Commercial real estate debt and equity specialists are dusting off playbooks – and thinking differently about the impact higher interest rates, lower valuations and rising distress will have on the commercial real estate markets going forward.
The changes being seen in the market are both cyclical and secular, according to market participants who spoke with Real Estate Capital USA. But the biggest driver behind these changes is the more than 500 basis point increase in the federal funds rate over the past 18 months.
The coming changes will not always be easy, but are necessary, says Joe Rubin, real estate services consultant at New York-based advisory Eisner-Amper.
“We are in a transition period from a low interest rate environment to a more historically normal interest rate environment,” Rubin says. “While everyone knew it was going to happen, it happened fast and is causing a lot of distress. It will be a very long and difficult transition to what comes next.”
Market participants cited a wide swath of potential changes, including the possibility of an increase in loan-to-own strategies and an increasing likelihood of non-performing loan securitizations. But there are also more positive discussions afoot, including an expectation that more institutional and private investors will be turning to commercial real estate debt as an investment.
Here are five things you need to consider.
Loan to own
Higher interest rates, a wall of maturities and constrained commercial real estate capital markets mean the potential for more loan-to-own opportunity for alternative lenders. The last time loan-to-own was a major factor in the market was in the period following the global financial crisis, says Rob Gilman, partner and co-leader of Anchin’s Real Estate Group, a New York-based accounting and advisory firm. “Until now, everyone has been able to afford debt at a time when prices were going up. Owners never fell into a point where their lenders had to take back the keys,” Gilman adds. “The loan-to-own model was somewhat phased out. But now in a market where prices are decreasing and borrowers cannot pay their existing debt, it is apparent that there are funds out there lending with the approach of loan-to-own.”
Commercial real estate sponsors facing near-term maturities often need to buy time to execute their business plans. This is where continuation funds could come in, says Brian Forman, a partner at New York-based law firm Morrison Cohen. While these funds have often been used in the broader private equity market, this has not been the case within commercial real estate. “In the private equity space, managers started to butt up against the extension period of funds for assets that they believed still had a lot of run room,” he says. “There is potential for this strategy to be adapted for the commercial real estate market.”
Credit risk transfer, a strategy in which lenders can structure the risks associated with originating loans into securities, is mainly used by Fannie Mae and Freddie Mac. But credit risk transfers could also be used in the private real estate markets in a similar way, says Rick Jones, a partner at New York-based law firm Dechert. There are already detailed, in-place regulations around credit risk transfers, with the Federal Reserve adopting rules from the Basle regulations. “We are having a lot of conversations around it,” Jones says. “If you do a synthetic credit risk transfer on an asset, the asset stay on your balance sheet but is characterized for risk-based purposes as either a securitization or as corporate exposure tied to the credit rating of the party that trades the risk with you. For banks, this could be one way of reducing their commercial real estate exposures.”
NPL in the cards
Non-performing loan securitizations, another signpost of a distressed market, could be in the cards, according to a report released in August from New York-based rating agency KBRA. A key factor in this outlook is the valuation declines of commercial real estate loans on bank balance sheets, which could ultimately end up in future securitizations. Historically, these deals have been a mix of non- and re-performing loans as well as REO assets. The agency is starting to field some inquiries, with Christina Moy, managing director and a co-author of the report, adding there is a potential for some of these deals to be completed next year.
Securitization is always a good idea
There is a tried-and-true strategy that could come into play should the loan books of regional US banks become a more serious concern: the commercial mortgage-backed securities market. While markets seem to be more stable in the wake of a trio of failures in early March, it would be naïve to state that there are no problems in the market. “The FDIC created the CMBS market to help small banks get loans off their balance sheets. There was lot of technological innovation, including the start of the CMBS market and the dawn of the modern REIT era, which helped the market to recover from the S&L crisis,” says Richard Hill, a senior vice-president and head of real estate strategy and research at New York-based Cohen & Steers. “It is even more interesting that the FDIC used the same technology in the aftermath of the Global Financial Crisis.”
Despite the potential for innovation, something needs to happen first: a return to transaction activity. And at this point, market participants are not expecting to see that before the start of 2025.
“The consensus in January was that there would be a recession by the third or fourth quarter of the year and the business would start up again by the end of the year. It is clear that is not going to happen, and things will take 18 months or more to have everything flushed through the system,” Rubin says.
While a key question right now is if the Federal Reserve will raise rates again, Rubin says what is more important is how long rates will stay at their current level.
“The 10-year [Treasury] is within a historically normal range right now, at around 4-4.5 percent and if it stays there, that could be the new reality. At that point, people can get out their calculators, but right now the math just isn’t working,” he says.
“Real estate is, by nature, a leveraged business and you need the leverage to achieve an adequate risk-adjusted return. Maybe you don’t need quite as much leverage, but particularly now in a risky environment, you need a higher yield to make that investment and the only way to get there is to leverage. That is the irony of the moment – the leverage is too expensive to make the yield work and that is why deals are not getting done.”