The US commercial real estate debt markets are learning to navigate what is becoming the new normal: a higher rate environment, a shakeout in the traditional order of lenders and the understanding that all deals going forward will use less leverage.
Interest rates are expected to be higher for longer, per comments made by Federal Reserve chair Jerome Powell after the US central bank’s June meeting. Although the Federal Reserve opted to keep rates unchanged at that meeting, Powell outlined a plan for two more increases through year-end.
The Federal Reserve is looking at stringent regulations and capital controls for banks, Michael Barr, the Federal Reserve’s vice-chair for supervision, said in remarks published after the central bank released the results of its annual stress test for banks. These changes are expected to result in higher debt costs for commercial real estate borrowers and reduced lending capacity for banks, market participants say.
New lender order
There are two key metrics lenders and borrowers are looking at right now. The first is the roughly $1.3 trillion of loans slated for maturity over the next three years, per data from New York-based MSCI Real Assets. The second is the rising levels of distress in US real estate, which MSCI pegged at roughly $64 billion in early July.
“Borrowers do not have the liquidity, and that is creating a huge market for either mezzanine or preferred equity capital to come in and bridge that gap”
Richard Ortiz, Realty Capital
“The need for liquidity and recapitalization should extend well beyond the office sector, where we have already seen the first significant defaults,” says KKR’s global head of real estate Ralph Rosenberg.
Part of what alternative lenders are doing against this backdrop is providing rescue capital for borrowers that have fundamentally good assets that are facing near-term operational or financial headwinds, says Richard Ortiz, co-founder and managing principal at New York-based manager Hudson Realty Capital.
“Borrowers or current owners of real estate do not have liquidity, and that is creating a huge market for either mezzanine or preferred equity capital to come in and bridge that gap,” Ortiz says. “The hop is that they can continue to increase NOI, and hopefully they will, in three to five years’ time, be able to go back out to the market and refinance at higher level and pay back the preferred equity.”
As the market moves closer to a reset, there is a further consideration for lenders and borrowers: how will leverage be used going forward.
Leverage, which was used during the last cycle to amplify yields, is expected to make up a smaller part of the capital stack, market participants say. Additionally, as the market adapts, borrowers likely will have less tolerance for deals where there is negative leverage, particularly if growth moderates, says Jeffrey Fine, global head of real estate client solutions and capital markets within Goldman Sachs Asset Management.
“What is happening today is unwinding the widely accepted investment metrics of real estate over the last few years in short order,” says Robin Potts, chief investment officer of Dallas-based Canyon Partners. “While there is a lot of optimism that rates will go down in the last half of this year, there are also concerns about the pressure on balance sheets if that ultimately does not come to pass.”