Lenders navigate challenges and opportunities in tighter lending environment

Borrowers and lenders are coming to grips with higher interest rates and tighter liquidity, and that new reality could be painful. With the volatile conditions brought forth by the pandemic still fresh in our minds, the current market environment is encumbered with a lingering sense of uncertainty. In the aftermath of what is now 10 consecutive rate hikes from the Fed, the CRE industry is still trying to figure out what the reset in property values looks like. At the same time, bank failures from Silicon Valley Bank, Signature Bank, First Republic Bank, and others, inspire further concerns about weakness in the banking sector, bank exposure to CRE debt and more constrained lending for CRE assets.

“We’ve had a drawdown in deposits, high concentration ratios, and at the end of the day, the only way to come back in line is to pull back on lending. So, it’s not looking great from a bank lending side, which accounts for about 50% of the overall outstanding CRE debt for the entire market,” said Stephen Buschbom, a Research Director at Trepp. Buschbom was one of four panelists at the Altus Connect 2023 conference that took a deeper dive into the topic of Liquidity and Lending. The discussion addressed some of the foremost questions now facing the industry – what is the current climate for market stressors and values? What should lenders be thinking about in today's climate? Where are the opportunities for debt funds?

The biggest concern for balance sheet lenders right now lies in the middle market banks, specifically the roughly 800 banks with $1 billion to $50 billion in assets. A Trepp analysis of banks with between $500 million and $50 billion in assets shows that CRE concentration ratios for about 23-30% of that market segment are above the 300% guideline for the entire CRE portfolio or above 100% for the construction part of their portfolio. Banks, and mid-tier banks specifically, are a very significant capital source that is now heavily constrained, notes Buschbom. “We’re seeing that flow into credit spreads and deal volumes. It’s difficult right now, and it’s not looking like it’s going to get any better in the next three to six months,” he says.

Opportunities for real estate debt funds

Although banks are a significant source of capital for the commercial real estate market, it’s important to note that capital is now being deployed across different lender sources including the agencies, life insurance companies and private debt funds. Debt funds, in particular, have seen demand pick up as banks have pulled back.

Coming out of the 2007-2009 global financial crisis (GFC), lenders were staying disciplined, but it was a relatively “borrower-friendly world” up through the beginning of 2022. While the start of the COVID-19 pandemic interrupted the CRE lending market, bringing it to a standstill, this interruption lasted only a few months before many of the post-GFC trends resumed. With the overall cost of financing falling below historical levels, stable underwriting conditions, and a new surplus of liquidity in the market, many lenders had to compete to win each deal – competition that benefited the borrowers.

In contrast, today's lenders have the power to either pare back leverage a little bit or establish more favorable terms. That being said, experts on the panel agreed that the uncertainty of the current environment is challenging many transactions and slowing the number of closed financings. “That lack of certainty doesn’t help lenders, which then spreads to owners who are looking to transact in the market,” noted Mark Misto, Senior Vice President at Cerberus Capital Management.

“Making new investments is challenging when the cost of capital is rising and uncertain going into the future,” agrees Joshua Tarnow, a Vice President at Mesa West Capital. “Private credit will fill more of the void going forward, but we are still connected and reliant on the securitization markets, the repo markets and regional and money center banks freeing up liquidity, and it seems as though that is going to take some time to play out through the end of the year,” he says.

Glass half empty view - Debt/collateral valuations

One of the key challenges underwriters contend with today is the need to establish an accurate assessment of how property values have moved in the higher rate environment. Altus Group has several different ways to calibrate valuation returns for clients. An example of this can be found in Altus Group's analysis of open-ended credit fund structures, which make up a representative sample size of the alternative lending market. On average, these are short-term transitional fund structures – typically with 2+1+1+1 or 3+1+1 loans targeting a core plus or value add strategy. The analysis excludes anything in higher-yield vehicles. To provide context, loans have an average of two years to maturity and LTVs at 76% with weighted average cap rates at 6.2%. (7.5% for office). The analysis showed a same-store value decline for multifamily from 4Q 2021 to today of -20% and same-store value decline for office at approximately -30%.

“Over the course of 2021, we also saw a massive reduction in the office exposure across our client base,” says Jason Cheffy, Senior Manager at Altus Group. Going back 2.5 years, the benchmark concentration was 50% office and 25% multifamily. Now the multifamily and industrial concentration within funds is about 53% and office is at 23%.

Cheffy notes that 1Q 2023 valuation conclusions for Large-Cap open-ended funds reveal that the percent of par unlevered for the benchmark is at 97.2 out of 100. In comparison, the lowest level during the pandemic was closer to 98. On average, expansion and credit spreads for the entire fund structure today, contract versus market spreads, is at about 125 basis points. Take into consideration that a majority of the loans in this benchmark are multifamily and industrial that are either at par and no expansion of credit spreads, or have a nominal increase associated with higher LTVs. “So, the vast majority of credit spread expansion impacting fund performance is office,” says Cheffy.

When we look to the office sector, we see that higher capital costs are now exacerbating high-stress market conditions. Altus calculated the Q1 2023 all-in market coupons (reflecting Term SOFR at ~5%) for Large-Cap open-ended funds ranging between 8.6% for multifamily/industrial and 11.5% for office. “The 11.5% market coupon for transitional office assets excludes the impact of non-performing, defaulted or REO office assets. The composition of these loans constitutes close to 5% of our entire valuation universe of ~1,600 loans,” notes Cheffy.

Glass half full view

Although the cost of capital has gone up across the board, it seems to still be manageable for the product types that people are pursuing. “There was a massive pivot in the lending space in 2022 where everyone shunned office and went headlong into multi(family) and industrial, student housing and some others,” says Misto. For office properties that do not have cash flow, the carry costs are significant, and no one knows how challenges in that sector are going to play out. But speaking to non-office property types, there continues to be liquidity for the right borrowers, the right projects, and the right stories, he adds.

The glass-half-full part of the story is that there are still a lot of good-performing assets. For those assets that are struggling, borrowers and lenders are trying to make deals work by getting creative, whether it is working out blend and extend with lenders or trying to do conversions of office to housing in some cases. “As a lender, you hope that the borrower comes to the table, and as a borrower you’re hoping that the lender also comes to the table and isn’t necessarily throwing the book at you. So, there is a focus on how do we make this work when there is still a tremendous amount of uncertainty,” says Misto. Lenders are generally willing to find creative ways to extend out milestones or maturity dates in exchange for some sort of equity contribution or enhanced recourse, he adds.

Another positive for the market is that there seems to be a lot of patience on both the borrower and lender side, adds Buschbom, noting that Trepp is not seeing stressed loans moving quickly through the pipeline from when a loan is transferred to servicing through resolution. The playbook from 2008 is still getting dusted off, but borrowers will need to recapitalize, whether that is through reserves or a paydown to keep them in the deal, notes Buschbom.

As the year progresses, the need for recapitalization is going to force some hard decisions in terms of what assets are going to be supported and what assets are going to be let go. “We’re still three to six months away from getting some better clarity on that,” says Buschbom. “When we start seeing updated valuations come through on distressed loans, we will get a better idea of the valuation trajectory, ideally the trough, and ultimately what structures make sense going forward.”

“It’s about finding the path forward that's best for each situation and each borrower,” adds Tarnow. “Generally speaking, lenders are being patient if the borrower is willing to come to the table with a reasonable plan forward. No one wants an event-driven liquidity event in this environment; people want to see how things play out a bit longer. There will be winners and losers, and there will be a silver lining for some.”