Inflation and Rising Interest Rates: Where Will the Hardest Hits Be Felt?

A peek into the future of Greater New Orleans’ commercial real estate market

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Does the combination of increased inflation and rising interest rates pose a threat to the commercial real estate market in the Greater New Orleans Region? The answer is, “It depends.” While all sectors of commercial real estate will be affected, the degree to which the impacts are felt will vary. The two sectors that will likely be most vulnerable to the double whammy of rising interest rates and inflation are office buildings and lodging facilities.

Office Buildings
The office market was in the process of recovering from the effects of the pandemic when it became faced with significant pressure from high inflation and increasing interest rates. In the fourth quarter of 2022, rental rates for office space in the New Orleans CBD averaged approximately $19 per square foot, with a vacancy rate of about 15%. This translates to an effective rental rate of ±$16.15 per square foot ($19.00 X 85%, rounded). When combined with average expenses of ±$11 per square foot, net income of a little more than $5 per square foot is available for debt service and other ownership expenses (i.e., income taxes, etc.).

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A net operating income of $5 per square foot would indicate a value of approximately $80 per square foot. In comparison, the buildings currently listed for sale in the Central Building District have asking prices in excess of $175 per square foot. This implies a market-indicated discount of ±54% between value and price.

Lodging Facilities
Similar to office buildings, lodging facilities are highly susceptible to inflation as the cost of all the goods and services in the operation of the property will continue to rise. While operators are able to raise their room rates to compensate, if inflation continues at the current level or higher, the market will eventually prevent significant rate increases as travel is not considered a necessity and will be curtailed, as was seen during the pandemic. This will lead to a reduced net operating income available for debt service and an overall reduction in value.

Industrial/Retail Sectors
Due to the triple net lease nature and long-term status of industrial leases with only minimal rent increases, the industrial market is somewhat isolated from the direct impact of inflation and rising interest rates. The impact that will be felt in the industrial market will be due to the impacts in other sectors. For example, inflation, if left unchecked for too long, will cause retail businesses to falter and possibly fail as consumer spending is reigned in to be reserved for the essentials of housing, food, clothing and health care. This curtailment will affect the need for industrial properties related to manufacturing, storage and transportation of goods.

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As shown above, the foregoing impacts will cause lenders to reevaluate the properties held as collateral for commercial loans as the cash flow generated by the properties is reduced due to inflationary impacts. There are approximately $162 billion in commercial loans scheduled to mature in 2023 across the four primary financing sectors: single-borrower large-loan securitizations (SBLL), commercial mortgage-backed securities conduit trusts (CMBS), collateralized loan obligation (CLO) and agency backed securities (Freddie Mac and Fannie Mae). As these loans reach maturity, they will have to either be paid in full or refinanced (which is the typical route). Property owners and business operators with recourse loans will have to put capital into their real estate, which will curtail business investment as they will be personally liable for the debt. Those with non-recourse debts will be able to forfeit the property to the lender with no personal liability. Those lenders who have issued the non-recourse debt, however, will be saddled with a property valued at a fraction of the original loan amount. These lenders will then have to set more capital aside as reserves against “bad loans” reducing the amount of money available for lending to consumers.

When reviewing the commercial real estate market for the coming year, it makes one wonder if we will see a commercial real estate bubble similar to the housing bubble in 2008-2009 where property values are “reset”? Or will it be the beginning of something far greater, akin to the savings and loan crisis of the late 1980s? Or, hopefully, will the Federal Reserve be able to judicially set a fiscal policy that will both curtail runaway inflation and reduce interest rates to a manageable level?

As the old curse goes, “May you live in interesting times.” Friends, we will definitely be living in interesting times for the next several years.

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