The commercial real estate market is moving closer to a future in which leverage is expected to be significantly lower than it has been over the past 15 years.
The more than 500 basis-point increase in interest rates over the past 18 months, which came as the Federal Reserve worked to combat rising inflation, was initially expected to be a shorter-term phenomenon.
But lenders and borrowers who spoke with Real Estate Capital USA now believe rates will be higher for longer. And while market participants do not believe leverage will disappear, the way in which it will be used is the key question facing the market today.
“The big debate is: how long will we be in this new regime of change where the cost of capital is up and capital availability has broadly been reduced?” says Joel Traut, partner at New York-based manager KKR.
“Over time, markets normalize, and where there is excess yield to be had, new forms of capital will fill those voids. The question is: how long does that take, and how does that impact real estate investors between now and then?”
The impact so far includes lower valuations, reduced transaction activity and a need for more expensive sources of capital to bridge the gap between a sponsor’s equity and a senior mortgage. But there is a bigger psychological shift which needs to occur, says Brad Salzer, president at Tampa, Florida-based alternative lender Redstone Funding.
“Real estate borrowers became complacent after years of historically low rates – slowly they will realize that to get deals done, they must either adjust to the new leverage or pull up the sheets and go back to bed,” Salzer says.
A historical perspective
Historically, leverage has been a way for sponsors to increase returns, allowing them to put less equity into each deal. In recent months, senior lenders have scaled back their loan-to-value requirements (LTVs) from 65-80 percent to as low as 50 percent.
“The real estate lending market has continued to evolve from the 1980s to today, in both the composition of capital providers and the lending products that are offered,” Traut says. “But leverage has always been a factor in commercial real estate, but it varies by the investor type and property type. Real estate has many positive attributes, one of which is that it can be levered.”
The evolution of the commercial real estate capital stack
In an ideal – or positive leverage – scenario, the cap rate is higher than the interest rate on the debt. But in a negative leverage situation, the cap rate is lower than the interest rate on the debt – a scenario that is being seen more frequently today.
“You generally want your leverage to be accretive,” says Shlomi Ronen, managing principal and founder of Los Angeles-based real estate merchant bank Dekel Capital. “The cost of capital has moved up faster than cap rates so, in almost every instance, you are borrowing at rates today that are much higher than the cap rate you would be able to acquire the assets.”
While cap rates and interest rates do not always move in tandem, the impact of the Federal Reserve’s rate increases over the past 18 months has had a measurable impact on cap rates. Every 100 basis-point increase in long-term interest rates has resulted in a 60 basis-point rise in commercial real estate cap rates, according to an August report from Dallas-based advisory CBRE. The report gave a hypothetical scenario in which an increase in the 10-year US Treasury yield to 4.75 percent from 2.2 percent would result in a 150 basis-point increase in the average cap rate. Further, a prime asset which in the past had traded at a 4.5 percent cap rate would now trade at a 6 percent rate. This is equal to an approximate 25 percent fall in capital values.
“The big debate is how long will we be in this [period of] change where the cost of capital and capital availability have
It is at times like this that leverage becomes a double-edged sword. It has become difficult for sponsors to finance properties, from a cost of debt, amount of leverage, and availability of lenders perspective, says Mike Acton, managing director and head of research at Boston-based investment firm AEW Capital Management.
“When the interest rate environment changes fast, like it has done, it causes a lot of things to get messed up,” Acton says. “The borrowing costs have gone up faster than the property’s yields. The leverage isn’t particularly effective, even when you can get it.”
The impact of lenders offering sponsors lower loan-to-value ratios is being seen throughout the commercial real estate capital markets today. “Commercial real estate as an asset class is very dependent on the debt capital markets being open and operating in a more traditional way,” says Robin Potts, partner and chief investment officer of Dallas-based manager Canyon Partners Real Estate. “But today, the real estate debt capital markets are quite frozen. That’s rippling through the market, and in several different ways.”
A common effect being seen today is a significant gap between sponsor equity and senior mortgages for acquisitions and refinancings. “Debt is more expensive, so the equity required from borrowers is greater. The transactions are also more challenging for borrowers to put together,” Potts says.
“Leverage is very constricted right now. And the number of players participating is greatly reduced. All of those elements make it a challenging borrower market.”
Anne Jablonski, executive managing director and head of commercial real estate at New York-based property services manager SitusAMC, says that as LTVs have dropped, capital stacks have become increasingly complex.
“Using a combination of senior and junior, mezzanine debt, and even preferred equity layers can help reduce the reliance on senior debt at lower loan-to-value ratios,” she adds.
In addition to finding ways to bridge the financing gap, sponsors are looking to interest-only loans to decrease their monthly debt service payments. An August report from CBRE found the percentage of partial or full-term interest-only loans reached an all-time high of 82 percent in the second quarter of 2023.
“Deals getting done certainly include things like full-term interest-only and much larger slices of equity,” says Steven Bernstein, managing director of credit investments at Norfolk, Virginia-based manager Harbor Group International.
In addition, commercial property-assessed clean energy financing is proving to be another method for sponsors to use lower-cost leverage to build or retrofit their buildings. It is significantly cheaper than senior or subordinate debt and can be used to help fill the gap between sponsor equity and a senior mortgage, says Jillian Mariutti, a senior director on the debt and equity financing team at Chicago-based advisory JLL.
“C-PACE is no longer viewed as a tool to get borrowers more leverage and go up the stack. In this environment, it is being used to bring down the weighted average cost of capital,” Mariutti adds.
Navigating frozen markets
The impact of lower leverage and higher rates is having a direct impact on the transaction market. Through July 2023, US transaction volume was at $83.6 billion, down 63 percent on a year-over-year basis, according to August data from New York-based analytics provider MSCI. The firm also tracked a 10.2 percent year-over-year decline in asset pricing over the same period.
“If sellers are not willing to take a lower valuation, or if they do not have to sell, they will hold on to the asset as long as possible until rates come back down in line,” says Elie Rieder, founder and chief executive of New York-based manager Castle Lanterra.
“When 60 percent of the lending capacity is out of business, you ask, ‘Who really is lending?’”
Matthew Dzbanek, senior director of capital services at New York-based Ariel Property Advisors, says the advisory company is starting to see sponsors’ attitudes shift as they account for today’s lower leverage, higher-rate market.
“Buyers are looking to purchase from sellers who have already adjusted their prices based on current rates and leverage points,” Dzbanek says. “What is becoming interesting is you now have the question of cap rate versus price per foot in different metric [evaluations], and different asset classes are bought based on different situations.”
Part of the fall in transaction activity stems in part from sponsors that simply cannot achieve their returns without high leverage, says Harbor Group’s Bernstein. “The more highly syndicated, low cap rate deals that were prevalent earlier in the cycle have gone away,” Bernstein explains. “Syndicators can no longer get really high leverage at the rates they need in order to make those work.”
SitusAMC’s Jablonski believes there will be no return to transaction activity until rates have stabilized. “As investors evaluate their investment strategies, they may tend to be more conservative, shying away from speculative or high-risk projects and instead, lean to properties with stronger cashflows and stronger sponsorship and established relationships with borrowers they know and trust,” she says.
Market participants often compare what is going on today to previous episodes of instability and stress. Real estate is cyclical, and the market regularly ebbs and flows, says Michael Stark, partner and co-head of New York-based advisory PJT Park Hill Real Estate.
“Demand and financing are elements of cyclicality within the space – the debate is around how long of a cycle it will be.” Stark says. “On a historical basis, things were very cheap for a while. The pendulum has now swung the other way – it’s a matter of how far and for how long. The question is: where will credit markets stabilize and when?”
Traut believes the commercial real estate market is in a period of contraction. “All risky assets are going to be repriced, real estate being one of them,” Traut says. “In this case, we may see stress or distress in the real estate sector as we work through the repricing [phase] and then re-emerge from a new footing and a new framework for the monetary policy and economic cycle.”
Marc Norman, associate dean at New York University’s Schack Institute of Real Estate, believes much of the trouble that could emerge this cycle will be tied to financial distress around maturing debt rather than property-level issues. “Many of the problems arising are from existing portfolios with maturing or floating-rate debt. The issue [this cycle] was that the rises were so fast and so abrupt,” he says.
But Toby Cobb, co-founder and co-managing partner at Miami-based alternative lender 3650 REIT, believes what the market is seeing today is unprecedented because traditional capital providers – national and regional banks – have dramatically curtailed their lending.
“Prior cycles – specifically the global financial crisis and the savings and loan crisis, and you could throw in the Russian debt crisis and the pandemic, too – were resolved principally by capital,” Cobb says. “The only way to generate new capital is to make sure to let loans expire, to reduce the size of their balance sheet, so you have these very strong currents against new lending. When 60 percent of the lending capacity is out of business, you ask who really is lending?’”
KKR’s Traut is also of the mindset that rates may stay higher for longer and that debt could remain scarce. This, in turn, will keep the cost of debt high. “Costs may also go up for other components of the capital structure, whether that’s preferred equity, mezzanine, or equity, as risk free rates remain elevated,” he says.
Leverage versus ability to lend
The question of lower LTVs is tied up with a bigger issue around the availability of capital. In addition to scaling back the LTVs of individual deals, national and regional banks have also reduced their commercial real estate lending since March, when a series of bank failures roiled the global financial markets.
“The smaller, regional banks expanded pretty strongly into property [in recent years] and now a big portion of their balance sheets is property,” Hill says. “To the extent that if there’s any problems in property today, [these lenders] are exposed to it in a way that they weren’t last time.”
An August report from New York-based advisory Newmark found commercial real estate debt originations dropped 50 percent year-over-year through the end of June. The firm also found that there are 32 percent fewer active lenders in the market than there were a year ago.
While regional banks are decreasing their real estate lending in part due to the duration mismatch between loans on their books and their capital base, it has meant borrowers have had to move further afield, says Manish Shah, senior managing director at Austin, Texas-based manager Palladius Capital Management.
“Loans will be increasingly funded by private capital lenders, which tend to have lower leverage and longer-term capital than banks,” Shah adds.
Plans are being advanced to impose more stringent capital requirements on the largest lenders in the US
The US Federal Reserve, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation are planning a regulatory overhaul. The requirements would apply to banks with more than $100 billion in assets and, regulators believe, result in banks that are less prone to the distress seen in 2008 and, to some degree, the turmoil seen this spring.
The new regulations aim to bring the US into compliance with international standards, including Basel III. The proposed plans also affect lending and leverage, notes Michael Stark of advisory PJT Park Hill Real Estate.
“A lot of people are waiting on more bank regulation,” he says. “The impact of that may generate real estate investment opportunities as well as an increased role for private lenders and private credit.”
Alternative lenders have increased their market share dramatically since 2012, providing roughly $100 billion of capital to the commercial real estate markets every year.
Abby Corbett, global head of investor insights at Cushman & Wakefield, describes the current situation as “a private credit opportunity of a lifetime.”
“Given more constrained liquidity for conventional senior mortgage financing, private lenders have a great opportunity to provide subordinate capital in the form of preferred equity or mezzanine debt for maturing loans that need infusions of capital,” she says.
Life insurance companies, which make up an estimated 20 percent of the market, have also been stepping up their lending.
“Life companies are having an absolute field day right now,” Cohen & Steers’ Hill says. “Over the past decade, they have been starved to originate loans at levels that actually worked for them, but now they are originating loans at really high yields in a less competitive environment.”
Even as market participants become reconciled to a lower-for-longer leverage environment, a key question they are asking is: when will leverage levels start to rise again? For Shah, this could happen once interest rates start to come down.
“Interest rates will come down when the Fed sees data that it can lower rates without overheating the economy,” Shah says. “[This] will decrease pressure on regional bank balance sheets and they will return to real estate lending. The increased supply of capital and lower rates may push leverage higher again.”
“Commercial real estate as an asset class is dependent on the debt capital markets being open and operating in a more traditional way”
Canyon Partners Real Estate
But Bernstein believes that even if rates fall, the way sponsors use leverage will be different.
“I think, in the near term, even as rates start to decline, participants in the market will be more thoughtful,” Bernstein says. “I don’t think it’s going to go back to [previous cycles’] leverage levels, at least not in the short term.
“Current interest rates are in the normal range, historically. The period of the last 10 years was the anomaly. I would say the leverage we saw before was due to an environment of easy, low-interest money that could be taken out with even lower-interest money quickly.”
Sponsors’ inability to easily refinance low-cost maturing debt has also meant lenders and borrowers are both looking at different ways of conducting exit and refinance tests.
For Harbor Group, both a borrower and lender, the prevailing wisdom is that any loan or investment it makes will mature in a higher-rate environment.
“We are certainly incorporating the possibility of higher-for-longer and longer-term elevated interest rates when measuring exit and refinance tests. That continues to limit leverage, even with a business plan that works and growing net operating income. You’re still somewhat constrained on the back end of the refinance or exit test, assuming rates remain elevated,” adds Bernstein.
The old normal
Market participants are adapting and adjusting their business strategies for what many describe as a new normal.
“The new lower-leverage environment will be the new normal until rates come down and new lenders, particularly leveraged lenders like regional banks, return to the market,” says Shah.
But for some market participants, what comes next might represent more of a return to the norm. “The last 10 years were extremely abnormal, dealing with a low interest rate environment and below-trend inflation,” Hill says. “What is very normal is what happened prior to the GFC. In many respects, the market is just returning to that environment.”
As part of this adaptation, lenders and borrowers are working to figure out which metrics are the best for evaluating loans, including loan-to-value. There is also debt service coverage ratio (DSCR) – which measures the amount of cash flow to pay debt obligations – or debt yields, which is calculated by dividing loan size by interest payment.
“Twenty years ago, everyone was focused on DSCR as a primary metric, but people were concerned about where [net operating income] was going to go after the GFC. This concept of debt yield started to be prioritized,” Hill says.
“If you believe that you are going to continue to get NOI growth, then maybe debt yield isn’t that big of a concern. Maybe your bigger concern is the ability for the loan to cover interest in a higher interest rate environment. If you believe in this narrative, it’s not a new normal, it’s an old normal. Maybe we’re just going back to old-school underwriting.”