Interest rates crash commercial property Covid recovery

452 Fifth Avenue (Wikipedia, iStock, illustration by Shea Monahan for The Real Deal)

In early December, Andrew Chung’s Innovo Property Group paid a deposit and signed a deal to purchase a 30-story HSBC-anchored office tower overlooking Bryant Park for $855 million.

As Chung worked to close the deal at 452 Fifth Avenue that would take him from a run-down industrial builder to a Midtown office leasing company, the Federal Reserve signaled that it would raise interest rates to fight inflation. By May, the SOFR rate — a rough estimate of a bank’s cost of borrowing — rose to 0.78 percent from near zero in mid-March.

Five months later, Chung missed his deadline to complete the tower and lost his $35 million bail.

While the deal came with various challenges — Chung struggled to raise equity from the start and took a risk by dumping the initial deposit, sources said — rising interest rates certainly made things more complicated. Chung had to give up more and more money to secure funding. Innovo did not respond to a request for comment.

The public collapse of Chung’s deal for the HSBC tower captivated the city’s commercial real estate industry and fueled concerns about rising interest rates.

“We definitely believe now is a good time to be the second best bidder in the business.”

— David Schwartz, Slate Property Group

And while it’s the largest deal to fall apart since interest rates skyrocketed earlier this year, it’s far from the only one. Buyers, sellers and owners across the city are trying to grapple with an interest rate environment that many younger professionals have never faced in their lives.

In June, the Fed raised interest rates by 75 basis points, the largest such hike since 1994. Economists expect similar hikes will follow in July and September.

Higher interest rates mean financing becomes more expensive, which in turn means homeowners have to pull more money out of their buildings to cover the costs. At the very least, it makes selling more complicated since all sides change things on the fly.

“There are certain trades that I’m working on that have not yet been retraded, but we fully expect them,” said Andrew Sasson, a broker at Ackman-Ziff. “Lenders trade pricing to borrowers mid-transactions.”

The big cold

As interest rates have risen, dealmaking has slowed.

Across the country, commercial property sales fell 16 percent annually to $39.4 billion in April, according to MSCI Real Assets, falling for the first time in more than a year.

A wave of maturing office debt will continue to test the market as owners may find they can’t borrow as much as before to pay off their loans.

According to Trepp, more than $7 billion in CMBS office loans in New York will mature this year, more than the previous three years combined.

Trepp’s Manus Clancy said on a recent podcast that higher borrowing costs are likely to put pressure on owners who already had a small buffer to cover their debt servicing costs. In these cases, the owners are likely to have to inject equity into the business when refinancing.

“At that point, that’s probably going to become a cash-in,” he said.

For real estate owners with maturing debts, the refinancing options have not only become more expensive, they have also become more limited. In addition to rising interest rates, the CMBS market has declined in recent months on inflation concerns and instability in Ukraine.

“The CMBS market isn’t doing very well,” SL Green Realty president Andrew Mathias said at a Nareit conference in June. “There aren’t many cash buyers for triple-A bonds.”

With CMBS declining, borrowers must instead turn to banks or loan funds for refinancing or new purchases. But credit funds that are heavily dependent on credit lines, so-called warehouse financing, are also closely linked to price fluctuations.

“If you buy stabilized properties at a tight ceiling [rate]it’s hard to fund,” said Ian Ross, founder of Manhattan-based development firm SomeraRoad.

Rate Caps

Borrowers have protection against rising interest rates, but these are also becoming increasingly expensive.

One such protection – interest rate caps – has increased tenfold in recent months.

Lenders require most borrowers to protect themselves against unexpected interest rate increases by purchasing interest rate caps, where a counterparty agrees to make payments to the borrower if interest rates rise above a certain point.

Six months ago, a two-year cap on a $50 million loan cost a borrower $85,000, according to risk management consultancy Chatham Financial. That cap now costs $893,000.

“It’s gone from rounding errors to significant costs,” said Chris Moore, a member of Chatham’s real estate team.

Moore said volatility in commercial debt markets will continue to prevail to cap prices. And as with the movement of interest rates, uncertainty about how much caps will cost from signing a buyer’s contract to closing a deal is just another factor for borrowers to consider.

“It adds an extra layer of uncertainty and potentially higher costs to underwriting,” he said.

No safe haven

Sellers may find that the interest rate environment warrants a more conservative approach.

David Ash, founder of Prince Realty Advisors, said owners could seek to close more direct deals rather than a formally conducted marketing process, giving them and buyers more flexibility to accommodate changing financing conditions.

“I see a lot more interest in doing things head-on and calmly with people who they know can work with them and be close to,” he said.

In April, Vornado Realty Trust entered into a direct sale of its Center Building office property in Long Island City to 60 guilders for $173 million. Vornado’s Jared Toothman and 60 Guilders’ Kevin Chisholm negotiated the deal over dinner.

It’s clear that rising interest rates are making things difficult for buyers and sellers, but it’s not like they can sidestep the problem by holding.

After Chung’s deal to buy the HSBC tower fell through, its owner, Eli Elephants Property and Building Corp., had to refinance the property as its existing loan matured. PBC ended up paying a higher rate of 3.9 percent – effectively a penalty for not selling.

Ackman-Ziff’s Sasson said sellers had nowhere to hide.

“The alternative is secure financing through loans, and the financing market has also changed,” he said. “Either the value goes down when you sell it, or the interest goes down when you finance it.”

emergency game

Some think rising interest rates may present new opportunities as more deals fall apart.

In some of these cases, the highest bidder on a deal may not be able to secure financing, resulting in bidders with smaller offers walking away with a property.

“We definitely believe now is a good time to be the second best bidder on the deal,” said David Schwartz, co-founder of New York-based Slate Property Group.

Patrick Carroll, CEO of development firm Carroll, said his firm recently closed two deals in South Florida after falling out of contract with the original buyer.

“In times like these, lenders become extremely picky,” Carroll said.

When the pandemic hit New York City in March 2020, opportunistic investors were ready to pounce. However, distressed plays were largely absent thanks to record low interest rates, government stimulus packages and ample capital. Now that dynamic is changing.

SL Green’s Mathias said if the LIBOR or SOFR rate goes to 3 percent some “capital structures will come under pressure”.

“You could see some interesting distressed possibilities,” he said.

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