 months, under-construction square footage dropped 33.5%, accompanied by a net absorption of -281%, and a vacancy rate increase of 2.1% according to Co-Star data, showing us just how crucial the affordable cost of debt is to complete a successful project.

A changing debt market can offer a glimpse into the economic outlook of financial institutions. As the cost of debt rose it made real estate values more volatile, debt service less manageable for mortgage-holding owners, and increased the riskiness of lending on real estate for banks. This dynamic has been directly reflected in the way capital expenditures from these institutions are structured. ‘The spread between commercial mortgage rates and corporate bonds widened to an average of 121 basis points over the last six months of 2023 as opposed to an average spread of 9 basis points from 2014 to 2023, reflecting more lender concern over the viability of loans against real property versus loans against corporate income’ according to MSCI.

Not only do lenders adjust how much is allocated to different sectors based on their respective risk factors, but frequently adjust the underlying structure of these loans depending on the health of the overall market. When industrial values in New Jersey were on a rapid ascent, banks were willing to give terms favorable to the mortgagor in the form of low interest rates, LTV’s, and easier pre-approval processes. In such an environment, banks were not as wary of a default because it was likely that upon repossession of the asset, it would be worth more than what they initially lent. As volatility has increased, banks have tightened up the terms offered to prospective borrowers with interest rates and required LTV’s that are almost double from the low point.

Overall, this information allows us to better predict certain movements within the economy before they happen based on the outlook of where we think capital markets are shifting. As the cost of debt moves, we too can expect movements in economic activity, real estate fundamentals, and the way our financial institutions make capital available.