Bridge loans are in favor while the extent of commercial distress today is likely to depend on how long interest rates are high, and the impact on pricing.
MINNEAPOLIS, MINNESOTA (February 8, 2023) - While there is plenty of debt capital available waiting to deploy, fewer borrowers are willing to transact unless they must and there is an increase in activity from private capital, and regional and local banks from those who do, according to a new report from CBRE.
Rachel Vinson, President of Debt & Structured Finance, U.S. for Capital Markets at CBRE, said in prepared remarks that she expects demand for shorter-term, fixed-rate debt with shortened call protection to endure well into the second half of 2023.
“The Federal Reserve’s commitment to reduce inflation with aggressive rate hikes continues to heighten market uncertainty, as borrowing costs increase and a lack of price discovery persists,” Vinson added.
CBRE’s Lending Momentum Index declined 27% year-over-year in January.
Who’s Lending, And How Much
Banks had the largest share of CBRE’s non-agency loan closings for the third consecutive quarter at 58.3%—up from 46.4% in Q3 2022. More than 80% of bank loans were floating rates. Construction loans accounted for 37% of total bank lending volume, followed by 36% for refinancing and 27% for acquisitions.
Life companies were the second-most active lending group in Q4 2022 with 21% of closed non-agency loans—up from 16.7% in Q3 2022. More than half of life company volume in Q4 2022 was for industrial deals. Multifamily accounted for 22%.
Alternative lenders, such as debt funds and mortgage REITs, accounted for 18.7% of loan closings in Q4 2022, down significantly from their 32.3% share in Q3 2022.
Higher spreads and interest rate cap costs created a challenging environment for financing floating-rate bridge loans. Collateralized Loan Obligations (CLOs) issuance was limited to $2.95 billion in Q4 2022, bringing the 2022 total to $30.3 billion—down 33.3% from 2021.
CBRE’s Agency Pricing Index, which reflects the average agency fixed mortgage rates for closed permanent loans with a seven- to a 10-year term, increased by 60 basis points (bps) in Q4 2022 and 193 bps from a year ago to an average of 5.21%.
Higher mortgage rates and loan constants were the key feature of loan underwriting criteria in Q4 2022. Underwritten debt yields and cap rates on closed loans inched up in Q4 2022. Meanwhile, the average loan-to-value (LTV) ratio increased by 0.3 percentage points from the previous quarter. The percentage of loans carrying interest-only terms remained high, increasing to 72.6% in Q4 2022.
Government agency lending of multifamily assets totaled $47.1 billion in Q4 2022—up from $30.6 billion in Q3 2022. For the entire year, volume totaled $142 billion—up slightly from $139.6 in 2021.
Appetite for Shorter-Term Loans
Daniel Trebil, Northmarq, executive vice president and regional managing director, tells GlobeSt.com that he’s seeing an increased appetite for shorter-term loans in the 3- to 5-year range.
Normally this would lend itself to a bank execution, and local and regional banks are active in that space. Both life insurance companies and agency providers, however, are targeting that space with both fixed- and floating-rate executions that include prepayment flexibility in the last few years of the term.
“That way borrowers can take advantage of aggressively underwritten non-recourse financing but still preserve flexibility should rates fall in the next few years.
Property Owners Being Squeezed by Rates
Yardi Matrix’s director of research Paul Fiorilla tells GlobeSt.com that debt availability has diminished, and property owners are being squeezed by an increase in commercial mortgage rates, which have increased by 200 to 400 basis points since reaching historically low levels in the spring of 2022.
“The extent of the commercial distress today is likely to depend on how long interest rates remain high and the impact on pricing, Yardi Matrix said. “If interest rates settle in at 200 basis points higher, cap rates will settle in (approximately) 200 basis points higher. With values falling and much uncertainty about pricing, the only sales taking place “need to transact rather than want to transact.”
The circumstance has created an opportunity for high-yield capital to fill the gap between the balance of maturing mortgages and take-out loans.
Deals Not as Robust as a Year Ago
Peter Margolin, commercial loan originator at Alliant Credit Union, tells GlobeSt.com, “Similar to other capital providers and traditional lenders, opportunities are surfacing, and we are seeing deal flow in all our markets albeit not as robust as it was 6 to 12 months ago.
“Deal requests in this market are for shorter terms of five years or less. Sponsors and investors are expecting that the recent spike in interest rates will come down in the near term, so requesting shorter tenure loans will allow them to take advantage of future rate decreases.
CMBS and Larger Lenders Leave a Void
Andrew Spindler, senior vice president of Green Street’s Advisory Group, tells GlobeSt.com that it’s positive to see an increase from private capital and smaller banks as the decreased activity from the CMBS market and larger lenders leaves a void to be filled with impending maturities.
“These sources can sometimes provide more customizable solutions that may be more difficult to address with larger lenders,” Spindler said.
“Even though private capital and smaller banks are increasing activity; the cost of debt is still comparatively very high,” he said.
“Those looking to tap into debt markets are likely only there out of necessity and will be doing what they can do extend current financing with lenders or special servicers. The sectors that are already hard hit from a fundamentals perspective (malls and offices for example) will also be negatively affected by the changes in lending. These sectors can have longer term, larger balance debt that is typically sourced through large banks or public markets.”
Keeping Interest Risk, Credit Risk Under Control
Xiaojing Li, managing director of CoStar Risk Analytics, tells GlobeSt.com that CRE loan lenders to need to carefully strategize to achieve multiple goals of benefiting from a long-waited profit margin without draining the demand pipeline and keeping interest risk and credit risk under control.
“The shorter-term, fixed rate and shortened call protections are financing options that contain favorable features for both lenders and borrowers under the current conditions when macroeconomic indicators, rates, and valuations are yet to stabilize,” Li said.
“In an upside scenario of the economic outlook, the shorter term and shortened call protections prepare borrowers for better rates and higher loan proceeds when rates start to fall, and valuations resume the rising momentum.
“Loans with fixed-rate will also help cap the debt service obligations from rising, a probable situation throughout 2023 with the variable-rate counterparties.
“The combination of shorter term and fixed rate could mitigate the credit default risk potentially caused by insufficient debt service coverage and shortens the credit exposures for lenders.”
Li said the cost of being agile and flexible with borrowers, from lenders’ perspective, is giving way to the opportunity of locking a higher rate for longer, and a higher prepay risk.
“However, these types of losses are more likely to be realized in a recovery or expansionary scenario where credit risk is overall lower, and the profit of higher lending activities can offset the loss,” Li said.
Transaction Volume Not Showing Significant Traction
Lauren Gerdes, real estate senior analyst with RSM US LLP, tells GlobeSt.com that there continues to be a gap in valuations between buyers and sellers.
“We are seeing an increase in short-term financing solutions on upcoming maturities until the lending environment stabilizes rather than exiting,” Gerdes said. “This trend is likely to be in play throughout 2023 with interest rates expected to stay elevated through the end of the year.”
She said for the private capital debt market to take off, deals need to close.
“Transaction volume has not yet shown significant traction and most analysts are not predicting a recovery in deal count through the second half of 2023,” Gerdes said.
“Until transaction volume picks up and we see where valuations land, lenders will continue to be cautious keeping loan-to-value (LTV) ratios low and focusing on debt service coverage ratios which are likely to continue into 2024. This keeps the opportunity open for private debt funds.”
Data shows private capital real estate funds in the U.S. have over $200 billion of dry powder available, according to RSM.
“With lower LTV ratios, investors are deploying capital to fill the gap between equity and senior loans,” she said. “We have seen a significant increase in mezzanine debt and preferred equity strategies allowing investment in commercial real estate to continue at high yields while transaction volume stays quiet and interest rates stay elevated.”
Impairments Must Be Taken
Christopher Arruda, chief investment officer, SALMON Health and Retirement, tells GlobeSt.com there’s no question that liquidity is absent from the debt capital markets.
“I don’t expect conditions to normalize until impairments are taken on both debt and equity positions and the Federal Reserve stops raising rates,” Arruda said.
“Impairments won’t happen until trading resumes and trading won’t resume until the market knows where debt pricing stabilizes but with that said, I think we are getting close to these trigger events happening.”
Fed Close to Ending Rate Hikes
Ted Jung, chief credit officer, Parkview Financial, a direct private lender specializing in ground-up commercial and residential real estate financing, tells GlobeSt.com that it’s difficult for all lenders to navigate risk in a rapidly increasing interest rate environment.
“This is especially true for banks and life insurance lenders with strict credit boxes and the need for longer duration loans,” Jung said. “However, the Fed has telegraphed they are close to ending rate hikes with a terminal rate in sight. This should allow lenders to better forecast future refinance risk.”
Jung said that today’s borrower needs to come to terms that more equity is necessary to get deals done in a higher rate environment compared to years past as debt coverage is playing a stronger role in underwriting new loans.
“The expectation is that capital markets will stabilize once the Fed reaches its terminal rate,” he said. “Bridge and perm lenders will likely increase their originations as volatility in the bond markets is reduced. Construction lending will stay low as expectations of a recession in the second half of the year remain high.”
Private Capital as the Source Means Certainty of Execution
Malcolm Davies, founder & senior managing partner, Way Capital, tells GlobeSt.com that as the supply of capital from money center banks has receded and debt funds have had a tougher time souring back leverage, private capital sources and regional and local banks have stepped into the void.
“They can lend out discretionary balance sheet capital or deposits,” Davies said. “This pattern is familiar in a challenging market. We saw similar activity in the back half of 2020. One of the positives of borrowing from a private capital source with discretionary capital or a regional or local bank is the certainty of execution.
“They are generally not back levering so are insulated from the volatility in the note-on-note market. Understanding how a lender is capitalized is critical when market conditions become more challenging.”
Some Banks Experiencing Payoff Delays
Zachary D. Streit, founder & managing partner, Way Capital, tells GlobeSt.com that one thing to look out for when borrowing from a regional or local bank is liquidity.
“Some banks are experiencing delays in payoffs due to more conservative permanent financing markets and are also subject to regulatory audits,” Streit said. “As such, liquidity for them is at a premium. We are seeing an uptick in feedback from banks where deposits are requested or required to close a financing.”
Using Bridge Products to Wait Out Uncertainty
Keyvan Ghaytanchi, chief investment officer at BEB Capital, tells GlobeSt.com that he’s seen very strong demand for bridge products.
“Borrowers typically utilize bridge loans to ‘bridge the gap’ and execute their business plan, therefore, take-outs of our loans are typically permanent financing or dispositions,” Ghaytanchi said.
“We are now seeing borrowers looking at bridge products to wait out the debt market uncertainty and hoping to refinance with more attractive terms in 12 to 18 months.
“While this trend has increased demand for this product, lenders need to be careful in properly examining the borrower’s business plan and staying disciplined.”
Lending in 2023 Will Be Muted
Constantine (“Tino”) Korologos, NYU clinical assistant professor, founding principal of Leonidas Partners; and member of the Counselors of Real Estate, tells GlobeSt.com that many private lenders use credit facilities/warehouse lending lines, which are getting pricier, and many lenders are finding the cost of their debt (to leverage the loans that they are making) is too expensive now.
With limited transactions available for price discovery, and a wide disconnect between buyers and sellers, the lending in 2023 should be muted, he said.
“Better assets, better markets, better sponsors, and more conservative leverage metrics will attract capital,” according to Korologos. “Shorter-term debt allows for the borrowers to get to the other side of the mountain, where they are counting on the scenery being better than today.”
A Major Pickup in Underwriting Activity
Thomas Foley, co-founder and CEO of Archer.re, tells GlobeSt.com that with the capital markets in flux, he’s seen a major pickup in underwriting activity to figure out how to make new deals pencil.
“Lenders are more frequently needing to evaluate property performance on prior loans they made, while traditional equity investors are shifting into trying to become mezzanine debt or preferred equity investors,” Foley said.
The pressure is on for lenders to get very smart, very quickly as to the performance, current value, and risk they are holding as they continue into uncertain waters, he said.
Bridge Capital Can Get Projects Off the Ground
Jack Laughlin, senior investment associate with Pangea Mortgage Capital, tells GlobeSt.com that while private lenders have a higher cost of capital in the current environment, other factors can justify a higher rate.
“Balance sheet bridge lenders, for example, provide speed, flexibility, and oftentimes relatively higher leverage,” he said. “A tradeoff of 400 to 500 basis points affords borrowers quick closes, creative capital structures, limited recourse, and prepayment, all at LTCs in the 70% to 80% range or greater. Borrowers can use private bridge capital to both get their projects off the ground as well as buy themselves time until market volatility cools.”
Credit to ‘Exceptionally High-Quality’ Projects
Alex Horn, managing partner and founder of BridgeInvest, tells GlobeSt.com he is seeing unique opportunities to provide credit to “exceptionally high quality” projects.
A transitional bridge lending fund, BridgeInvest Credit Opportunities Fund LP, has provided flexible short-term financing solutions to projects that would have met a bank’s DSCR and LTV requirements less than a year ago, he said.
C-PACE Financing a ‘Bright Spot’
Chris Robbins, managing principal at GreenRock Capital, tells GlobeSt.com that one bright spot in the capital markets landscape is C-PACE financing where we are experiencing a significant increase in interest from owners, developers, and in some cases, senior lenders, for C-PACE to round out new construction projects and recapitalize deals recently completed with maturing loans.
“These are fixed-rate loans with 20- to 30-year terms,” Robbins said. “In many cases, this non-recourse capital is pricing 200-plus basis points below senior debt. We are seeing combined senior and C-PACE executions in the 65 to 75 percent range with the senior financing attaching below 50 percent.”