Having just returned from a fantastic adventure mountain biking in Guatemala, a biking metaphor feels apt for the changes taking place in the CRE debt markets today. It would appear evident that we’re currently occupying the space between two cycles. One has certainly ended while another is slowly emerging. What follows is a scenic single track of where we’ve been with hope that insight can be gained for what lies ahead.
Defining The Last Cycle
In response to the near (global) market collapse in 2008 when credit default swaps took down the likes of Lehman Brothers and Merrill Lynch, The Fed began to bolster the financial sector with significant infusions of capital. Monetary and fiscal policy geared up with the intent to stave off collapse and shift towards recovery: money poured into the system. What followed was the longest period of sustained economic expansion in US history. For commercial real estate, this was the Golden Era. Money flowed toward CRE debt and equity as never before. Property performance flourished, debt flowed with low rates and ample supply, and equity poured in from sources far and wide as investors savored the dual benefits of current cash flows and steady appreciation.
When the Global Pandemic hit, capital continued to flow despite the fear and uncertainty. Though transaction volumes geared down, and property performance faltered, CRE debt and equity largely remained abundant and fluid. There were only hints that an unprecedented cycle might be coming to an end. Then, inflation figures revealed an economy in steep ascent. It was time to apply the brakes. The Fed began its counter-offensive: 11 hikes in roughly 18 months raising the Fed funds rate over 500 basis points. End of cycle.
A New Landscape
The flow of funds, particularly equity, has slowed dramatically. Acquisition activity has all but come to a halt. New developments have been sidelined. Investors faced with the prospect of cash-in refi’s and capital calls are hesitant if not defiant.
From the debt side, banks and credit unions face the prospect of reduced deposits, overweighted real estate exposure, and capital mismatches of funds (overnight deposits invested in longer term fixed investments don’t align well), all in the wake of the bank collapses in 2023. So, these sources have pulled way back.
Fundamentals
CBD office is exceptionally challenging in today’s market. In most instances, it appears values may still be in decline. Same goes for urban retail. And hotels are all but off the table for most capital sources except in very rare instances.
The property types that are still in vogue are multi-tenant industrial, well-located apartments, and grocery or credit anchored retail. Also receiving favorable demand are medical offices, self-storage, and well located, multi-tenant strip retail centers with solid tenant sales history.
Niche Discipline
A theme that emerged in 2023 was that lenders who had a well-defined market niche and priced their risk tolerance appropriately, found tremendous success. In fact, 2023 was a record year for certain capital sources. That’s in a year where overall lending volume was down significantly. What’s to be learned from this approach?
With banks and credit unions taking a reduced market share, other capital sources will find ways to increase theirs.
Life Companies: Expect these sources to hone their niche and price accordingly to win an increasing market share. Though many LC’s prefer a lower risk profile, the competition for fewer opportunities will necessitate sharpened risk definition. As such, we’re seeing increased stratification in pricing to accompany commensurate risk. Razor’s edge pricing will accompany the lowest risk request, while tiered pricing and creative structuring will capture the bulk of the market. At the wide end of the risk spectrum, those seeking a bit more yield will face competition from sources in the following buckets.
Agencies: Fannie Mae and Freddie Mac will continue to win the lion’s share of the multifamily lending market. These sources are aggressive for ‘mission driven’ opportunities, defined as those properties that meet affordability and or ‘green’ hurdles. Beyond that, they can often accommodate higher leverage requests, offer more interest-only term, feature supplemental loan provisions, and provide greater tolerance when it comes to asset quality, location, and borrower experience/history. These sources provide an abundance of liquidity when markets are in transition, helping to keep housing well capitalized.
CMBS: Over the last cycle, Commercial Mortgage-Backed Securities had their struggles. But a comeback is expected. Wall Street is resourceful and innovative and will counter a challenging perception and higher resulting rates with full-term interest only, and creative pursuit of fringe property types: single-tenant loans in secondary locations, hospitality, malls. Most notably, these sources will push leverage by sizing loans on an interest-only basis (most lenders size a loan based on an amortization schedule, even when offering interest-only payments) which will allow for 80% of the project’s NOI to service debt (a 1.25:1 DSC ratio) on apartments.
Debt Funds, Bridge Debt, Rescue Capital: Pools of funds have been raised and await deployment in a challenged market. These are largely opportunistic sources that will seek to fill the void created by market turbulence and dislocation. To achieve above market yields, these sources will look to provide creative equity and or debt structures. Borrower beware: if there’s no meaningful lift to a property’s net operating income, these sources may simply be the next owner.
The Next Cycle
New cycles can only be accurately defined in hindsight. But we’ve clearly come to the end of a glorious run for US commercial real estate. And it’s only a matter of time before the next cycle is in our midst. What we’ve learned over time is this: markets, like people, generally tend to mature and hopefully, become more efficient. In the case of the CRE debt markets, we’re seeing ever increasing niche stratification. Those sources that best define, articulate, and price their risk tolerance will cruise to the yellow jersey!