Bridging the gap: Recaps present chance to shine

While the tumult in the US banking sector continues, loans written against real estate during the era of low interest rates are maturing, creating a refinancing gap that could play into the hands of alternative lenders.

MSCI data shows that US commercial-property loans slated to mature in 2023 and 2024 total nearly $900 billion. Meanwhile, borrowing costs are rising as the Federal Reserve ratchets up interest rates in its battle with inflation, prices are falling and traditional lenders are increasingly risk-averse.

“There is a significant reduction in the banking sector’s ability to lend, with $450 billion of commercial real estate loans coming due this year, and $2.5 trillion over the next five years,” says Warren de Haan, founder and managing partner at real estate-focused credit manager ACORE Capital. “Only the non-bank sector can fill that gap, so we will see an explosion in the demand for our capital.”

In a May report, the Fed noted banks held 61 percent of outstanding non-farm, non-residential US commercial real estate loans, with the balance mostly comprising insurance companies (13 percent), commercial mortgage-backed securities holders (15 percent) and other non-bank lenders (11 percent). “Banks make up around half of the CRE loans in any year, so when their liquidity is squeezed, the market feels it,” says Jack Gay, global head of commercial real estate debt at Nuveen Real Estate.

Fear rising

For borrowers reaching the end of their loan terms, the lack of liquidity in the lending market is a serious concern, says de Haan. “Every borrower who has a loan maturity coming up is freaking out, because the availability of capital to refinance their loans today is minimal except in multifamily, where you have active federal agencies Freddie Mac and Fannie Mae. If you have an office loan coming due, you have a real problem. There’s no capital available.”

Higher interest rates have impacted the debt coverage ratios on existing loans, forcing banks to hold more capital on their balance sheets to cover potential losses. In the meantime, recent turmoil in the regional banking sector has increased the likelihood of regulation to bolster resilience, which may further constrain lending capacity.

“It is much harder to refinance covid-era loans in the current environment, and that is leaving lenders with three options as they face a wall of maturities,” says John Lippmann, managing director and head of structured debt at New York Life Real Estate Investors. “They can accelerate and take back the property, they can extend the current loan, or they can restructure.”

Avoiding risk

Where lenders have substantial equity investing arms, they may favor the first option if they believe they are well placed to manage the real estate themselves. But few banks will fall into that category. The extent to which banks will be willing to extend loans, and to which regulators will tolerate the practice, is not yet clear.

“The scale of upcoming loan maturities is massive, so my guess is that we will see a lot more extensions,” says de Haan. “While we will see a rapid increase in the scale of non-bank lending, particularly from the larger players, it will not be nearly enough to meet the demand, and we will likely see some leniency from the regulators around this issue.”

Even in extension situations, borrowers will frequently need to bring something to the table to reduce the lender’s risk, according to Joseph Iacono, chief executive officer at CRE debt specialist asset manager Crescit Capital Strategies. “That will either be through contributing some of their own equity to pay down part of the loan, or by bringing in another lender to bridge the gap created because their interest reserve has to be resized, or the value declines,” he says. “Private lenders are more than likely the ones that will step in to meet those types of needs.”

In addition, alternative lenders will play an increasingly key role in recapitalizing transactions, either by buying out the whole capital stack, or taking a junior position through mezzanine financing or preferred equity, so that traditional lenders can de-risk their positions. “Private capital shines in credit-tightening situations like this,” says Iacono.

“For a borrower, if they can maintain a lower rate on a component of his capital stack by negotiating with an existing lender, and then bring in higher-cost capital for a smaller component, that makes better sense than writing a whole new first mortgage.”

Where does opportunity lie?

The multifamily sector alone represents a “huge” credit deployment opportunity, argues de Haan, because in recent years, many good sponsors have bought high-quality buildings at historically low cap rates. Those with loans reaching maturity in a market where values have fallen now need to pay down their existing lender by borrowing higher-yielding bridge capital. “We are going to be providing a lot more high-yield money. ACORE will do billions of dollars of those deals at 13 to 15 percent rates,” de Haan predicts.

Lippmann points out: “It is a great opportunity for a debt fund to take advantage of senior lenders’ desire to de-lever when borrowers may be unable to recapitalize assets on their own. We are seeing that take the form of mezzanine and preferred equity in the market.”

For alternative lenders, the opportunity to provide senior or whole loan finance to borrowers needing to recapitalize is also compelling, particularly in a market in which investment activity, and therefore the ability to make loans against new acquisitions, has reduced. “Because of that, lenders will see more refinance activity, whether that be out of their own book, or somebody else’s,” says Gay.

Meanwhile, the pricing that can be achieved has grown sharply. Not only are base rates higher, but spreads have widened to reflect the increased credit risk caused by economic uncertainty and volatile asset values. Furthermore, lenders can now price for an “illiquidity premium” because of the scarcity of capital, he adds.

“This is one of the most attractive markets that we have seen in maybe a decade to make new loans on commercial real estate,” Gay says. “We are playing in the sectors that have better tailwinds in this environment. Industrial, and alternatives like student housing and self-storage, still have very good fundamentals. We can make an unlevered senior or whole loan and achieve a high single-digit return, whereas before we would have to use leverage to achieve the same level.”

However, grasping the opportunity is not entirely straightforward for alternative lenders. Those that have already deployed capital may have issues within their existing loan books, forcing them to hoard cash against the possibility of future defaults. Meanwhile, illiquidity in the banking market has hamstrung debt funds that had hitherto relied on back finance to achieve target returns.

“Previously prolific lenders on the warehouse lending side have pulled back dramatically,” says Lippmann. “That senior capital is much less available and more expensive. Without it, debt funds have to make unleveraged investments. Their returns are higher, but some have return hurdles that are so high that they aren’t able to achieve their goals without leverage.”

Alternative lenders must be “hyper-selective” about the loans they make in this economic environment, says de Haan. “The risk framework is different today than it was a year ago. Businesses and consumers are under pressure, so one has to take a much more conservative view on credit. At the opportunistic end of the market, that means taking debt-like risk and making equity returns. While there will be a ton to do, we don’t have to do all of it.”

Moreover, while market conditions may currently favor alternative lenders, a return of senior liquidity is needed for the restoration of its overall health, argues Lippmann. “Without more senior capital available, most of the $280 billion of dry powder sitting on the sidelines for subordinate debt and new equity may not be called into the market because real estate values could fall, causing a downward spiral.”

“As long as banks are worried about reserving capital against their current balance sheets, and are not encouraged to look at new loans, that is a problem,” he adds. “We need to find a way to restore normalcy in the capital markets so that senior capital can come back in, and the committed dry powder can be deployed to recapitalize over-leveraged assets.”

‘No liquidity’ for office recapitalizations

Alternative lenders show little appetite for beleaguered sector.

While non-bank lenders will be prepared to bridge at least part of the refinancing gap for some asset classes, office real estate remains particularly problematic. “It is the sector where there is the greatest uncertainty as to whether alternative lenders will step in,” says Jack Gay of Nuveen Real Estate. “There is little to no liquidity for new office loans. Even if a loan is performing well, there is a good chance that when it matures there will be no option but to extend.”

Crescit Capital Strategies chief executive Joseph Iacono notes that there have been periods in the past when office demand has slumped. However, he believes that current trends present a more complex challenge for underwriters. “In the early 1990s, downtown Manhattan was decimated, with very high vacancy. But you could lean into that by buying at less than replacement cost. There were tenants out there. It was just a matter of finding a way to attract them at the right price. Today it is different because we are dealing with a change of behavior, so it’s tough to discern what the impact will be on the long-term demand for office space.”

Taking the foreclosure route is also problematic, says New York Life Real Estate Investors managing director John Lippmann. “If a lender takes back an office building, they can’t necessarily do anything more to lease the building than the landlord could, especially if they are an experienced sponsor.”

Lenders must carefully consider how they can maximize long-term returns, he argues. “If there is unlikely to be an improvement in the underlying fundamentals, a one- or two-year extension may not be the right approach either. It may be better for either the original borrower or the foreclosing lender to recapitalize the asset for the long term so that a business plan can be effectuated to reposition it and maximize value.”