The US commercial real estate market, buoyed by regulatory changes in the wake of the global financial crisis, generally lower leverage and the growth of alternative lenders, appears to be in a better position to navigate what is widely expected to be another period of turmoil.
As global financial markets readjust to a normalized coronavirus environment, rising interest rates, higher inflation and lower valuations have taken over as the main pressures affecting transaction and lending volumes. Indeed, a health crisis has given way to an economic one, leading market participants to make natural comparisons between the post-GFC and post-covid worlds.
“The key differences between the two periods have much to do with their triggers,” says Lisa Pendergast, executive director of the Commercial Real Estate Finance Council, a New York-based trade group for the commercial real estate finance industry. “This current period of distress was 100 percent pandemic-driven, and its depth and devastation clearly outpaced any recent pandemics.”
This is in stark contrast to the GFC, when systemic financial and regulatory failures precipitated the crisis. “The [GFC] was triggered by a severe downturn in the housing market here in the US and elsewhere caused by a smoking hot single-family housing sector fueled by easy money. Read: runaway leverage and aggressive underwriting,” Pendergast says.
There is another factor that has changed since the start of the GFC, says Alan Todd, a managing director and head of commercial mortgage-backed securities strategy at Bank of America: leverage.
“The [GFC’s] was, in part, a leverage problem,” Todd says. “There was more leverage in the system across the board. Homeowners were levered more significantly. Some were taking out multiple loans on fraudulent financial income statements. The banks were more levered.”
As the financial crisis played out, leverage started to unwind, and volatility picked up. “The banks were making margin calls and clients couldn’t meet them, so they had to sell, and that led to more selling,” he says. “Because the banks were so levered, they couldn’t buy in and this became a downward spiral.”
Commercial real estate lenders today are carrying significantly lower debt loads.
“We are nowhere near that situation today,” Todd says. “Loans are underwritten more conservatively, more realistically. The banks aren’t carrying as much inventory and there is less leverage in the system across the board from the investors to the bank. The debt funds were very minor players 10 to 15 years ago. Now, depending on the quarter, they account for anywhere between 10 and 15 percent of commercial real estate lending.”
Part of the changes under 2010’s Dodd-Frank Act meant that banks could no longer hold riskier parts of loans on their books without incurring significant capital charges, a phenomenon that, in part, led to the development of alternative lending platforms (see related story, page 26).
Lending via a debt fund, where the originator often retains the risk, is very different than lending from a commercial bank.
Within banks, the regulations have been a driver toward more cautious underwriting and stricter covenants. “If you look specifically at CMBS, there was pretty broad pro forma underwriting [prior to the GFC] where the originators were basically factoring in future revenue,” Todd says.
CMBS lending standards are now more conservative. The average CMBS loan-to-value (LTV) prior to 2010 was 69 percent. In 2019, it dropped to 58 percent. It has remained under 70 percent throughout the pandemic, according to data from Moody’s Investors Service.
These lower LTV ratios may be partly due to regulatory changes, says Darrell Wheeler, vice-president and senior credit officer at Moody’s Investors Service. Wheeler also notes various control and oversight rights were worked into new CMBS structures when the market rebooted after 2010.
Wheeler points to 2016, when greater risk retention requirements were implemented, as a specific inflection point. “The leverage really came down in 2016 after they implemented risk retention. [The years] 2011 through 2015 had a slightly higher LTV and then suddenly you saw a drop,” Wheeler says.
“Financial markets entered this period in sound financial health, with the lessons learned from the GFC and the resulting regulations put in place post the GFC doing what they were intended to do”
Commercial Real Estate Finance Council
There is another major difference between today’s market and the GFC – liquidity is abundant, which should prevent the kind of investment slowdown seen in the aftermath of the GFC.
“When we hit the GFC, it was very hard to find any bottom feeders picking up properties on the cheap [because of the lack of liquidity]. It took a long time for that market to develop. Accordingly, we saw almost two years of no [commercial real estate] issuance as people waited out the market,” says Manus Clancy, a senior managing director at New York-based data and analytics provider Trepp.
Moreover, those which sold off at the bottom of the market missed out on major profits once the dust cleared and the economy rebounded.
“Everybody thought that triple-A would take losses in the [GFC], and they didn’t. And then people bought bonds at 60 and 70 cents on the dollar and made a fortune,” Clancy says, adding that investors absorbed that lesson. “[Now] it seems like every time spreads blow out there’s somebody ready to swoop in and buy,” Clancy adds.
Inflation: a new wrinkle
But there is one thing this time around that was totally absent from the GFC: high inflation. Inflation has not only driven up the cost of development, it has also prompted the Federal Reserve to hike interest rates, leading to higher pricing and lower valuations.
The Federal Reserve has already increased interest rates four times this year, with another meeting set for late September, and Ray Potter, a principal at Charlotte-based advisory R3 Funding, does not see the government department reversing course until inflation is under control. According to August’s CPI report, inflation was at 8.5 percent.
“I do believe inflation is still rampant in the economy. That means the Fed must stick to this raising of rates until they get down to the 2 percent [inflation] level. If they want to get to that 2 percent inflation level, they’re going to have to put their head down. I’m not buying into this false narrative that they’re only going to do one or two more rate hikes,” Potter says.
A too-aggressive Fed response, however, could take a toll on originations, particularly on floating rate loans, Wheeler adds.
“Markets remain liquid. But I would be concerned if the Fed gets too aggressive, as the market is having trouble pricing rate caps for floating-rate loans. [Rate] cap providers are exposed to what has become an uncertain and increasing rate environment, which makes it difficult for them to take on the cap that is required for floating-rate loans,” Wheeler says.
The uncertainty around inflation and the rate hikes deployed to tame it is taking its toll on originations, according to Chris Moore, managing director at Chatham Financial. “If you underwrite based on one rate, and then between signing the term sheet and closing the deal rates have gone up dramatically and unexpectedly, that’s very problematic,” Moore says.
Average leverage in CMBS deals pre-GFC
Average leverage in CMBS deals post-GFC
Average DSCR in pre-GFC CMBS deals
Average DSCR in post-GFC CMBS deals
As borrowing costs start to approach and even eclipse potential cap rates, the incentive to originate new deals evaporates as dreaded negative leverage takes hold (see related story, page 9). This could cause more and more market participants to slow activity. “I think anytime you start to see financing costs that are getting close to, or exceeding, cap rates, on the assets being purchased there’s going to be a need for market participants, whether they’re buyers or sellers, to step back and reevaluate where assets are trading,” Moore says.
Interest rate and inflation pressures have taken their toll on CMBS issuance as well, says Pendergast. For example, private-label CMBS new issue volume totals $83.3 billion year-to-date, compared with $85.2 billion during the same period in 2021. “Market volatility certainly has played a role in slowing down CMBS issuance. This is startling considering that in Q1 2022, CMBS volume at $44.1 billion was running well ahead of Q1 2021’s pace of $26 billion,” Pendergast adds.
Wheeler is also tracking dislocation between buyers and sellers, which is affecting transaction volume for both deals and lending, including CMBS. “There’s a sense that there is this standoff between potential sellers and potential buyers who are looking at where the cap rate is and where the interest rate is,” Wheeler adds. “You’re going to see volumes remain low between them because the seller obviously thinks it’s worth x, and the buyer thinks it’s worth x-minus-20-percent. So that that’s what will reduce [single-asset-single-buyer] and conduit transaction volumes.”
Not the end of the world
Still, lending activity has remained resilient through much of the summer. And Clancy sees what happened after the GFC as a cautionary tale to remind people that things are often never as bad as they seem to be. “We’ve been through several crises now where it seemed like the world was going to end, the biggest one in 2008. And yet, we never see conditions as bad as people think they’re going to be for the most part, and I think that over time, people get more confident,” Clancy says.
Pendergast adds the GFC ultimately lead to this market being in a much better position to weather another crisis. “Financial markets entered this period in sound financial health, with the lessons learned from the GFC and the resulting regulations put in place post the GFC doing what they were intended to do,” she says.