CenterSquare Investment Management is seeing a growing opportunity for private credit lenders to gain market share through 2024 and into 2025 as sponsors come to grips with the reality of interest rates and expiring blend and extend strategies.
In a research paper and outlook report published last week, the Plymouth Meeting, Pennsylvania-based manager said there is plenty of reason for optimism at a time when there is high demand for new loans, a lack of financing from traditional debt sources, and a reshaping of the capital stack in favor of more junior debt components and creative structures.
Michael Boxer, managing director at CSIM, told Real Estate Capital USA market participants who grew accustomed to the considerably lower interest rates of years past are dealing with the pain now. This in turn is creating a potential boon for private credit lenders still able to originate debt – be it senior or junior positions – in the current market.
In the multifamily sector specifically, a lack of rent growth, increasing expenses including insurance costs and elevated interest rates are proving to be too much pressure for the asset class to withstand without some downward pressure on values, Boxer added.
The three factors, when added together, mean multifamily valuations could be as much as 10 to 12 percent lower than expected. “That is nothing to sneeze at,” Boxer added. “If multifamily property values came down 10 percent across the board, that is certainly going to impact equity values.”
He continued: “It is going to impact the levels of financing that those borrowers are able to get and will certainly impact the ability for some borrowers to obtain refinancing proceeds sufficient to repay their old loan. It will, in all likelihood, trigger in a lot of cases some level of fresh cash or equity that is going to be needed to right-size the capital structure. But that also is what is creating opportunities for private lenders who are sitting on the sidelines with capital to deploy.”
Under this scenario of a potential 10 percent drop in multifamily values, Boxer said a private lender willing to originate loans at 75 percent loan-to-value today could theoretically see the LTV of the loan rise to 85 percent if valuations fall. But that increase in valuations is not likely to affect the lender’s projected returns.
“Our investments enjoy a ‘cushion’ that provides a meaningful element of insulation against swings in the underlying property value,” Boxer said. For example, he said if a lender were to make a 75 percent LTV at inception, and over the term of the loan the property or collateral were to fall in value by 15 percent, if the property were then liquidated, the loan could be completely repaid from the proceeds of the sale.
Boxer cautioned, however, that if property values were to fall by more than 25 percent, that would mean LTV is greater than 100 percent. At that point, the equity would be completely wiped out and the lender would begin to incur losses to the extent the property losses exceed 25 percent of its value.
Then and now
“The opportunity in front of us as debt investors has not really changed all that much from the end of last year to now, but the difference being is that owners and operators are for the most part coming to grips with the fact that higher rates mean lower values and it means they do not necessarily perceive the benefits anymore of continuing to wait and push off or extend their financing,” Boxer said.
For opportunistic lenders and investors, he said, this means owners and operators that have below-market debt are more likely to transact if they believe this rate environment is here to stay because there is no longer a benefit to merely kicking the can down the road for another three or six months.
“We are starting to see that willingness to transact now,” Boxer said. “It is going to spur more and more investment activity, and this creates a virtuous cycle of the marketplace learning where values are setting in because there are more and more transactions that all market participants can point to as an indication of value.”
Coming to terms with higher rates
While the transition to a higher-rate environment is likely to cause stress, this was not unexpected.
“The market really did get addicted to exceedingly low rates and reality is just setting in that this is a reversion to the norm,” Boxer said. “A 4 percent 10-year Treasury is nothing crazy, but it is almost 50 percent higher than where it was a year and a half or two years ago and that is painful.”
The pain stems in part from how market participants invariably financed their real estate with considerably lower cost of debt than exists now. While some lenders have been optimistic about deep rate cuts this year, Boxer said his belief is the magnitude and number of rate cuts will be much lower than what others have predicted of the US central bank.
“Based on my belief the Fed is suffering from a credibility problem, they will be keenly aware of making a knee-jerk reaction and acting too quickly in response to favorable indications on inflation,” Boxer said.
His stance is backed in part by Fed chairman Jerome Powell, who said during the central bank’s January 31 press conference that rates would remain in their current 5.25 percent to 5.5 percent range until the US was sustainably moving toward the 2 percent inflation target. Even then, immediate or severe rate cuts are not assured.