The New CRE Finance Normal is the Old Normal

Last Friday, at its annual meeting in Jackson Hole, Wyoming, the Federal Reserve made it clear that inflation was still—heavily—on its mind. Here’s what Fed Chair Jerome Powell said in part of his “shorter” and “more direct” than usual speech:

“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”

As he added, “While the lower inflation readings for July are welcome, a single month's improvement falls far short of what the Committee will need to see before we are confident that inflation is moving down.”

There is no way to put this comfortably—if you were hoping for the pressure to come off interest rates in the foreseeable future, you are bound for disappointed. Rates will continue to rise. The next increase, coming on September 21, is pretty much guaranteed to be 50 basis points and there’s a good chance of it being 75 again.

For those whose commercial real estate careers are relatively short so far, this may come as a shock. Since 2009, we’ve seen two stretches—between 2009 and 2015 and then 2020 to early 2022—of cheap money. Forget the federal funds rate, the amount at which banks lend to one another overnight, for a moment. Look instead at the history of the bank prime loan rate posted by a majority of the top 25 insured U.S.-chartered commercial banks and documented by the Federal Reserve Bank of St. Louis. Here’s the chart:

The prime rate in these two stretches fell to 3.25%. The previous time that last happened was August 1955. Prime is usually far above, with 4% and 5% being historically on the low side. Even if you ignore 1979 through 1984, when double-digit rates were the norm, 6%, 7%, 8%, and 9% made regular appearances.

Our take is that someone should queue up the song, “Everything Old Is New Again.” What people had come to expect in financing was the real aberration and no longer the case. You can get mad, disappointed, or even panicked, but that won’t matter because markets are going to do what they want, and for at least the next three to four years, that will mean much higher interest rates.

Advice we’re offering clients—and taking ourselves—is that it’s time to rework strategies and business models with this new-old reality in mind. There isn’t going to be plentiful cheap money. Even if you are well-capitalized, you have to at least consider how much borrowing would have cost because that capital also represents money that could be lent out to make interest.

For new projects or refis, you might consider mezzanine financing, with its hybrid debt-equity nature. Perhaps you’ll want to go the bridge route to add in some breathing space and watch the ups and downs of interest rates and making an opportunistic choice when possible. A second look at the graph is a reminder of how frequently significant changes can happen.

Most importantly, come up with realistic plans that work with new higher interest rates and don’t depend on a period of easy money again. It’s highly unlikely to happen again in the near future and expecting a rising tide to float your business boat is reckless. As Warren Buffett has said, it’s only when the tide goes out that you see who had been swimming naked. Don’t get caught out.

If you want some ideas of how to invest smartly, with a good return, in multifamily even as interest rates climb, give us a call.