Fed Hikes Could Hit Values: The Federal Reserve’s latest three-quarter bump in the borrowing rate is going to bring pain to commercial real estate values, according to new analysis by Alan Todd, commercial mortgage-backed securities strategist for Bank of America Securities. “We think commercial real estate values could adjust by as much as 20% to 30% over the medium term,” Todd wrote.

To calculate the impact higher interest rates could have on a property’s value, BofA Securities originated a hypothetical loan on a $50 million property using a borrowing rate that was prevalent two years ago. It sized the loan to a 60% loan-to-value ratio and a 1.45 times debt service coverage ratio. The ratio indicates that for every dollar of annual loan repayment, the borrower is bringing in $1.45 in net operating income — giving it more than enough return to make payments on the loan.

With all parameters constant, BofA then increased the loan’s borrowing rate to today’s prevailing rate of approximately 6.35%. The analysis found that the hypothetical property’s metrics were only able to support a $38.3 million valuation, or down 23%. If it simultaneously decreased net operating income by 5%, the value fell to $36.7 million, or down 27%.

“This is an admittedly tough example and depending on the asset in question and its expected fundamentals, price changes could be greater or lower than we show,” Todd wrote. “Regardless, we think commercial real estate prices will be unable to sustain their current levels and will fall over the coming year.”

The obvious — and potentially only — way to mitigate a steep value drop would be for the Fed to do an about-face, Todd added.

“We think [this] is unlikely given how vociferously they’ve recently drawn their ‘line in the sand’ with respect to combatting inflation,” he wrote.

Special Servicing Rate Notches First Increase in Two Years: The number of CMBS loans in special servicing rose 0.12% in August to 4.92% — the first increase following 22 consecutive monthly declines, according to the latest analysis by the CRE Finance Council. If a CMBS loan goes into default, servicing of that loan will generally be switched to a special servicer, which will work to determine if the borrower can become current through a debt workout or loan modification.

While the special servicing rate remains well below its high of 10.48% in September 2020, the height of the pandemic, higher borrowing rates and the real risk of an economic slowdown suggest asset valuations may be on the decline, according to CREFC analysts.

Loans on retail and multifamily properties drove the special servicing increase, rising 1.14% for retail loans and 0.67% for multifamily. All other property types saw decreases.

The current tally of specially serviced loans is approximately $31 billion, compared to about $14 billion at year-end 2019, before the onset of the coronavirus pandemic.

“While too early to declare a trend, the uptick in August special serving rate may reflect the challenges of refinancing loans in the current rate and economic environment,” CREFC analysts wrote. “We anticipate some increase in loans transferred to special servicing in the coming months.”