COMMERCIAL REAL ESTATE FINANCING IN THE CURRENT RATE ENVIRONMENT

Ryan Speirs 

Utah’s commercial real estate activity has softened in the past few post-pandemic years, but there has been modest growth momentum in the first half of 2024 and a foreseeable drop in the Federal Funds rates may drive more growth.

A lower federal funds rate is widely expected to be announced when the Federal Open Market Committee meets Sept. 17-18. This will be the first rate cut in more than four years, following a series of aggressive rate hikes — 11 over the span of a year and a half — aimed to tame inflation.

The last time rates fell was in March 2020 at the outset of the pandemic when the Fed held an emergency meeting, bringing rates near zero. The federal funds rate is currently set at a 23-year high of 5.25 percent to 5.5 percent. As the Federal Reserve reduces interest rates, lowered financing costs may increase the pace of new commercial property development.

Increased Equity Requirements Will Continue

Equity requirements have increased over the past two years in commercial real estate financing because interest costs have created loan sizing limitations compared to prior years. As a result, many developers had placed projects on hold. But with the industry acclimating to a higher interest rate environment, combined with an expectation of some near-term relief in rates, more are restarting developments in 2024 and into 2025. There remains an appropriate amount of caution, however, and borrowers are making careful and deliberate choices of when to move forward.

CRE Trends Follow Residential Construction Trends

As for residential housing, Utah’s positive demographics continue to drive healthy demand. From 2022 to 2023, Utah’s population grew by 1.1 percent to 3,417,734 residents, ranking ninth in the nation for growth.

But housing inventory is still too low to meet this demand. In fact, the state has experienced a housing demand and supply mismatch since 2010. This drove the Beehive State’s home values up 1.6 percent from July 2023 to July 2024, bringing the Utah median home price to almost $521,221.

Some good news is that mortgage rates are back to their lowest level since early 2023, providing some modest relief for homebuyers. Average rates on a 30-year fixed-rate mortgages have dropped more than 1 percent in the past few months, and some rates on 15-year fixed-rate mortgages are back below 6percent. We’ve also seen a mo dest increase in Utah residential permits, up 6.4 percent from year-to-date June 2023 to year-to-date June 2024, according to the Ivory-Boyer Construction Database.

Multi-family — an alternative to expensive single-family housing — continues with healthy demand, which accounts for the majority of borrowing activity we’re seeing.

Is a Severe Real Estate Downturn Looming?

Over the past several months, concerns about a possible economic recession were driving fears about a potential downturn in commercial real estate activity. And some regularly updated macro-economic data do support some of these fears, but in Utah we’ve seen a year-over-year increase in real estate development activity across all sectors, except office. Statewide residential and non-residential building permit value is on the rise, from $5.3 billion year-to-date June 2023 to $6 billion year-to-date June 2024 — a 12.8 percent increase, according to the Ivory-Boyer Construction Database.

The historically low cap rates of the early 2020s have increased but may now be peaking. There is currently wide variability in cap rates, the key driver in commercial property values. However, according to Statista, across the U.S. the average commercial real estate capitalization rates now rest near 10-year highs between 5 percent and 7 percent or more, depending on asset class — office, industrial, retail, multifamily, hotel, and senior housing — and an increase of around 200 basis points from 2021 lows.

Understandably, because of these factors along with some softening property performance in select markets and property types (notably office), CRE investors have bid down prices, creating a bid-ask price gap. But it’s unclear now whether prices will continue to flatten or downward drift. It’s possible that a lowered interest-rate environment may spur a reversal in cap rate increases and stabilize income property valuation variability.

Changes Continue in Office Space

It’s unclear whether office space will ever return to pre-pandemic usage. Proactive office landlords are working with their tenants well in advance of their lease maturities to determine tenants’ occupancy plans for the future. On the positive side, a May 2024 study by ResumeBuilder.com found there are signs that more workers are returning to the office, noting that 23 percent of companies require employees to be in the office five days, and 26 percent require four days per week. On top of that, one in four companies are planning to expand their return-to-office work policies in 2025.

Now is the Time to Prepare for Maturing Loans

Nearly $2 trillion of the $4.7 trillion in commercial real estate loans nationwide will mature over the next three years, according to the Mortgage Bankers Association. As many commercial real estate loans mature in the coming years, banks are working with borrowers to prepare them well in advance. In some cases, more capital will be required for refinance. As maturity approaches, banks typically evaluate a property’s loan sizing metrics, including debt service coverage, cash flow, loan to value and other underwriting considerations. Borrowers are well- served to develop strategies to improve property performance, reduce debt, and explore options to enhance the property’s appeal to tenants ahead of loan maturity.

Utah’s Fundamental Strengths Endure

Overall, Utah continues to be better insulated from potential economic downturns than other markets, due to our diverse economy, our low unemployment, continued in-migration and new businesses relocating to our state. Utah’s July 2024 unemployment rate was 3.2 percent, compared to the U.S. rate of 4.3 percent. The state’s annual total employment increased by 2.8 percent, or 48,000 jobs, from July 2023 to July 2024. The Beehive State’s diversified economy continues to be a source of strength through economic fluctuations.

Ryan Speirs is senior vice president and Real Estate Banking Group manager at Zions Bank. He has more than 20 years of experience offering solutions to commercial real estate borrowers in the metro Salt Lake City market.