Two weeks after the Federal Reserve’s most recent interest rate increase, the yield on the 10-year Treasury is stabilizing.
A more stable 10-year Treasury, the most commonly used benchmark for writing long-term, fixed-rate loans, is signposting a reboot in the investment sales and lending markets, market participants told Real Estate Capital USA.
As of February 14, the yield on the 10-year Treasury was at 3.77 percent rising slightly after the most recent Consumer Price Index report. The CPI rose by 0.5 basis points for an annual gain of 6.4 percent.
“Right now, we are seeing the 10-year Treasury stabilize and that has provided stability on the fixed-rate lending side. But we don’t have that on the floating-rate lending side yet,” says Marcus Duley, chief investment officer of Walker & Dunlop Investment Partners. “Still, I don’t think we are going to see a particularly strong first or second quarter because there is still a lot of discovery in terms of current cap rates and there are also challenges around underwriting exit cap rates and future cap rates.”
Hessam Nadji, president and chief executive of Marcus & Millichap, told Real Estate Capital USA the firm is closely watching key metrics but believes the market could start to transact again in the coming months.
“We share the view that the worst should be over and the Federal Reserve is through the worst part of the tightening cycle,” Nadji says. “We are confident inflation is coming down and the worst of that component is over.”
While the Federal Reserve would like to see a less robust job market, this has not yet played out in the numbers. “The effect of the rate increases from 2022 haven’t yet shown up and we think there will be a mid-year reversal,” Nadji adds.
No fire sales
There is a broad consensus that while there will be distress, there will not be fire sales of assets similar to that during the late 1980s and early 1990s. “There has to be some price correction as the era of free money is behind us,” Nadji says. “The government had to be super-aggressive during the pandemic to stimulate the economy but that is over, and we need to transition back to normal.”
Scott Lawlor, founder and chief executive of multifamily development company Waypoint Residential, does not believe the market will see the dislocation in the same way the market saw in the Resolution Trust Corporation days.
“The way we understand the real estate capital markets today largely got invented coming out of what happened with the Resolution Trust Corporation in 1991 and 1992. At that time, there was no such thing as an opportunity fund and, as a practical matter, REITs or CMBS. That was real estate taking capital markets techniques from corporate America and using those to finance out of the crash,” Lawlor says.
Watching the metrics
As macroeconomic factors came to roost during the second half of the year, the impact of a decline in the equity markets and a general risk-off attitude also affected the commercial real estate market, says Nick Parrish, managing director and head of business development at Cresset Partners, a Chicago-based manager.
“Generally speaking, the capital markets largely froze up, interest rates increased and suddenly the cost of capital was higher. Those are all impressive issues – those are also all real estate issues,” Parrish says. “In terms of where 2023 is starting, there have certainly been some favorable market dynamics, some indication that the Federal Reserve might be slowing down and some positive market performance.”
The key metrics market participants are watching now, in addition to commentary and movement from the Federal Reserve, are this week’s upcoming jobs report and monthly inflation numbers. This week’s inflation numbers will be key.
“There was a collective relief in the real estate world and on the lending side when the rate hike was only 25 basis points,” says Paul Rahimian, founder and chief executive of Los Angeles-based construction lender Parkview Financial. “But then with the jobs report last week, everyone is confused and isn’t sure what it means.
“Everyone is now holding their breath for the inflation numbers that will be coming out next week because if they for any reason go the other way and show inflation is not subsiding, that changes everything for the Fed, which will increase rates for longer and higher,” Rahimian said. “We need to know what that terminal rate is for the Fed so we can calculate our cap rates and know what an exit cap rate might look like in two or three years.”
Filling the gap
Like its peers, Walker & Dunlop Investment Partners started off strong in 2022, then saw the same slowdown in transaction activity. But in the interim, the firm has seen demand for preferred equity increase significantly as sponsors come up against near-term debt maturities or need to move forward on acquisitions, Duley says.
The middle-market specialist has two vehicles through which it can make preferred equity investments, including lower- and higher-leverage buckets of capital, as well as an equity business. Having both these businesses allows the firm more visibility for what is going on in both the debt and equity worlds.
“On the acquisition side, we are seeing more sponsors buying properties by assuming the seller’s existing with low-leverage, fixed-rate debt and going forward, I believe this means we will continue to see that demand for preferred equity,” Duley said.
Rahimian says the current market is in a wait-and-see environment and notes it can be difficult for lenders and borrowers to break from the mindset.
“With the Federal Reserve increasing rates over the past few months, everything has been in flux and we are noticing that everyone in the marketplace is still taking a position of wait and see. This is unfortunate because when everyone else waits and sees, you end up waiting and seeing as well and we are trying not to fall into that trap,” Rahimian says.
Outlook for this year
The consensus continues to be that originations will be slow for the next three to six months, until there is more clarity in the market over the direction of rates. Still, expectations are that the third and fourth quarters could be strong – and more than one market participant noted there is substantial dry power waiting to be deployed.
“There is a lot of equity capital on the sidelines waiting to buy distressed deals and the market is just not there yet,” Rahimian says. “And when it comes, it won’t be at the level we saw during the global financial crisis. But there will be some distress depending on geography and asset type. It will be based on what is a recalibration of true real estate values based on new data, new interest rates and sellers that don’t need to sell.”
Waypoint’s Lawlor concurs. “We will see some select opportunities because multifamily is a big asset class and there is always a needle that slips through the haystack,” Lawlor says.
“We will hear some stories, and whoever does will brag, about it so you’ll think it happened a thousand times but I don’t think it will be a systemic opportunity that is coming my way. I my space, there are too many factors that make it unlikely.”