Top five considerations for commercial real estate lenders and borrowers

21 June 2023
The commercial real estate industry is experiencing heightened volatility against the backdrop of high inflation, rising interest rates and a handful of widely publicised bank failures.

A recent IBISWorld report showed that while the US commercial real estate market was mostly steady over the past five years, it’s expected to see a marginal price decrease of about 2 percent in 2023. Other regions are facing similar headwinds. Investment in Hong Kong’s commercial real estate, for example, dropped 10 percent year-over-year in the first quarter of 2023.

It is worth emphasising that even in a global economy, certain economic realities vary by jurisdiction. The US’s inflation rate, for example, is on the decline as of this writing, in part because of the US Federal Reserve’s decisive rate hikes since March 2022. The 4 percent inflation rate over the 12 months ending in May 2023 is the US’s lowest since 2021. That’s still above the Fed’s 2 percent inflation target, but many experts believe the Fed will now pause rate increases. (Fed rates are now just above 5 percent.)

The UK’s inflation rate, by contrast, was at 8.7 percent in April 2023 (based on the most recent numbers available), down from 10.1 percent the month before but still high enough for UK chancellor Jeremy Hunt to say recently that the UK had “no alternative” but to raise interest rates further. (They’re at 4.5 percent.)

These numbers are intended to illustrate the general truth that while global economic trends are real, they are not evenly distributed by region or country, or in many cases by industry and sector. It’s certainly true that businesses and investors in virtually every region must now account for relatively high inflation and interest rates and prepare themselves for sudden changes in these and other areas.

Given these realities and a general increase in global economic uncertainty, commercial real estate lenders and borrowers are now exercising greater caution before working together. This article summarises five factors borrowers and lenders need to consider now.

1. The changing macroeconomic environment

Macroeconomic factors, including geopolitical tensions, inflation, rising interest rates and still-tepid economic growth, are hindering the commercial real estate industry. The macroeconomic environment is more fluid than ever, and how lenders manage their interest-rate risk may determine if they stay afloat. In the current environment, lenders might prefer to offer funds on a floating-rate basis. If that’s not possible, they may want to present a fixed rate that's hedged to a floating rate. 

When interest rates increase, borrowers get hit with increased debt costs. If borrowers can’t pass these costs to tenants, their profits will decrease and they could struggle to repay their loans. Borrowers should also consider that inflation has led to increased labour and maintenance costs for the commercial real estate industry at a time when many assets have declined in value. 

2. The importance of the sector

More than ever, lenders and borrowers must understand and account for sector trends within the broader commercial real estate market. Tenant demand is high for logistics hubs and data centres, for example. Office property owners, meanwhile, are struggling to attract renters due to the prevalence of remote and hybrid work arrangements. Similarly, brick-and-mortar retail stores continue to suffer in an era of online shopping. And retail and office spaces in smaller towns and rural areas appear to be struggling more than those in prime locations.

3. Credit quality

As interest rates rise, credit quality is more important than ever. To qualify for a US commercial real estate loan, most lenders require borrowers to provide a down payment of at least 25 percent and confirm that no more than 36 percent of their monthly income will go toward repaying the debt. Meeting these criteria minimises the risk of a borrower defaulting on their commercial real estate loan, the rate of which hit 5.2 percent in the US in February, the highest it’s been in 14 years.

Lenders and borrowers must consider whether a borrower can pass rising rate costs on to tenants, and if not, how long they can withstand the pain.

4. Asset price volatility

Asset prices in the commercial real estate market have been notably volatile, and certain portfolios have suffered significant markdowns. Borrowers and lenders must understand that certain sectors are more volatile than others. For example, warehouses remain steady while offices are declining — but these trends can change suddenly. Lenders need to exercise some caution when lending against an asset class declining in value. If a borrower were to default on capital or interest payments, the asset’s diminished value may not cover the loan amount owed.

5. Sustainability and safety

The World Green Building Council reports that buildings account for 39 percent of total carbon emissions, a remarkable statistic. Commercial real estate lenders, borrowers and other stakeholders (including tenants) are increasingly aware of real estate’s carbon footprint and are demanding action. Lenders are more than ever assessing borrowers’ ESG strategies — in particular their plans for reducing their carbon footprint — before working with them. For this and other reasons, borrowers can’t afford to ignore the importance of developing and implementing sound sustainability strategies.

Lenders and borrowers must also consider the high costs of complying with new and changing ESG regulations. Examples include those in the UK related to boilers and heating systems which require high energy-efficiency ratings and, in the future, hydrogen-ready gas boilers or hybrid gas boiler-electric heat pumps.

Health and safety compliance costs — often considered part of ESG — are also rising. The UK’s Building Safety Act 2022, for example, recently established a new building safety regime for high-rise residential buildings in England that will affect new and existing properties. These and similar obligations in other jurisdictions make it more costly to acquire and maintain commercial real estate in a time of rising inflation and increasing debt costs. 

The commercial real estate sector is facing real challenges, but like other sectors it’s subject to cycles and has had downturns in the past, such as those during the recession of 2008-2009. That said, the sector has shown remarkable resilience. No matter what the conditions, lenders and borrowers can significantly lower their risks by keeping abreast of global and regional trends and considering relevant factors before making commitments.