Commercial real estate owners in the United States face an interesting period in 2019 as they assess the best properties to acquire, and, specifically, how to finance them.
Broad economic and demographic conditions, as well as real estate fundamentals, continue to be strong. Though many have concerns about how much longer that can persist, recent high acquisition volumes indicate buyers remain optimistic. Since the vast majority of US commercial real estate is acquired with debt financing, the availability and terms of that financing are a critical component to any buyer’s investment strategy. Here are the top five themes that borrowers should keep in mind as they navigate the financing markets in 2019.
1. Interest rates will prompt decisions about loan duration: With interest rates having increased during the past 18 months, borrowers looked to lock in longer duration fixed rate capital. However, with the Fed signalling patience and a “pause” given the slowing growth of the economy, market participants are expecting rates to remain relatively flat over the next 12 months and even decline beyond that. As a result borrowers may benefit from floating rate loans.
2. Private lenders are flourishing, but not all have the necessary experience: The advent of private real estate debt fund lenders as a conventional form of financing has vastly increased the diversity of funding sources for owners of real estate. This has created intense competition among the various providers of debt capital, thus reducing spreads for the highest quality assets. Borrowers must be careful in selecting these new lending entrants, however, as many have limited track records and may not be around in the long run to service their loans.
3. Spread compression will bottom out: Though increased competition among lenders has driven spreads down, the conventional wisdom is that spreads are likely as tight as they will get. Lenders, particularly the growing share of private market lenders, have an absolute spread threshold below which it no longer makes sense to lend. This suggests that borrowers who may be considering a refinance should pull the trigger before spreads rise again.
4. The CMBS market will remain uncertain: The securitisation markets have never fully recovered and have remained quite volatile since the global financial crisis. This has forced CMBS lenders to be more conservative and focus on lower loan-to-values, which has made acquisitions in a low cap rate environment more challenging for many borrowers. However, there is a trend of CMBS lenders teaming up with mezzanine providers to create a ‘one-stop shop’ model. This could be an attractive option for borrowers who need additional leverage to generate higher yields for their investors.
5. Construction lending returns make sense in certain markets: Banks and private lenders are re-energising the construction lending market. Given the general conditions of low vacancies, limited rent concessions and growing net operating incomes, new construction may well be warranted in certain markets, but the question is whether developers can deliver before the markets contract. Accessing construction lending sources that can move quickly will be critical to any development project.
There are several uncertainties ahead in 2019 despite the strong metrics that are driving steady growth across the markets. Real estate owners are showing no signs of trepidation as they continue to acquire properties at a steady pace. However, the real estate markets are operating in a tight performance window given the low cap rate environment and that makes the financing of these properties more critical than ever. Borrowers will do well to carefully monitor the capital markets in 2019 to make the right investment decisions for their portfolios.
Mesa West Capital is a commercial real estate debt provider founded in 2004. The Los Angeles-based firm is owned by Morgan Stanley Investment Management.