The outlook for the US commercial real estate debt market is not as gloomy as it may seem.
That is the message Real Estate Capital USA has been hearing from industry specialists, who are pointing to a small number of positive metrics like lower inflation readings and a less hawkish outlook from the Federal Reserve on the size of future rate increases in the first weeks of 2023.
At a meeting on Wednesday, the Federal Reserve announced a widely expected 25-basis point increase in its target rate to the range of 4.5 to 4.75. Moreover, Federal Reserve Chair Jerome Powell projected a more moderate pace of rate increases going forward than has been the case over the past year. Powell said a slower pace of hikes will allow the central bank to better assess future actions.
The Federal Reserve made its decision based on lower inflation over the past two to three months. Indeed, the annual inflation rate for the United States was 6.5 percent for the 12 months ending December 2022 after rising 7.1 percent previously, according to a January 12 US Labor Department report. The next inflation update is scheduled for release on February 14, 2023.
Marc Norman, associate dean for NYU’s Schack Institute of Real Estate, believes inflation is being tamed but that the market hasn’t seen the end of the interest rates hikes. However, Norman said it is not just rates that are the problem.
“[The problem] is more a psychological impact, [with rates] being down for so long. You get used to three or four percent mortgage rates but seven and eight percent lending rates are not awful historically – it is the shock of [rates] rising so fast,” he said. “The priority is waiting it out [and] thinking about the longer term.”
The idea of normalizing rates – and leverage – resonates with Dan Lisser, a senior director at advisory Marcus & Millichap.
“There is money out there, but it’s eight percent money, [which is] an indicator of where rates are,” Lisser said.
Lower leverage is another metric that is making for a stronger lending market right now, said Katie Keenan, senior managing director at Blackstone Real Estate Debt Strategies. “Lower leverage makes for positive debt service coverage ratios,” she said.
While there is capital available, lending opportunity are not always easy to evaluate, market participants said.
“The lending opportunities are bifurcated. On one hand, base rates are higher, and spreads are wider – we’re talking about 8, 9 percent coupons on loans for new acquisitions,” Keenan said. “So, borrowers are borrowing less because their incremental cost is getting into equity cost territory.”
Still, there is a sense that for the right deals, it is a good time to be a lender.
“Deals where you can get positive DSCR make sense as a lender [which means] there are more opportunities to invest in the debt side,” Keenan said. “The hardest thing right now for a debt investor is to balance appropriate return with higher cost to the borrower. You don’t want a higher return so much that your borrower cannot afford the debt. The deal has to have sufficient cash flow. The risk return has to make sense for both the investor and borrower.”
Rising costs, rising caps
Jeffrey Fine, global head of real estate client solutions and capital markets at Goldman Sachs Asset Management, sees concerns around the increased cost of borrowing, existing floating rate loans, debt coverage service ratios, LTVs on challenged assets and significantly higher cost to purchase interest rate caps, which are required to extend most floating rate loans.
“The real estate market lives and dies by the health and functioning of our debt capital markets. Dislocation is increasing demand for flexible credit right now, which is less good for borrowers, but liquidity that is desperately needed in a growing number of cases,” said Fine. “Insurance companies have reloaded – banks will tell you for excellent clients they will try to figure out solutions, otherwise there is little activity in the most efficient parts of the capital markets. This is where alternative capital is filling the gaps.”
Fine believes the market are in early stages of a new cycle, and that in the next 12-36 months things will re-adjust – and that the capital markets will reignite. “The market lives and dies by the health and functioning of debt capital markets,” he said.
Matt Salem, partner and head of real estate credit at KKR, sees a common theme of property owners who are trying to buy time until rates are lower and there is a more normalized capital markets environment. As of January 31, SOFR was at 4.31 percent, a significant increase from 0.05 percent during the same period last year.
“In the interim, these borrowers need capital. With SOFR and LIBOR doing what they’re doing [and the] Fed funds rates where they are, it’s creating a lot of stress in the system,” Salem said. “Borrowers are looking for ways to bridge themselves and [are] employing things like preferred equity.
Although this cycle is different to previous crises, the market has become more adept at navigating periods of distress.
“The last crisis got here in a hurry, and it was pretty complicated what drove that,” said Bryan Donohoe, partner and co-head of US real estate at Ares Management. “The velocity this time is slower. I’m not saying there isn’t distress there, but it is about location [and sector.]”