A Cloudy Forecast: Will A Volatile Interest Rate Climate Dampen Deals In 2023?

Posted by Christina Alvino on Jan 17, 2023 12:00:00 AM

Predicting the movement of interest rates is like blowing on the dice before you toss them to the green felt. You can read the signs to help hedge your bets, though.

In early November, the Federal Reserve System’s Federal Open Market Committee raised the federal funds interest rate by 75 basis points to a target range of 3.75 percent to 4 percent. The federal funds rate is the interest rate banks charge one another for overnight lending from cash reserves so borrowing banks can meet reserve requirements.

The Fed said in its FOMC statement that through this action the committee sought to “achieve maximum employment and inflation at the rate of 2 percent over the longer run.”

Soon after the Fed released its FOMC statement, Kiplinger forecast that the 10-Year Treasury yield would remain above 4 percent “until evidence of slowing inflation occurs. Eventually, rates should fall as the economy weakens.”

Brian Wesbury, chief economist at First Trust Portfolios, said in July 2022 that goods spending was negative, but that services spending was positive in the second quarter. Wesbury forecast that profits and revenue would rise by the end of 2022 compared to 2021, whose second quarter saw the peak of government stimulus during the COVID-19 pandemic.

Still, Wesbury predicted a recession within 18 to 24 months from mid-2022. Politics affects the Fed, he says, and the political argument that there is no recession pressures the Fed not to raise interest rates. If the Fed does raise them, they will cut them in early 2023, he says.

Up, Down, Or Flat?
Chris Sonne, executive vice president and specialty practice co-leader for self-storage for Newmark Valuation in its Irvine, Calif., office, predicts interest rates will continue to rise in 2023. Neal Gussis, principal with CCM Commercial Mortgage LLC, which is based in Skokie, Ill., agrees, though he says the Fed probably will make smaller increases than in 2022.

“It is prudent to believe that no matter what type of financing you are seeking, rates will likely be near where they are now,” Gussis says.

Variable-rate loans with interest rates based on indices that mainly keep pace with the Fed funds rate will stay in line with the Fed actions, Gussis says. More factors influence fixed-rate, longer-term loans tied to treasuries and other indices, which could cause rising or falling spreads in 2023. This could make some rates rise and others fall.

“The hard part about predicting the future is that there are so many factors that are simply unpredictable that can cause a new course for interest rates, including war, pandemic, supply chain issues, sanctions, Federal Reserve actions, global politics, unrest, and markets,” Gussis says. “Thus, when predicting interest rates, the real answer is: Anything is possible. Who would have ever predicted the severe increases in rates that we experienced in 2022?”

Shawn Hill, principal with Chicago-based The BSC Group, agrees that multiple factors affecting interest rates complicate the prediction equation. A look at the “inverted yield curve” suggests things will likely worsen before they improve. Upward pressure on the federal funds rate will continue as the Fed tries to control inflation. Though borrowers’ interest rates are indirectly tied to the federal funds rate, short-term rates will probably stay higher and could rise more in the near term. With the midterm elections over, the next two years of governmental policies should bring some clarity to the interest rate picture.

Once clarity emerges in geopolitical conditions, and the Fed signals that inflation is under control, rate increases should shrink, even while remaining higher, Hill says. He thinks rates will stabilize in 2023 and could drop slightly by late in the year.

Belinda Rosthenhausler, vice president and commercial loan officer for San Diego-based CDC Small Business Finance, predicts relatively stable interest rates in 2023. Small Business Administration (SBA) loans, with which Rosthenhausler deals exclusively, have double-digit rates because they’re tied to the prime rate, adjusted quarterly. Small business owners have seen their payments more than double in the past year. But investors constitute “a completely different submarket,” and “there’s still so much uncertainty.”

Economic And Political Effects
As Sonne points out, rising prices cause inflation. In keeping with basic economics, when demand exceeds supply, prices rise. Pandemic-induced supply chain problems fueled the increased demand when people “came out and started to buy” after “sitting on their hands at home during the pandemic,” he says. Housing also quickly rose, and fast economic expansion drove up prices and job growth.

“The only answer to inflation is to raise interest rates, which causes the economy to slow,” Sonne says. “If you look at the classic economic theory, interest rates must be as high as core inflation. The federal lending rate would have to go up another 100 basis points, or 1 percent. So, we still have a ways to go. I think 2023 is going to be a challenge in terms of interest rates.”

Unlike some cycles in which interest rates rose because of lacking fundamentals and increased risk, Gussis says that the Fed’s recent actions occurred while real estate and business operations mostly were “booming.”

“As far as political influences, based on a split of power, there is good chance that little drastic movement or policy is going to happen in the next couple of years,” Gussis says.

Hills notes that benchmark indices have historically matched current levels with “much lower all-in rates, and that is the direct effect of elevated spreads. The wild card in all of this is the recession. It appears imminent, but when does it manifest and how deep will it cut?”

Implications Of Changing Rates
Self-storage projects that were financially sound before interest rates jumped might become less feasible or even infeasible, Sonne says. As interest rates rise and cap rates follow, valuation typically falls. Self-storage development in 2023 “will continue to be muted by historical standards.” Sales volume has already started to decrease, from 5 percent in urban infill markets to 25 percent in smaller or rural markets.

“Declines in sales volume are usually followed by declines in pricing, because if somebody’s facing a 10-year mortgage coming due and they look at the new interest rate that might be double what they’re paying, suddenly that digs into their cash flow,” Sonne says. “You might think about selling, but then you might have to sell at a lower price than maybe a year ago because of the higher interest rates.”

Gussis foresees reduced sales and acquisitions in 2023 because of higher interest rates. Cap rates rose because buyers’ cost of funds rose. Even cash buyers have adjusted their price modeling. For example, when considering the valuation of a property with $300,000 in net operating income, the valuation difference based on a 5 percent vs. 6 percent cap rate is $1 million less. That’s a million reasons to beware of a volatile interest rate climate.

“Owners enjoying strong operating results are likely not to be as eager to sell at lower valuations,” Gussis says. “There may be instances where seller financing may be very attractive to both the seller and buyer in this market. The seller could possibly sell at a higher price offering higher leverage and ask for a rate that is lower than what a lender may provide but yield a return very attractive to the seller. Lastly, if there is a silver lining, those owners that had locked into [commercial mortgage-backed security] long-term, fixed-rate loans have much lower prepayment implications should they decide to pay off or decrease their current CMBS loan, particularly if there are only two or three years remaining.”

If the climate stabilizes in 2023, then Hill says transactions should bounce back in the second half of the year. Developers, though, will be forced to further scrutinize their projects because of rising construction costs and more burdensome interest carry, which could help prevent industry overbuilding over the long term.

“Overall, in the short term this may cause some pain in the industry, but over a longer-term perspective it may prove to be healthy for an industry that was potentially overheating,” Hill says. “For projects that have recently been built over the past two to three years, there could be some equity injections required for projects that have not fired on all cylinders because they may not be able to take out their existing construction debt without a capital infusion due to the current cost of debt.”

The probable continued increase in interest rates, regardless of the spread, will yield some stalled deals, Rosthenhausler says. But those with sufficient capital can and will do their transactions, though possibly with higher constructions costs. Some, however, will forgo development or purchases.

Preparing For Coming Rate Changes
Despite the uncertain interest rate climate, Sonne is “bullish on the sector.” While managing rental rates is always important, he says it becomes increasingly so in this environment.

“We estimate rental income will keep pace with inflation this year, so it’ll be in the high single digits for rent growth, and that includes existing customer rate increases,” Sonne says, noting that “street rates are always lower because it gets people in the door.”

Preparation through managing operating expenses is also especially important in the current environment, particularly for insurance, utilities, and advertising, says Sonne. And more operators are considering remote management of facilities to lower costs. Contactless management became popular during the pandemic. Algorithms for pricing models on rental rates can be adapted to determine when you need on-site management, which can cut costs as well. Larger operators are using these tools, but some smaller ones aren’t as much. He attributes that to resistance to change, describing one of the Six Sigma principles of management as, “People don’t want to change unless their level of dissatisfaction exceeds their resistance to change.”

Gussis says the key to preparing for the interest rate ride is portfolio and debt management, tracking upcoming debt maturities. New loans will have higher interest rates than those already on their books, so they must assess whether their operating income will support a new loan sufficient to pay off their existing loan. An owner who has variable-rate financing might be wise economically to refinance to a fixed-rate loan, which is typically cheaper than a variable-rate loan. That removes that specific risk of further rate increases.

“Folks that are currently at the beginning stages of a construction loan or are in lease-up are likely most vulnerable to the interest rate increases that we have experienced in 2022 and any more in 2023,” says Gussis. “These loans had interest reserves built in likely calculated based on rates 3 percent or 4 percent less than the rates they are now paying. Those reserves are going to be utilized much quicker than projected, and those investors need to have a capital plan to fund the additional cost of construction and lease-up due to the bumps in interest rates.”

Gussis adds that developers must consider not only the increased cost of material and labor but also the interest rates they’ll probably have to pay. Despite that rental rates are showing healthy year-over-year increases and that a given feasibility study shows a market can handle more supply, “the economics may simply not work in many markets.”

A realistic and pragmatic approach to analyzing a transaction is a good way to prepare for the uncertain interest rate environment, Hill says. The current market doesn’t lend itself to thinking that “rose-colored glasses are the trick to making everything look better; rather, this is a market where an abundantly clear view will provide the best and most strategic vantage point.”

Hill says it’s also very important for borrowers to think carefully about the time necessary to execute their business plans “and then be very strategic when utilizing debt products to understand how things like duration, amortization, and liability can impact their cost of capital.”

“This is not a market where capital is homogenous,” says Hill, “so it will likely pay dividends to spend a little more time to understand your full array of options.”

Hills thinks interest rates don’t tell the current environment’s whole story about rental rate and occupancy fundamentals. The speed with which interest rates rose in the second half of 2022 “had a chilling effect on the transaction market,” he says, but “if you read between the lines and listen carefully you can also see there is concern that market fundamentals may be softening with a recession looming.”

“So, really there is a combination of factors at work that have brought headwinds to the transaction market, and that is not lost on the banks and capital providers, many of whom are taking a wait-and-see approach currently,” Hill says. “I am optimistic that as 2023 plays out, we will start to gain some clarity into the depth and magnitude of the recession that the Fed seems intent on creating with the dramatic monetary policy we have witnessed this year. Once there is some clarity, I think the capital will come back in abundance to support transactions, and that will help bring down rates as credit spreads normalize.”

Sonne remains sanguine on self-storage. The sector will continue to see strong institutional investor interest and investment among all commercial real estate types, he says, “and that tells you a lot.”

He cites Ken Nitzberg, chairman and CEO of Emeryville, Calif.-based Devon Self Storage, who recently asked Sonne: “Where … else would you rather be than self-storage in changing economic times?”

“And I agree with that,” Sonne says. “Self-storage has proven in boom and bust markets before, for decades, that it outperforms other sectors. And I believe self-storage will continue to outperform other sectors. So, I wish I had a big 10×10 kind of outlook on the year for you, but I think it’s going to be a more muted 5×5 kind of a year. But I think, compared to everything else, that’s pretty good.”