There are three significant issues affecting commercial real estate borrowers today: an increasing cost of capital, rising interest rates and a paucity of active lenders, says Robin Potts, co-head of real estate investments at Los Angeles-based Canyon Partners.
“There are a lot of parts of the market that are not working,” Potts tells Real Estate Capital USA. “There are also a lot of parts of the market where it does not matter how strong of a borrower you are. There just might not be any financing available. The real estate debt markets are extraordinarily dislocated.”
Our conversation takes place at a time of extreme, almost generational, uncertainty for the commercial real estate market, with Potts citing concerns widely echoed by other institutional managers in the US and further afield.
Since the start of the year, the benchmark 10-year Treasury has risen by more than 150 basis points to around 3.83 percent at the time of writing. The forward SOFR curve, which has become a commonly used benchmark for commercial real estate debt as LIBOR sunsets, has also seen a precipitous increase.
“The cost of capital has risen dramatically,” Potts says. “This time last year, the forward three-year SOFR curve was 40 to 50 basis points, but now it is 420 [basis points]. At the very low end, [spreads over SOFR could be] 100 basis points and in certain cases [we’re seeing] spreads of 300, 400, 500 basis points wide. It varies dramatically by asset profile, but the cost of borrowing being so much wider has been a tremendous shock to the system.
“The base rate for all commercial real estate floating rate debt has increased tenfold. On top of that, spreads have widened out, depending on the profile.”
To understand the market today, Potts believes it is essential to break down what is going on into its component parts. Along with rising rates, borrowers are seeing higher pricing and lower proceeds on new loans, and there remains a gulf between borrower and lender expectations.
“The real estate debt markets are extraordinarily dislocated”
“The result is that with the proceeds levels now, our debt service coverage ratio is constrained and so you have higher borrowing costs and lower loan proceeds,” says Potts. “This is resulting in borrowers needing to put in additional equity for financings to move forward.”
These factors are amplified in sectors facing headwinds, she says: “Unless you are willing to pay more and accept lower proceeds, there might not be any lender willing to take the risk, especially for certain out-of-favor asset profiles or sectors.”
She cites an extraordinary amount of pullback across all types of traditional lenders, ranging from money center banks, large and small regional banks, insurance companies, commercial mortgage-backed securities conduits and CLO issuers.
“It is extremely broad based [and] very unusual for this level of pullback to be so deep – and we expect it to continue into next year,” Potts adds.
A November report from CBRE reviewed by Real Estate Capital USA details the drop in lending, finding that the pace of commercial real estate loan closings in the US declined by 11.1 percent from the second to the third quarter. Meanwhile, commercial real estate CLO issuance dropped from $12.3 billion in the second quarter to $3.39 billion in the third quarter, and CMBS originations fell from $20.8 billion to $13.3 billion during the same period.
As a lender, one of the things Potts considers Canyon’s number one priority – even before property type – is borrower profile.
“Especially now, [we prioritize] lending to best-in-class borrowers with strong balance sheets that enable them to weather challenging capital markets like this,” Potts says. “As a lender, we are also able to size the leverage level and advance rate on deals to our comfort level from a downside protection perspective.”
By sector, the firm believes in the prospects of the multifamily sector. “When you’re looking across the different asset classes, multifamily [is] a key sector for us that we remain very positive on,” says Potts. “But there are opportunities beyond the most favorite asset classes – in office, student housing and hospitality, for example – where you’re working with very strong borrowers and at fairly low leverage levels, so that becomes quite attractive as a lender as well.”
While there has been some hope across the market that transactions and lending would be reinvigorated at the start of the year, the recovery may take longer. Potts believes the market may reopen marginally in 2023, but cautions that there will not be the same flush of debt solutions as were being seen at the beginning of 2022. “I think it’ll be a very constrained market for the foreseeable future,” says Potts.
On the flip side, Potts points out it is an interesting time to be an alternative lender with so many gaps and cracks that need to be filled from a financing perspective due to pullback in the market. “Right now, banks, for the most part, are completely on the sidelines,” she says. “There were certain banks that have broadcast that they’re not issuing quotes on any new deals for at least the next three months.”
Looking toward to next year, the firm predicts more players will step off the sidelines. “I think in 2023, some of those participants will start dipping their toe back into the market, even if it is at very conservative levels,” Potts adds.
In the bigger picture, real estate’s place remains the same. “Real estate that provides the opportunity to capture upside from the rate movement with built-in downside protection from the equity subordination will become a more interesting spot to be in, [amid] a pretty volatile market,” says Potts.