Key takeaways:
- Focus on maintaining a strong cash flow through rate volatility
- Try to keep tenants in your building, as the cost to replace them is higher now
- Consider restructuring or refinancing your loan to avoid debt maturities
- Work with an advisor to identify strategies to lower debt expenses
The commercial real estate market is facing strong headwinds right now. Rising interest rates, continued disruption in office spaces and work environment following the COVID-19 pandemic, and future uncertainties have created a volatile environment for business owners operating in this space. Slow revenue growth and heightened costs are applying further pressure, especially for those with limited liquidity.
However, despite these concerns, there are opportunities for businesses to protect themselves and set themselves up for the future. In this article, Huntington’s Executive Managing Director of Commercial Real Estate Trish Kelly and Senior Managing Director of Financial Risk Management Larry Heath discuss how to help navigate this challenging market by maintaining liquidity, protecting your assets, and employing risk mitigation strategies.
Maintaining liquidity is a top priority
The Federal Reserve (Fed) opted not to increase rates at their meeting in June, keeping the benchmark rate at 5% to 5.25%. Prior to this meeting, the rate had been increased ten consecutive times since March 2022. This significant change in the cost of money and the speed with which it has risen has understandably impacted operating, labor, and material costs for real estate projects. According to commercial real estate organization JLL’s latest construction outlook, U.S. construction costs increased by 12% in 2022 and are estimated to grow an additional 4-6% by the end of 2023†.
These elevated costs could impact existing financing on commercial projects, putting borrowers in a difficult place to bring in more equity or rely on revenue growth to cover the gap.
"The movement of interest rates is more impactful than the newly established rate. Underwriters factor in a certain amount of interest rate stress when structuring a loan, but the rapid movement of rates beyond what was projected means loans increasingly need to be restructured."
Trish Kelly
Executive Managing Director, Commercial Real Estate, Huntington Bank
Maintaining a strong cash flow is crucial as financing projects becomes more expensive.
“Hold onto your liquidity, and don’t rush into a deal,” says Kelly. “What might seem like a good price now could lead you to lose money saved in the cost of borrowing. There will likely be opportunities to purchase real estate at better prices a year or two from now rather than today.”
Keep tenants in your building
Supply and demand imbalance in real estate is not uncommon. However, typically that imbalance is a localized problem. The shift to remote and hybrid work has created a national imbalance that disproportionately affects central business districts that once relied on in-office workers. As of Q2 2023, just 42% of surveyed U.S. companies work full-time in offices‡. Hybrid work structure is on the rise, meaning office workers occupy commercial buildings fewer days per week. Office vacancies could lead to companies not renewing leases or downsizing to accommodate fewer in-office workers.
Office properties come with long-term leases, so owners of these buildings may be able to avoid immediate cash flow issues. However, lease maturities coming up now pose a problem – and an expensive one.
“There is a very high cost to replacing a tenant right now. Commercial real estate owners facing lease maturities should consider doing everything possible to keep their tenants in the building,” says Kelly.
Avoid debt maturities in the short term
Loan maturity during a period of volatility in the commercial real estate market can present an added risk to a business. Real estate owners with debt obligations maturing within a year could, at best, face less favorable terms due to today’s rates or, at worst, be at risk of defaulting on a loan. If revenue has not grown to counteract the effects of the 5% rate increase, new financing might not be affordable.
“If you’re facing debt maturity in the next 18 months, refinancing your loan now can help you get ahead of future market shifts. Those concerned about short rates lowering before that happens could still save money with a 3- to 5-year term and a fixed rate loan,” says Kelly.
Restructuring is an option for business owners facing a potential default. Extending the loan repayment length could provide dual relief by lowering the risk of not meeting obligations and reducing concerns about maturing before interest rates ease in the future.
“The bottom line is business owners want to avoid debt maturity as much as possible right now. Your banker or advisor can work with you to determine what would work best for your loan and cash flow needs.”
Trish Kelly
Executive Managing Director, Commercial Real Estate, Huntington Bank
Identify strategies to lower debt expenses
Predicting where rates will be in the future is a challenge. With the latest pause in rate hikes from the Fed, some business owners might balk at locking in rates now when those rates might decline over the next 1-2 years. Those with sufficient cash flow have the luxury of adopting a wait-and-see approach, but businesses with tight cash flow or variable-rate debt might benefit from acting now to remove as much risk as possible.
Opting for an interest rate cap is one risk mitigation strategy. However, these have become more expensive in today’s market, making it a difficult choice for businesses already facing tight cash flow. On the other hand, interest rate swaps have emerged as a strategy to potentially reduce interest expense immediately due to the U.S. experiencing an inverted yield curve.
“Interest rate swaps have become more attractive. Because the yield curve is inverted, the market has allowed business owners to lock in a lower rate than the current floating rate and realize immediate cash flow savings,” says Heath.
By taking this approach, borrowers could reduce their expenses compared to their current floating rate and lower the risk of experiencing future rate increases, Heath explains.
Weather the storm with the right strategy
The commercial real estate market is full of unknowns and speculations. Businesses operating in this space can weather the storm by taking smart steps to protect their cash flow, assets, and debt.Huntington can work with your organization to develop the best solution for your business. Reach out to your relationship manager to start the conversation.
† JLL. 2023. “2023 U.S. and Canada Construction Outlook: Navigating a Changed Reality.” Accessed May 30, 2023.
‡ Semuels, Alana. 2023. “Return to Office is Losing. Hybrid Work is on the Rise.” Time Magazine. May 19, 2023. Accessed May 30, 2023.
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