Today’s commercial real estate lending market is grappling with the impact of higher inflation and rising interest rates at a time when the cost to lock in new debt is significantly higher than this time last year.
Against that backdrop, there is currently a widespread class of borrowers that need more time to execute business plans on properties affected by the covid-19 pandemic, or need to secure new debt at a time when there is a continued gap between borrower hopes and lender capabilities. According to Alan Todd, head of US commercial mortgage-backed securities research at Bank of America, timing is proving to be everything – and many sponsors today are worried they might be forced into making expensive moves at the wrong time. “You don’t want to have to be forced to do something at an inopportune time,” Todd says.
But many borrowers are facing precisely that reality, and soon. There are roughly $162 billion of commercial mortgages slated for maturity in 2023, according to commercial real estate data and analytics platform CRED iQ. This amount includes loans securitized in commercial mortgage-backed securities (CMBS) deals, single-asset/single-borrower securitizations, and commercial real estate collateralized loan obligations, as well as multifamily mortgages securitized through government-sponsored entities.
The coming year also holds a dubious distinction with the highest volume of scheduled maturities for securitized commercial real estate loans over a 10-year period ending 2033, says Marc McDevitt, senior managing director at CRED iQ.
A look at CMBS maturities over the next two years provides further context to the challenge that sponsors are facing. Data and analytics provider Trepp identified roughly 3,000 loans totalling $52 billion that are slated to mature over the next two years that have a debt service coverage ratio of 1.25x or less. Almost half of these loans are in the multifamily sector and about $17 billion have occupancy levels of less than 80 percent, and were originated at rates anywhere from 200 to 400 basis points lower than what is available in the market today.
Furthermore, there is expected to be different levels of capital available for different property types, market participants say. While there is substantial capital likely to be available for multifamily maturities, office properties could get short shrift.
In Todd’s view, it will only be a matter of time before sponsors are asking lenders and special servicers to extend loans. “That is the type of mindset where you are just buying time,” Todd says. “It is about easing the pressure points until you can get into a more tenable environment.”
There will be no single playbook for buying time in the coming year, Real Estate Capital USA hears. Instead, lenders are combining strategies that have worked in the past with logical solutions for the moment. Flexibility and creativity will be key, says Tim Johnson, global head of Blackstone Real Estate Debt Strategies.
“There are going to be a lot of different ways to approach this market,” Johnson says. “Being able to capitalize on as many of those as possible is going to depend on the flexibility of your capital to move from one opportunity to the next and making sure you have the right tools in the toolkit.”
Access to flexible capital during today’s market conditions is crucial. Johnson notes that, while today’s environment has been characterised by a relatively small amount of distress, more distress is coming. Still, there are some important mitigants. “When trying to assess what distress looks like in the overall real estate markets, there are a couple of important indicators to look at that generally precede difficult markets for commercial and residential real estate,” explains Johnson. “Supply and construction activity is one, and the overall leverage in the system, debt to equity, is another.”
Supply is in check. Given the rise in costs for materials, labor and financing, new construction activity has slowed dramatically – a healthy scenario for real estate markets from a medium-term perspective.
Thankfully, leverage is also in check. “When you look at leverage in the system, [you’ll see] this is not a highly leveraged market,” Johnson says. “The leverage in the system [during the financial crisis] was much higher than it is today. It’s dramatically different.”
Johnson believes that, although debt is more expensive, it is available. The New York-based real estate investment giant is also confident there will be an opportunity to work with less well-capitalized sponsors that might be in a liquidity crunch with properties that are fundamentally solid. “That can create some really interesting opportunities to provide capital to deal with a refinancing, which are going to be more challenging just because today’s market has less liquidity,” Johnson says, stressing that lenders are offering lower proceeds than they did a couple of years ago. “That creates a gap between the debt coming due and the new loan in today’s market.”
Some of the creativity will come in the way lenders and sponsors will work to fill that gap.
“That’s where folks like us can really provide a lot of capital solutions to borrowers,” Johnson says. “That could come in the form of just traditional mezzanine financing, it could come in the form of preferred equity, it could be in a variety of different shapes and sizes, and it’s all going to depend on what the underlying asset looks like and what the capital need is.”
Alliant Credit Union, a Chicago-based credit union active in the institutional commercial real estate lending market, has seen more borrowers who need more time to complete deals seeking bridge-to-bridge financing, says Charles Krawitz, the firm’s head of commercial real estate lending.
Bridge-to-bridge lending occurs when a sponsor seeks to replace an existing bridge loan with another short-term financing rather than lock in permanent financing due to concerns about interest rates or because the sponsor needs more time.
While not a new phenomenon in commercial real estate lending – its re-emergence over the past few months was seen as almost inevitable by lenders who have weathered several cycles – it typically occurs in stressed or distress situations, Krawitz notes.
“We see a lot of bridge-to-bridge requests,” he says. “The claim is ‘We are now on the 10-yard line and almost in the end zone.’ While this is often true, there are also cases when getting in the end zone requires achieving rents that are disproportionate to the market.”
Alliant anticipates completing only about $450 million of new loans in 2023, a significant drop from the roughly $1 billion completed in 2022, primarily due to concerns around risk. Still, some of its activity will be directed to transitional opportunities.
“Some of our lending will be directed to transitional opportunities,” Krawitz adds. “That said, we will avoid highly leveraged transactions wherein success hinges on the achievement of aggressive income levels, such as a highly amenitized multifamily property seeking peak rents in a small marketplace. This is where there will be more bridge-to-bridge financing as a means of proving out performance.”
Preferred equity has been on the rise in recent months as another creative means of navigating the current environment, buying time and bridging the gap between a sponsor’s equity commitment and a senior mortgage, says Jonathan Roth, co-founder and managing partner at national commercial real estate lender 3650 REIT. “Preferred equity investments, like bridge debt, tend to find favor in markets where traditional equity investors are skittish about values and are inclined to accept lower returns in exchange for lower risk,” Roth says.
A growing number of equity investors are looking at short-term credit opportunities to help sponsors buy more time or bridge funding gaps.
Bruce Stachenfeld, chair of New York-based real estate law firm Duval & Stachenfeld, is seeing substantial opportunities to recapitalize existing projects and fill the gap on new ones – likely via preferred equity or mezzanine debt, or other short-term financing solutions. “There is almost a feeding frenzy for parties that are going to need this capital and parties that want to provide this capital,” he says.
Managers that are allocating capital now include multifamily specialist Carroll and Boston-based Taurus Investment Holdings. “Interest rates likely will stay higher for a while,” says Peter Merrigan, chief executive officer and managing partner at Taurus. “[This] means there will be some distress relative to financing – exits just won’t pencil out the way people were expecting.”
No stone unturned
Some market practitioners say today’s market stress is leading strapped sponsors to consider new or lesser-used capital sources, like C-PACE or EB-5 financings. Each of these strategies has benefits and restrictions, including where it can sit in a capital stack and how it can be used and structured.
The EB-5 Immigrant Investor Program guarantees permanent green cards to immigrant investors who make substantial investments in real estate or other job-creating ventures in the US. EB-5 capital is typically used for construction financing or can be part of a capital stack as mezzanine debt or preferred equity, says Reid Thomas, chief revenue officer and managing director at JTC Americas, a fund management company in San Jose, California, that does significant work in the EB-5 arena.
The current market has meant that EB-5 is gaining popularity among commercial real estate investors that need to fill gaps in their capital stacks. The nuance in the usage of this capital right now stems in part from its relative cost. Because EB-5 investors have a primary goal of benefiting from the immigration aspect of the program, they are seeking lower returns than the amount a traditional private equity fund manager might expect.
“Mezzanine debt is extremely expensive, and EB-5 capital has been typically used as mezzanine debt in construction projects,” Thomas says. “The cost of that capital is less if you just consider what those investors need to make in terms of yield to make the investment worthwhile. It becomes less expensive mezzanine financing for real estate developers, compared to traditional mezzanine financing.”
Another tool at sponsors’ disposal is commercial property assessed clean energy (C-PACE) financing, says Alexandra Cooley, CIO and co-founder at lender Nuveen Green Capital. C-PACE financing can be used to improve the resiliency and sustainability of a property.
“We are starting to see an uptick in all types of C-PACE lending too, which, in some ways, helps lock in fixed-rate funding for a portion of a building’s capital stack in a time where rates are very volatile, [and] can also help more projects pencil,” Cooley says. “This is the case when building owners need to increase their reserves because rates, or costs, have gone up, or they need more time to stabilize.”
Nuveen Green Capital’s C-PACE program allows sponsors to access low-cost, fixed-rate financing for energy- or resiliency-related upgrades at existing buildings, facilitate new construction and make renewable energy accessible and cost-effective. “[We have] structured equity, which looks and feels like debt but is actually equity, and preferred debt, which looks and feels like equity, but it is actually debt,” Cooley says. “Nuveen has demonstrated its commitment to supporting these products and creating that resilience for the highest-quality projects.”
Over the long term, this creativity fosters more resilience in the sector. “There is not just one type of financing so that when that goes away the music stops,” Cooley says. “We’re not in that [environment] anymore. Green lending is one of those sectors that will always be a win on the investor side, as well as on the building and owner side. It really has staying power.”
Case study: The Elise
The 341-unit apartment community at 1720 John West Road in Dallas was facing a difficult environment when its owner, WindMass Capital, needed to recapitalize the property.
While WindMass was able to source a senior lender, the manager was facing a gap in the capital stack after executing on a business plan that renovated the 1987 vintage asset. Enter Pensam Capital, which provided incremental preferred equity to bridge the gap for the sponsor.
“With the rapid increase in interest rates, proceeds from senior loans have been dramatically compressed, making Pensam’s various capital and lending solutions a vital source of financing for multifamily owners,” says Ray Cleeman, principal and head of capital markets and lending at Miami-based investment manager Pensam.
In this transaction, Pensam was able to increase total loan proceeds up to 75 percent of the capital stack, a significant increase above the senior loan. The firm is ready to deploy capital into other, similar, situations, Cleeman adds.
“Pensam has a deep pool of capital ready to deploy for these types of scenarios and [we] are seeing a significant increase in demand for our lending solutions, including both preferred equity and mezzanine loans that go behind other senior lenders including the agencies, commercial banks, life companies and debt funds,” Cleeman says.
Darkest before dawn
Going into 2023, the US commercial real estate market was at a virtual standstill, with lending and investment volumes in the second half of 2022 well below what was completed in the first six months as borrowers and lenders grappled with higher interest rates and a broadening gap between buyer and seller expectations.
Doug Weill, founder and co-managing partner of New York-based advisory firm Hodes Weill, believes the coming wave of maturities will force some transactions to market and end the current stalemate. “There’s an expectation the markets will overshoot,” Weill says. “The industry is anticipating that over the next couple of years there will be more volatility or inefficiencies in the transaction markets, and then, perhaps, it’s a good opportunity to deploy capital.”
Additionally, slower transaction volumes over the past couple of quarters mean managers are sitting on significant dry powder. “They are waiting for this market to present itself,” Weill says, adding that more interesting transactions will emerge in 2023. “And as some of this transacts, then there’ll be price discovery and [ultimately] transactions.”
Already, Weill is starting to see some signs of life in the debt markets: “We have also seen some investors look to either make investments with no leverage or with a plan to put leverage on at a point in time when, hopefully, the cost of debt is more palatable. We’ve also seen transactions [with] assumable debt [that have] gained more interest in the market, and that includes opportunities to take companies private. If those deals include a balance sheet with a good remaining term of low-cost debt, that is going to facilitate some of these transactions.”
Indraneel Karlekar, global head of research and portfolio strategies and real estate at Principal Asset Management, says there are some potential bright spots coming in the next six to 12 months amid the larger conversation about the potential for distress.
“We have enjoyed a really great run of real estate performance and are seeing a new cycle emerge, and when we see the dominant moments of dislocation and volatility, it’s also the moments when we see opportunity arise,” Karlekar says. “As you look at the next 12 months, we see opportunity in the private debt space, and we are really excited the merits of that space is going to look really attractive.”
Any time there is dislocation in the private markets, there is an opportunity to fix broken deals or recapitalize properties. “It is always darkest before the dawn,” Karlekar says. “Yes, it is easy to get drowned out by all the negativity. But I think it’s also important to stress that with dislocation comes opportunity.”