AllianceBernstein is gearing up for a year in which commercial real estate lenders will be focused on defending their existing loan books rather than aggressively expanding their activity. But some clear opportunities will emerge, including the potential to originate loans for high-quality sponsors and acquire distressed loans or assets in which price correction has already occurred, says Peter Gordon, chief investment officer of the Nashville-based manager.
“If you have an existing book of loans, 2024 will still be a lot of modifications to protect existing investments. But at the same time, I expect lending opportunities will start to appear,” Gordon says. “You have to be able to invest and defend, but the weight will still be on defending for 2024.”
The firm, one of top 10 managers in Real Estate Capital USA’s annual ranking of debt platforms, is mapping out its strategy in a market continuing to feel the effects of the Federal Reserve’s moves to fight inflation over the past two years. Since March 2022, the US central bank has increased its target rate from 0.25 to 0.5 percent to a range of 5.25 to 5.5 percent.
This rise – and uncertainty around future rate increases – had a significant impact on valuations and transaction activity in 2023. This included sponsors’ ability to refinance maturing debt, Gordon says.
But over the past six months, the equation has changed as more stability has emerged. The Federal Reserve last increased the target rate in July and continues to hold that range, with Gordon noting this stance – and additional guidance around the potential for rate cuts – is starting to trickle down into commercial real estate.
As the impact of more stable interest rates permeates the commercial real estate lending market, Gordon says the market will continue to see a “narrowing range of valuations” and more lenders re-entering the space.
He adds: “Interest rate policy seems to have had the desired impact on inflation, but the Federal Reserve’s messaging still feels hedged, implying we may not be all the way there. The hope in 2024 is for a more stable interest rate environment, which should start to create more transaction activity.”
The question of valuations is a key one for AllianceBernstein, particularly for the multifamily sector, Gordon says.
“In the first part of 2023, it was difficult to know how high and for how long interest rates were going to be elevated, which made it challenging to determine even fundamental questions like what long-term cap should be used for Class A multifamily assets.”
Valuations in flux
Prior to the Federal Reserve’s moves on rates, there were established valuation metrics for property types, including relatively predictable spreads above Treasuries. But over the past two years, there has been substantial dislocation in cap rates, particularly around exit cap rates, due to a nearly 100 basis point differential between the Treasury rate today and where it is expected to be one year from now, Gordon says.
“That 100 basis point swing in the terminal cap rate creates a big value change in an asset type like multifamily.”
While new originations are expected to remain low, the opportunity set is wider than simply lending, Gordon adds. “The opportunities in 2023 either came from buying performing loans discounted for pricing or lending against assets where the value of the asset had been adjusted to reflect the realities of the new interest rate environment.”
Distressed note transactions were rarer last year and typically stemmed from situations in which an underlying asset was not distressed but a lender needed to get a loan off its books, Gordon says.
“We bought a couple of performing loans at discounted prices where we thought the underlying real estate was good. Accounting for the discount, we could buy them at an attractive risk-adjusted yield.”
“A lot of that distress will be driven by upside-down capital structures on healthy underlying assets”
Peter Gordon, AllianceBernstein
By sector, AllianceBernstein is open to opportunities beyond the asset classes – like multifamily – which are widely regarded as safe. There are many other property types in which lenders can find good opportunities, and their valuations may have already been adjusted to reflect the new interest rate environment, Gordon explains.
“We felt we were lending into good real estate at defendable LTVs from a risk standpoint. We also felt like we were getting paid well because the asset might be from a less favorable asset class – for example, the hotel or mixed-use, [or] some portion was comprised of office. When liquidity is scarce, lenders tend to stay away from real
estate that is less easy to explain to their credit and risk departments,” he says.
Gordon also notes some lenders today do not want to get into mixed-use or other alternative asset classes.
“Since equity subordination is our best form of defense, in times where value is difficult to peg, we tend to veer towards assets we feel have been valued less aggressively. Lower leverage means our basis is lower, our debt yields are higher, and we have a better chance of protecting principal if values are further diminished.”
In addition, Gordon notes lenders would like to refinance a deal where equity partners were willing to reinvest more capital into the assets, thereby making lenders able to maintain reasonable leverage.
Distress on the horizon
Looking ahead to 2024, Gordon anticipates some distress as more borrowers may give up on some assets due to continuously elevated funding costs.
“I believe that interest rates would need to come down materially in 2024 to shrink the current spread between buyers and sellers and prompt more transactional activity. If that doesn’t happen, I think we will see more distress in 2024. A lot of that distress will be driven by upside-down capital structures on healthy underlying assets,” Gordon explains.
However, he believes actual distress – properties being sold at a greatly discounted price when changing ownership – could first happen in the office sector.
“In terms of different assets classes, I believe we could see increased transaction activity in the office space in 2024. At the end of 2023, we saw more activity with office precipitated by lenders needing to sell and values being so far below replacement cost,” Gordon says.
“We could see more of that in 2024. Having said that, the tenant demand side of the office puzzle has not yet been solved and that will keep offices prices low for the foreseeable future.”
Since back-to-office mandates haven’t happened at scale among many occupiers, lenders cannot decide whether the office buildings they are lending against will match the future demands and not be obsolete soon going forward, Gordon adds.
“Sometimes there are obviously [viable] cases but they tend to be at higher prices. It’s some of the middle range of offices trading at $200 a square foot that feels cheap and of good value, but I still don’t know whether you can attract tenants to sign leases.”
The silver lining of 2024 is that the market has already felt some impact of a more stable interest rate environment, which builds consensus around value and brings more buyers into the market, Gordon says.
The firm is looking at several potential deals, including one value-add financing for a life science property. With a high occupancy rate, a tier-one location, and a sponsor that specializes in the sector, there have been multiple bidders looking at acquiring the property, he adds.
“When we talk about the benefit that more stable interest rates bring to the market, we really mean the ability for a seller to generate a competitive process and have multiple bidders willing to buy the asset.”