Rising Rates Are Blowing Up Commercial Real-Estate Deals

A growing number of commercial real-estate buyers are threatening to walk away from recent transactions unless sellers offer better terms.

Rapidly rising interest rates are to blame, and investors who agreed to a purchase price earlier this year when financing was cheaper are now demanding price cuts or other concessions before closing.

The retrade wave

The insistence on retrading deals began when bond yields started rising in late summer. It intensified last month after the Federal Reserve raised its benchmark rate by a quarter percentage point and signaled more to come.

"Rates went up, what, just a few days ago and I'm already getting calls where they're talking retrade," Jeff Powers, a Cushman & Wakefield managing director, said last month.

The typical six to 12 months between when a buyer signs a contract and when the sale is completed can make a substantial difference in financing costs when borrowing rates are rising this fast.

Eastham Capital agreed to pay about $20 million for a roughly 200-unit apartment property in the Midwest. Before it put down a deposit, borrowing costs jumped by more than six-tenths of a percentage point, said Matt Rosenthal, the Boca Raton, Fla.-based firm's founder and managing director. Rosenthal convinced the seller to cut the price by $600,000 after threatening to walk away. "It's certainly a different deal now," he said.

In June, real-estate firm Medalist Diversified agreed to sell a 65,000-square-foot retail property in Greenville, S.C., for about $10.2 million. As rates rose during the summer, the buyer sought a price cut, and Medalist eventually agreed to reduce the price by $100,000. The deal closed in September "due to the potential impact of the interest rate environment," said Chief Financial Officer C. Brent Winn Jr.

Early signs of broader distress

These retrades are an early sign of broader market distress weighing on property values, slowing development and making maturing loans harder to refinance.

"We are working harder to close deals now than we ever have before," said Bobby Werhane, a managing director of Marcus & Millichap's IPA Capital Markets division.

Commercial real estate, from offices in certain cities to shopping malls and hotels, had been enjoying a budding recovery. Reduced new supply, a pickup in workers returning to the office and a leveling off in interest rates in recent years helped boost property values. Now, the sudden surge in interest rates is derailing that progress.

The fallout extends beyond property owners. Falling real-estate values and fewer sales squeeze property-tax and transfer-tax collections. Higher rates also make it harder for developers to earn their targeted returns, cutting demand for construction workers, architects and building materials.

"The hurdle is simply higher," said Alfonso Munk, co-head of investment management at Houston-based Hines, one of the country's largest developers.

The distress numbers are climbing

More than $5 trillion of commercial and multifamily real-estate mortgages are outstanding. That is far more than Americans owe on credit cards or auto loans combined.

Higher rates are also adding to landlord distress because mortgages made when borrowing costs were lower are coming due. Owners that cannot refinance or repay the loans at maturity are falling behind or being pushed into special servicing.

Data firm Trepp reported that in August, 11.42% of mortgages packaged into commercial mortgage-backed securities were being handled by special servicers, a sign those loans were facing problems such as missed payments or difficulty refinancing at maturity. That is the highest special-servicing rate since February 2013.

From late August, when rates began rising more sharply, through Friday, the FTSE Nareit All Equity REITs Index fell more than 8%, while the S&P 500 gained 1%, according to real-estate analytics firm Green Street.

One bright spot: lenders and investment funds still have ample capital to put to work. Northwind Group, a New York-based lender, recently provided a $208 million first mortgage to convert much of a 355,000-square-foot office tower in Brooklyn into apartments, with banks and private lenders competing heavily to make the loan.

Still, on the front lines, fights over price and retrade attempts are becoming more common. "There's just much more friction in the market," Werhane said.

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Options market and stocks to watch

CRE distress is a classic rates-driven rotation trade. Falling REIT prices and rising special-servicing rates tend to push put flow into real-estate ETFs and rate-sensitive lenders, while developers and brokers see choppy, headline-driven moves.

Stocks to watch include REIT ETFs like VNQ and XLRE, which track the sector getting hit by the 8%+ REIT slide. Brokerages living off deal volume are in the crossfire too: CWK (Cushman & Wakefield) and MMI (Marcus & Millichap). Office and retail REIT names like VNO and SPG are worth watching for elevated put activity if retrades keep spreading.

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