Executive Summary
It is Caro Investors’ view that the new administration’s policies on tariffs, immigration, and deregulation amid increased geopolitical risk will lead to further disruption in commercial real estate capital markets. Instead of asking when will rates come down, we might want to begin asking when will rates increase again and by how much? While it has been 30 years since I sat in Sanders Theater to hear renowned economist Marty Feldstein teach “EC 10,” I clearly recollect the adverse consequences of tariffs leading to a higher equilibrium price on domestic goods, in addition to supply chain and labor shortage issues. A protectionist strategy for the U.S. economy could also lead to a very different level of influence long-term over geopolitics given trading partners may form new alliances.1 Secondly, we believe the United States has structurally low unemployment due to decreased household formation. A lower level of immigration and mass deportations would reduce the labor force size, potentially resulting in upward pressure on wages. Lastly, it is our view that geo-political risk is broad, heightened, and correlated with the tariff policy. The failure of the Assad regime in Syria, temporary South Korean martial law declaration, North Korean involvement in the Ukraine/Russia war, the France budget crisis, Romanian election annulment, a Moldova state of emergency, increased Chinese military deployment and the resulting threat to Taiwan, U.S. threat of Greenland, Canada, Panama annexation and the Israel-Hamas war all contribute to new alliances and changes in the world power dynamic.2 Geopolitical risk can lead to supply chain shocks and further inflationary pressure. The combination of these three occurrences, within the backdrop of an economy that is already exhibiting robust job growth and fundamentals may not only limit interest rate normalization and keep rates higher for longer but may even lead to an increase in rates as a Fed response to renewed inflation.
We believe the consequences for commercial real estate capital markets will be deep and extended. Commercial real estate valuations have undergone the first significant correction (~20%) since the Great Financial Crisis3 and it will remain challenging to refinance maturing debt originated at peak valuations in a low-rate environment, as well as capitalize new developments and acquisitions wherein proceeds remain coverage constrained by higher rates. Distressed opportunities may increase as banks are forced to reckon with borrowers who have pretended and extended for as long as feasible, hoping more material rate declines would bail them out of rebalancing requirements.
Further, after the Great Financial Crisis and evidenced by the March 2023 banking crisis, there has been increasing pressure from bank capital constraints to ensure adequate liquidity. Basel III is expected to cause banks with over $100B in assets to hold up to 19% more capital in reserve to protect against insolvency. High volatility commercial real estate (or HVCRE), a new category in Basel III, changed the risk weighting for commercial real estate from 100%. HVCRE risk weightings can be increased to 150% or more, particularly for construction loans.4 Notwithstanding, the recent departure of the Federal Reserve’s vice chair could lead to less rigorous bank capital requirements than planned in Basel III5. Direct commercial real estate lending on behalf of banks is also hampered by more labor-intensive asset management and higher scrutiny from increased loan defaults. Florida Atlantic University conducted a study that would indicate challenges within banks’ legacy commercial real estate loan portfolios, based on the number of banks with high ratios of commercial real estate exposure to equity, wherein a ratio over 300% puts a bank at greater risk of failure. Among 4,594 banks, 1,849 had total commercial real estate exposures greater than 300% as of June 30, 2024; 1,096 had exposures over 400%; 536 had exposures over 500%; and 293 had exposures over 600%.6 Further bank failures or mergers should further constrict commercial real estate capital markets, particularly in the fragmented lower middle-market with borrowers that cannot access larger bank capital.
Share of Banks Tightening U.S. Commercial Real Estate Loan Standards
Source: SRR Consulting, U.S. Federal Reserve Board, Macrobond, data as of Q3 2024.
It is our belief that these structural regulatory changes and legacy exposures, will spur some transfer of market share from banks to private credit lenders and CMBS. Other lenders also have retrenched in commercial real estate lending, with CMBS, life insurance, and GSE loan origination down in 2023, 64%, 32%, and 37% from peak volumes in 2020-2021, respectively, albeit there have been year-over-year increases in 2024 YTD originations, largely driven by increased CMBS loan origination.7
Whereas commercial real estate lender retrenchment may place upward pressure on borrower demand for private credit, the asset class’ risk-return characteristics may positively influence capital flows into it. Over the period described in the inset, private credit exhibited less return volatility than direct real estate and core private equity real estate funds, while delivering higher average returns.
Risk-Return Characteristics by Asset Class, 2009-23
Source: SRR Consulting, Cliffwater, TPG, NCREIF, and St. Louis Fed.
This white paper, co-written with SRR Consulting, provides both custom research and our views on sustained and elevated interest rates, bank lending contraction, and the correlation and volatility of credit vis-a-vis other asset classes.
About Caro Investors
Caro Investors Management, LLC (“Caro Investors”) is an investment management firm domiciled in Maryland, founded in 2024. The firm’s flagship product intends to deploy capital into middle-market private debt investments with underlying commercial real estate exposure in U.S. markets and product types that Caro believes to be more resilient. Caro Investors’ (“Caro”) mission is to be a leader in the alternative asset management industry and deliver attractive results to institutional investors over the long-term, such as pension funds, university endowments and foundations, amongst others. Caro’s greatest priority is its fiduciary responsibility of securing the future for these investors’ underlying constituents, including government workers, teachers, firemen, or colleges. Caro’s brand was inspired by two individuals who were those constituents. The Firm’s mission is also to fill a growing void of institutional investment management firms addressing middle- market investment opportunities in real estate and credit. Caro believes enhanced yields can be achieved in middle-market transaction sizes. Caro’s experienced and diverse team will apply a fundamental research-based approach to investment underwriting and execution.
About SRR Consulting
Founded in 2018, SRR Consulting is a research firm serving the commercial real estate industry.
SRR Consulting offers clients custom reports and independent insights into investment strategy, macroeconomic conditions, and real estate market outlooks across commercial property types and investment styles.
Sara R. Rutledge, CRE® is the founder and chief economist of SRR Consulting. She began her real estate research career in 1999 and has broad industry experience working with data providers, brokerage firms, and investors to create and monetize research-oriented applications and products. Ms. Rutledge was previously the head of global market research for StepStone Group, leading the global macroeconomic and private equity real estate performance outlook. She has also served as the managing director of real estate products for a data science start-up, director of research at the National Council for Real Estate Investment Fiduciaries, and a regional director of research at CBRE.
She also spent eight years on Invesco Real Estate’s research team, leading US property market forecasts and global macroeconomic views. Ms. Rutledge has published real estate performance research in Business Economics and co- authored a Real Estate Research Institute-funded paper. She is a Counselor of Real
Estate® and an actively involved member of the National Association for Business Economics and Urban Land Institute.
IMPORTANT DISCLOSURES AND NOTES
Certain economic and market information contained herein has been obtained from published sources prepared by other parties, which in certain cases has not been updated through the date of the distribution of this letter. While such sources are believed to be reliable for the purposes used herein, Caro does not assume any responsibility for the accuracy or completeness of such information. Further, no third party has assumed responsibility for independently verifying the information contained herein and accordingly no such persons make any representations with respect to the accuracy, completeness or reasonableness of the information provided herein. Unless otherwise indicated, market analysis and conclusions are based upon opinions or assumptions that Caro considers to be reasonable.
We do not represent that the information contained herein is accurate or complete, and it should not be relied upon as such. Opinions expressed herein are subject to change without notice.
The information contained herein should be treated with strict confidentiality and may not be disclosed by the recipient or delivered to any person, except to the recipient’s advisers or with Caro’s consent.
The contents of this document may contain forwardlooking statements that are based on management’s beliefs, assumptions, current expectations, estimates, and projections about the financial industry, the economy, and real estate related investments. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict with regard to timing, extent, likelihood and degree of occurrence. Therefore, actual results and outcomes may materially differ from what may be expressed or forecasted in such forwardlooking statements.
1 Rediker, Douglas, “The consequences of Trump’s tariff threats.” Brookings, December 11, 2024.
2 Martin, Katie, “Geopolitics? What geopolitics?” Financial Times Unhedged Podcast, December 10, 2024.
3 Green Street Commercial Property Price Index, November 6, 2024.
4 Heschmeyer, Mark, “Bank’s strategy of extending commercial loans found to escalate financial risk” CoStar, October 25, 2024.
5 Son, Hugh, “Wall Street notches another win as Fed’s Barr clears the way for gentler banking regulator,” CNBC, January 7, 2025.
6 Heschmeyer, Mark, “Bank’s strategy of extending commercial loans found to escalate financial risk” CoStar, October 25, 2024.
7 Fitzgerald, Mark, “Favorable Conditions: Structural Changes to the Market Favor Nonbank CRE Lenders” AFIRE, September 24, 2024.
