Despite the Fed's higher-than-expected interest rate cut in September, results will be slow to trickle into the CRE funding market. Pressure from the coming wave of debt maturities, valuation difficulties, and weak demand means that lender expectations are set to change by 2025, leading to a more competitive financial environment. Developers on the fence about borrowing should act sooner rather than later as the desires of construction lenders can change quickly.
That said, work in the fields within CRE is beginning to diverge so that a few stand out as stronger than others. Developers will need to work closely with buyers to identify unique opportunities and implement a few key strategies for success. As lenders impose more restrictions and change their criteria, you can be ready to move around to meet these challenges with customized advice from your broker.
Current Conditions
On September 18, the Federal Reserve announced a rate cut of 50 basis points. The next day, banks announced a new Prime Rate of 8.0%. The resulting increase in the S&P 500 in the following weeks shows how much this change pleased investors. But the Fed has made it clear that this is not a sign of a new trend. Since CRE loan rates are based on more than the Prime Rate, they have less of an impact on borrowing than it might seem.
Supply chains are still overwhelmed, causing many already broken projects to be put on hold. Lenders in some cases offer loan extensions to avoid defaults. However, when those extensions expire in 2025, they will add to the trillion-dollar maturity wave expected to arrive next year.
Banks, especially regional banks, and life insurance companies remain the primary sources of financing for construction loans. Banks have slashed margins from 75% on loan-to-cost (LTC) to as low as 50%, meaning borrowers have to find new ways to make up the difference. Equity financing is where the real challenge lies. Those lenders have tightened interest rates and loan terms, now using higher exit rates and debt service coverage ratios (DSCR) in their underwriting.
2025 Predictions
Many CRE sectors may have seen a dramatic slowdown in growth, but not even across the board. Sales and office turnover will remain very low as the difficulty of predicting future performance causes lenders to shy away. On the bright side, numbers for warehouses, data centers, and manufacturing look strong in the non-residential 40% of the market, even if the overall industrial sector is stagnant. Expected growth for institutional, health care, and leisure facilities is 4%, the strongest in education (according to the AIA). This growth may be influenced by immigration levels (closely related to election results). In terms of borrowing, the slowest sectors may see less loan availability than the most efficient sectors.
Larger banks will see higher defaults due to the maturity wave than smaller banks, will. There is also more risk for lenders in rental properties than in owner-occupied properties. If borrowers are defaulting, lender strikes lower CRE rates. A reduced ability to meet debt service requirements also puts downward pressure on available loans. To protect against this risk, lenders now require higher exit rates and DSCRs in their underwriting.
Finally, Some Good News
The key to success is to act now before the credit situation worsens. Our team provides personalized advice based on your business goals and objectives, and helps clarify how lenders' expectations have changed overall. Achieving funding goals at this stage may result in less competition in the near term.
While 2025 may be a challenging time to fund new construction, there is still an opportunity in 2024. By working before the end of the year, there is an opportunity to gain long-term benefits such as a competitive edge over developers who delay, leading to a better position in the market where access to finance improves.
In particular, look for financing outside of the big banks to find non-traditional lenders that won't face the same risks. Our team is here to help you match your project with the right funding. We'll help you use what's left in good market conditions before the end of the year.
