The Ripple Effect: High Interest Rates Alter CMBS Activity

By Carlo Batts, MAI, Rittenhouse Appraisals

The middle of 2024 presents a blend of opportunities and challenges for the commercial real estate industry. Multifamily, industrial, and retail sectors are doing well, while high interest rates and office vacancies remain a concern. It’s important to review the trends and factors that have shaped the first half of 2024, and specifically look at a financing alternative gaining traction. To begin, a quick snapshot of current conditions by sector.

Sector Specific Insights

The national office vacancy rate rose to 19.6% in the fourth quarter of 2023, which surpasses the previous record of 19.3%. Moody’s Analytics CRE says this is the largest quarterly increase since Q1 2021. Despite this negative trend, investors continue to pursue prime office locations.

While multifamily remains strong overall, there are differences in housing types. According to Moody’s Analytics CRE, the 2023 vacancy rate for B and C class properties was 4.6%. Set in opposition, the vacancy rate for luxury properties was nearly two percentage points higher at 6.5%.

Industrial properties are experiencing high demand and growth, largely driven by the need for warehouses and distribution centers. These property types are needed to support e-commerce, which now accounts for 15.6% of retail sales.

Despite the rise in e-commerce sales, traditional brick-and-mortar retail performs well. Grocery-anchored neighborhood shopping centers are leading the sector as they typically serve as convenient locations for everyday necessities and services.

Major Forces Influencing the Industry

Higher interest rates and the lack of a rate cut continue to pressure the ability to secure financing or refinance existing loans. But as we’ll discuss shortly, a different loan type is gaining popularity.

The persistence of remote work and hybrid models have consequences beyond empty office buildings. With fewer people in those buildings, surrounding businesses experience decreased sales. This in turn impacts entire neighborhoods and communities, reducing property values and creating financial hardships for owners and employees of the struggling businesses.

Other forces include the emphasis on eco-friendly development, the upcoming election both here and internationally, and global conflicts.

Investment & Financing Trends

Mortgage Bankers Association (MBA) reports traditional commercial lenders closed $306 billion in commercial real estate loans in 2023, which was 49% of the $595 billion in loans closed in 2022. As banks focus on keeping their existing assets in good health, and not establishing new originations, CMBS (Commercial Mortgage-Backed Securities) has become an attractive alternative for those seeking capital.

In 2023 $39.3 billion in CMBS was issued, according to Gantry. The firm anticipates the figure will nearly double in 2024 with $60-70 billion of CMBS issuance. In juxtaposition, defaults of CMBS are also on the rise, some of which are led by the decline in office properties often included in the CMBS package.

Of all CMBS loans maturing by the end of next year, more than half - $75.74 billion - are CMBS loans against office properties. This scenario will require moving underperforming assets, be it through foreclosure or other tactics. Specifically, as the office market is experiencing turmoil, it means a necessary shift in this asset class. In contrast, other sectors including industrial, retail, and multifamily have already adapted to meet new market demands, a process that began prior to the COVID-19 pandemic. This transformation is neither quick nor confined to a single year and is expected to linger for the next 10-15 years.

Carlo L. Batts, MAI, is the principal of Rittenhouse Appraisals, a regional commercial real estate valuation firm based in Center City Philadelphia.