The Transmission Mechanisms of Higher Rates
Commercial mortgages are at the intersection of evolving capital market conditions, shifting real estate fundamentals and complex regulatory landscapes. Today’s investment conditions in the sector are unique, both historically and compared with other institutional asset classes. There are three factors in particular driving recent performance:
- Interest Rate Increases: The rise in interest rates since the spring of 2022, driven by the Federal Reserve’s campaign against inflation, has led to a decline in property values.1 Although MetLife Investment Management believe property values (office excluded) are now past the trough, the valuation reset has caused many real estate investors to need debt or preferred equity capital when their existing mortgages mature, reducing liquidity.
- Remote Work Impact on Office Sector: A rise in remote work has strained the office sector, contributing to rising risk premiums across all commercial real estate sectors. This has also strained real estate liquidity.2
- Banking Sector Stress: Increased regulatory requirements have led to a reduction in commercial mortgage lending by banks, historically a key source for medium- and high-risk loans. This contraction, coupled with the anticipated regulatory shifts like the Basel III Endgame, has opened doors for debt funds and other lenders to fill the gap, although not entirely.
As a result of these factors, the spread between commercial mortgage rates and Baa corporate bonds, which has historically been highly correlated since the global financial crisis (Exhibit 1). However, unlike during the GFC, remained elevated due to the conditions mentioned above.
Cycle Timing and Systemic Overestimation of Risk After Downturns
Lenders are focused on three measures when evaluating the credit of commercial mortgage loans: loan-to-value ratio, debt service coverage ratio and debt yield. While these factors have established correlations with bond-equivalent ratings, the commercial mortgage market often lacks a comprehensive understanding of how loan terms impact loan risk. The primary non-quantified factors include interest rate caps on floating-rate loans, cash management and escrows for building capital, leasing costs or other cash flow shortfalls. This gap in understanding leads to an overestimation of risk by mortgage investors when loan conditions are more favorable to lenders (such as from 2010 through 2013 and today) and underestimation of risk whey they are not (such as 2005 through 2007 or 2021), in our view. Moreover, the relationship between real estate values and inflation is critical, yet often overlooked. Real estate values have historically tracked inflation closely, due to construction costs tied to commodity prices and labor (Exhibit 2). Post-downturn periods tend to see reduced construction starts, lowering “construction risk” or “overbuilding risk” for commercial mortgage loans.
Upon evaluating these two factors today, we believe that loan terms are lender-favored, reminiscent of the global financial crisis era, and construction starts are decelerating at the fastest pace since 2010 (Exhibit 3). Despite lagging commercial real estate price indexes, early signs suggest a market upturn, indicating a potentially opportune moment for debt investors, especially in higher-yielding mortgage risk segments.
Conclusion
While the past 12 to 18 months have presented challenges, they have also unveiled opportunities. Specifically, current mortgage yields are offering attractive relative value, and it appears investors are being adequately compensated for moving up the risk spectrum. Moreover, pricing data suggest we may be at the start of a new cycle, which our research indicates can be a uniquely opportune entry point for mortgage investors.