State of relations: How the lending order is being shaken up

The established order of the US commercial real estate lending landscape will face a critical test over the next three years as borrowers work to refinance an estimated $1.3 trillion of loan maturities – and find the national and regional banks that traditionally have been their relationship lenders are scaling back their activity.

Share price volatility, imbalances in assets and liabilities and an expected increase in regulatory capital requirements have meant that despite long-term lending relationships, banks have had to be more selective on the loans they originate, the sponsors they work with and the pricing and proceeds they can offer on loans.

“All banks – relationship or not – are going to look at the economics of the transaction first and that is what is going to drive [their ability to make a loan],” says Richard Mack, chief executive and co-founder of New York-based manager Mack Real Estate Group.

This shift has meant that borrowers have had to look further afield as they seek to finance new acquisitions or refinance maturing loans, with many forming first-time relationships with alternative lenders.

“As traditional lenders have pulled back, there is a tremendous opportunity for alternative managers to step in to where the gaps have been left by traditional lenders,” says Robin Potts, chief investment officer of Dallas-based manager Canyon Partners. “This sets up alternative lenders with the ability to do very traditional lending that was previously captured by banks with best-in-class borrowers at lower attachment points.”

The volatility in the market means that any borrower transacting today is doing so because they must, says Jonathan Roth, managing partner and co-founder at national manager 3650 REIT. “With all the volatility and uncertainty, those of us that are long term providers of debt capital – whether in good times or bad – we tend to be a lot more popular these
days.”

Relationship keys

The hallmarks of a healthy relationship between commercial real estate lenders and borrowers are not unlike those in a healthy interpersonal relationship: communication, transparency and a willingness to work through problems.

Lending relationships often transition during periods of volatility, says Peter Gordon, head and chief investment officer of the US commercial real estate debt team at Nashville-based manager AllianceBernstein.

Lenders who are active in the market today are also able to have a more significant impact than they might otherwise. “In any part of the risk spectrum, you are bringing more solutions if you are lending [in an environment like] today than you are in a benign market,” Gordon adds.

While alternative lenders typically represent a higher cost of capital, borrowers working with these lenders for the first time are likely to find having a direct relationship with their lenders is wildly powerful, 3650’s Roth says. “When something goes wrong, it is very easy for the borrower to know who to call.”

“If there is a sharp edge already, that edge is going to get sharper again over the next six months”

Warren de Haan
ACORE Capital

Eventually, banks will increase their lending volumes again and Gordon reckons that to maintain relationships formed today, alternative managers will have to understand where they best fit a borrower’s needs. This could be in providing bridge loans, transitional loans, mezzanine loans and other types of financing that address a sponsor’s immediate needs rather than a long-term, senior mortgage.

But there is an important factor to consider: banks, due to the breadth of their balance sheets, have more ways to work with borrowers. Deposits, subscription lines and commercial real estate secondaries capabilities will help banks to keep some of these borrower relationships in-house, market participants say.

“Non-bank lenders do not have as many levers pulling them toward relationship lending at less economic terms because they do not rely on deposits or other service items,” Mack says.

To maintain these newly forged relationships, non-bank lenders will have to offer a wider slate of financing options and act more as a one-stop shop. “All of that can shift into where alternative lenders fit going forward,” says Scott Greenfield, a managing director at Minneapolis, Minnesota-based AB CarVal, part of AllianceBernstein’s private alternatives business.

On a break

As of the end of 2022, regional and national banks accounted for 42 percent of US commercial real estate lending across all major property types, data from New York-based research firm MSCI Real Assets shows. By comparison, regional and national banks represented 32 percent of all lending in 2021 and between 2015 and 2019 had a roughly 33 percent share of the market.

Though an MSCI snapshot of the first half of 2023 will not be available until September, industry analysts say that anecdotally, there are fewer banks originating loans today than there were a year ago.

Deals that would have previously attracted five to 10 bank lenders are today only able to source bids from two to three active banks, market participants say. And oftentimes, the bids that do come in are offering lower proceeds as banks focus on originating lower-leverage loans.

“Good deals from good sponsors are getting done,” says Andrew Thornfeldt, a managing director who leads Kennett Square, Pennsylvania-based advisory Chatham Financial’s real estate investment banking advisory practice. “It is just that lenders are being more selective.”

This selectivity is seen in data from the Mortgage Bankers Association, a Washington, DC-based trade group, which shows commercial mortgage loan originations were 56 percent lower in the first quarter of 2023 compared to the first quarter of 2022. Loan originations also dropped 42 percent from the fourth quarter of 2022.

The banks that are lending tend to be focused on relationship clients, market participants say.

“Strong relationships between borrowers and lenders developed over years of working together are always important, but even more so today,” says Sadhvi Subramanian, senior vice-president at Minneapolis, Minnesota-based US Bank. “With a sharp increase in interest rates and uncertain market conditions, the commercial real estate lending environment is currently very constrained.”

Subramanian says it is much more challenging in the current market to establish new relationships, though there are always sponsors and transactions that are exceptions.

Lending alternatives

Insurance companies, alternative investment managers, real estate investment trusts and commercial real estate debt funds are all seeing an increase in inbound inquiries.
Ross Pemmerl, chief credit officer at Boston-based manager UC Funds, says his team is seeing a specific niche in mid-market loans and notes the firm is fielding more inquiries of loans of $10 million to $30 million. In the past, borrowers may have typically looked toward regional banks with which they had an existing relationship for loans.

“With heightened scrutiny focused on lending, it forces some of the larger banking institutions to prioritize their clients into their ‘gold’ or ‘platinum’ borrowers and then everybody else,” Pemmerl says, noting banks are often still originating loans of $75 million or more while eschewing mid-market clients. “Our experience has taught us that those ‘everybody else’ borrowers have great deals, too. They just might not grab as many headlines as some of the more high-profile borrowers.”

Changes in sight

The Federal Reserve in July released the results of a nine-month holistic analysis of the banking sector that, over the long-term, could force banks to become much more selective in their lending.

Michael Barr, vice-chair for supervision at the Federal Reserve, is calling to lower the threshold for long-term debt and risk capital requirements from $700 billion in total assets to $100 billion.

The Federal Reserve’s report came in the wake of the collapses of New York-based Signature Bank and San Francisco’s Silicon Valley Bank as well as JPMorgan Chase’s rescue of First Republic Bank.

“Events over the past few months have only reinforced the need for humility and skepticism, and for an approach that makes banks resilient to both familiar and unanticipated risks,” Barr said in the July 10 remarks.

Greg Michaud, head of real estate finance at New York-based manager Voya Investment Management, says the firm has seen inquiries from borrowers double of late. There has been a specific request for five-year loans – financings that typically would have been provided by banks.

At this point, Voya has originated so many five-year loans that the team is now focused solely on loans with seven- to 10-year maturities. These are more of a standard part of its strategy, he adds.

“It has been a good opportunity in that we have been able to get deals with wider spreads and better underwriting, but in the last two weeks, we cut off five-year money,” Michaud says. “You are seeing a lot of insurance companies say, ‘We have eaten as much five-year paper as we can eat.’”

Drew Fung, managing director and head of the debt investment group at New York-based manager Clarion Partners, says the opportunities he is seeing have shifted toward mezzanine and preferred equity financing as senior mortgage lenders have cut back on proceeds.

For construction lending especially, Fung says the gap has only grown. “A lot of those guys who were doing prolific construction lending are not doing it right now or only doing it with their best relationships,” he says. “The banks will still do construction [loans], but it is more conservative, and it is expensive, leaving room for other non-bank lenders like Clarion to help provide.”

“You are bringing more solutions if you are lending today than you are in a benign market”

Peter Gordon
AllianceBernstein

Patrick McGlohn, a senior managing director for the mortgage banking platform at New York-based advisory Berkadia, says says debt funds, life insurance companies and government-sponsored enterprises like Fannie Mae and Freddie Mac are helping to fill financing voids from banks pulling back.

“Given the uncertainty in the capital markets right now, we are running wide financing processes to make sure we find the best outcome for our clients,” McGlohn says.

Altitude sickness

A key question facing the market today is how borrowers will establish new relationships with lenders at a time when lending spreads are much wider than they were two or three years ago.

Michael Comparato, president of Franklin BSP Realty Trust and head of commercial real estate at Benefit Street Partners, the New York-based credit-focused alternative asset management arm of Franklin Templeton, says no financial model predicted senior loans with 8 percent interest rates or mezzanine loans with 14 percent interest rates built in.

“It is a really difficult time. And I think it is going to be really difficult for the next two years.”

Although the US Federal Reserve did not hike rates during its June meeting, chair Jerome Powell left the option of future increases on the table to combat any persistent flickers of inflation. Comparato, like many of his peers, does not believe the Fed is done increasing interest rates.

Warren de Haan, chief executive officer and co-founder of Larkspur, California-based debt manager ACORE Capital, says another 50 basis points of rate increases will have a dramatic effect on the cost of capital and liquidity.

“If there is a sharp edge already, that edge is going to get sharper again over the next six months,” de Haan says. “In terms of impacting real estate values, [borrowers] are going to be in a high-interest-rate environment for a longer period of time.”

What’s next

Al Brooks, head of commercial real estate at New York-based bank JPMorgan Chase, says finding liquidity in a difficult commercial real estate market is usually hard and expensive and negotiating from a position of weakness is never a good business strategy.

“Those who do not maintain liquidity during the cycle upturn, do not put cushion on deals or over leverage are more likely to find themselves needing to find additional capital in downturns,” Brooks says.

Dry powder

One of the paradoxes of today’s market is the amount of debt and equity capital that has been raised – and how little of it has been deployed.

According to data from Dallas-based advisory CBRE, $43 billion of dry powder had been amassed for commercial real estate debt funds as of March. During the same period, firms had raised $80 billion for value-added funds and another $74.5 billion committed to opportunistic real estate funds.

Nitin Chexal, chief executive officer at Austin, Texas-based manager Palladius Capital Management, says his firm has seen lots of opportunity to deploy its inaugural debt fund because of the absence of bank lenders. The firm, however, has remained selective.

“What you have [in this volatile] environment is a favorable playing field for alternative credit providers and debt funds. We are seeing strong borrowers with thoughtful execution plans and high-quality collateral willing to borrow at higher rates to get their projects done,” Chexal says.

In times of stress, lender and borrower relationships are more likely to come under strain. But ultimately, the ability for lenders and borrowers to work collaboratively will define the strength of relationships and these relationships will come into play when the transaction market ultimately unlocks.

ACORE’s de Haan notes the industry seems comfortable, to a certain extent, in today’s holding pattern: “You need a catalyst to drive sellers to sell.”

That catalyst will only arise when there is a more stable interest rate market or when more banks start to sell loan portfolios. In either case, de Haan notes there would be more transaction volume as real estate prices reset at lower levels than today.

Chatham Financial’s Thornfeldt notes that many lenders and borrowers are trying to maintain the status quo, particularly in light of what happened following the global financial crisis in 2008 and the dotcom bubble burst in the early 2000s. That could bode well for borrowers with existing bank loans.

“In those scenarios, lenders that were able to eat the mark-to-market losses and be patient for 18 to 24 months largely got repaid and largely remade whole with very few losses,” Thornfeldt explains. “We might see things dragged out just a little bit longer as inflation continues to be pesky. Our tools are blunted, and it will be interesting to see how that plays out.”

That drag – be it 18 months or longer – keeps the door open for alternative lenders to widen their relationships while national and regional banks remain selective or sidelined.

“In 2021, there was a general disrespect for capital. It was so bountiful and so plentiful that borrowers did not respect lenders, they did not care about relationships, they wanted the most money at the cheapest rate, they did not care who it came from,” says Franklin BSP’s Comparato. “Now, the world has done a complete 180, and all that matters is relationship.”

Universal requirements

The universal requirement for establishing and maintaining relationships remains having a real person available to field questions if or when loan complications arise – and following through on commitments.

“If there are problems that arise, [you as a lender need to] work with your borrower to find solutions and be reasonable about how you approach modifications and changes in the business plan,” Mack adds. “If you, as an alternative lender, show that you do not re-trade, you close, and that you can be flexible when things are difficult – these are the areas where relationship lending with a non-bank lender can deliver genuine advantages to the borrower.”

Commercial real estate is a people- and relationship-driven business requiring phone calls, in-person meetings and on-site visits to existing and potential assets. Fung also notes in the current market with fewer lenders active, borrowers are more willing to go to trusted capital sources even if it is to simply bounce ideas around.

Jonathan Bennett, president at New York-based real estate owner-developer AmTrust RE, says it is possible for investors to make inroads with lenders by having connections beyond the real estate business. But in the absence of a track record with any given lender, he notes deals can require more equity upfront. “People are going to go where the capital is,” Bennett says.