US commercial real estate debt markets made murky by lender pullback

The following are excerpts from the October 13, 2022 “Altus CRE Exchange: US debt in focus” webinar (recording available for replay here). During the webinar, Lonnie Hendry, Head of CRE & Advisory at Trepp, Inc. and Jeffrey Frey, Investment Director – Capital Markets at Principal Asset Management shared their perspectives of current and emerging trends in the US commercial real estate debt markets and what they are watching going into 2023.

How would you characterize 2022 for commercial real estate credit?

Jeffrey Frey

Going into 2022, the expectations were high that we'd have another successful year with the debt markets similar to the last couple of years, where you had record numbers. Going into mid-summer, there were still some indications that you might come out of this year on a pretty positive note.

But things have gotten away from us over the last several weeks, and I think there's a lot of uncertainty right now when it comes to players in the market that are placing debt. I think we're obviously seeing that the banks are pretty much on the sidelines and a lot of life companies are on the sidelines. There's a lot of uncertainty in the rate market right now with inflation. Overall, I'd summarize this year as probably being a little disappointing relative to what the expectations were going into the year.

Lonnie Hendry

I would echo that sentiment. I think 2022 has been a tale of two markets. We launched the first of the year, maybe through June and July where it was really pretty strong. From our perspective issuance was still robust and there was a lot of transaction activity even with some of the more macro- and geopolitical uncertainty.

The real estate markets, and the debt markets in particular, have remained fairly resilient, but inflation has finally taken hold and people have started to have to underwrite interest rates and cost of capital coming up, which lowers return expectations; which has created a bit of a bifurcation from the first half of the year. Over the last 60 to 90 days, we really started to see a slowdown.

We're about 11 years into a 7-year cycle, so the one thing I'm excited about on this panel is that we're not going to be asked “What inning are we in?” because I think at this point, we'd be in the fourth inning of a doubleheader. The market needs to cool a little and I think we're starting to see that play out.

What are the trends among bank lenders?

Jeffrey Frey

It's fair to say that most of the national banks are on the sidelines right now. I think everybody's dealing with the regulatory requirements; they're not getting the runoff in their portfolio like they generally see, and that's putting limitations on what they can do; there's price discovery and just the total uncertainty of what's going on in the market right now with rates, I think that trickles down into the regional banks as well.

Prior to everything blowing up here in these last few months, you’d see typically anywhere from 10 to 15 Lenders chasing a deal for financing. You may get one or two now that are looking for a deal if it's structured correctly. And that's generally a relationship play where you may have deposits or you may have recourse as part of that structure.

If you've got a relationship with a local bank, I think we're seeing some of the local banks still active in financing. But again, it's a one- or two-bank type deal if you can get them to entertain your deal.

What are the trends among non-bank lenders?

Lonnie Hendry

We've started to really see a pullback. September was the first month where we really started to see issuance this year dropping significantly below what we had seen in the previous couple of months.

The market has had to price in the risk and the uncertainty. You have known risk, which you can more readily quantify and make some adjustments to underwriting and other things. And in this scenario, you have a lot of unknowns. You have an energy crisis, supply chain issues, inflation.... And from a lender’s perspective, it's very hard to quantify and underwrite those. I think the other challenge is a lot of these deals, if you look at appraisal amounts and sales prices over the last four or five years, they've ramped up largely due to a really low interest rate environment.

So if you take your current book and you just mark to market, the interest rate on those upcoming maturities, there's a lot of distress that's potentially out there that's not showing yet. The question that I'm interested in is: is this a temporary 6 to 9 month-type of “tap the brakes” and then after everyone kind of resets to the new environment or is this something that has a little longer legs to it – in the sense that it may be a 12 to 18-month type of reset?

What changes are you seeing to underwriting?

Jeffrey Frey

When it comes to underwriting, it always falls back on debt yields or debt service coverage test and overall leverage structure. What we've seen on the construction side of things is that leverage has been constrained.

What used to be a 65% loan-to-cost is now more in the 50% to 60% loan-to-cost range and there tend to be more structural components when it comes to lease up. Lenders aren't underwriting traded rents by any means so that typically comes into the underwriting. And then when you look at what the life companies are doing, they're a little more conservative on their leverage levels and focused on those debt yields and coverage tests going in.

When it comes to sizing and I think with what we're seeing is the kind of that CM2 rating for the life companies. They want to stay in that realm, and that's definitely constraining what they can do from an overall leverage perspective.

Lonnie Hendry

Anytime there's uncertainty investors and lenders have to take a step back. Underwriting tightens up. I think we're just in the infancy of that in this cycle. If I were pontificating a little bit, I would say over the next 6 to 12 months, we're going to start seeing some significant slowdowns across certain asset classes due to those factors.

What factors matter the most to secure debt financing in this environment?

Jeffrey Frey

From our perspective, it's really been relationships on the banking side; if you got deposits with a bank, you can somewhat hang your hat that they might be there for you.

From a construction perspective, where you are typically doing non-recourse construction deals, you're having to put a sliver of recourse or some component of recourse in the deal.

But otherwise, I think there are so many lenders sitting on the sidelines right now that the activity levels are so low, it's really hard to gauge what's changed necessarily from what was your typical construction financing or financing to where they are today, because there's a lot of discovery going on out there when it comes to what I think lenders are looking to do or able to do from a pricing structure, leverage type levels.

What is the outlook for office?

Lonnie Hendry

We've written a bunch of research and done a bunch of analysis on the office market because logic would say that when tenants aren't in the building, the residual value of the real estate should come down. We haven't necessarily seen that to this point. Tenants are still paying the rent even if they're not occupying the space on a daily basis.

What we have started to see, though, is a clear delineation between the classes, highly monetized buildings and then everything else, where you're starting to see significant divergence in both price and rental rates. And I think to further that, it's market-specific.

On our podcast last week, we talked about two million square feet worth of space in the Minneapolis office market that just came online for sublease. You know, just personally, I'm surprised that office has maintained as well as it has. I know they have some advantages in the lease structure and the diversification of tenants across the building. But if you look at it, I think for us in the security space, they haven't gone above 2% delinquency since the onset of the pandemic.

It's interesting, some of the really high-end assets are financed 10-year full-term IO type of deals, so as those come up for maturity and they start to reset rents and cap rates expand and interest rates have been added on, it'll be interesting to watch.

I'm hopeful that office is still relevant, I think it's an asset class that's very difficult to reposition. We're seeing a lot of people try to go to like a multifamily conversion, but just based on floor plates and layouts, it's a difficult conversion, so it's a challenge. And just one other thing, we're starting to see some regulation that really puts downward pressure on those older assets.

In New York, as an example, they have Local Law 97 that actually measures the carbon footprint of your building. And if it doesn't meet certain EPA standards, the building owner gets fined. Those fines are going to directly impact the NOI at the property level. So, if you're a 1970s vintage, B or C building, that's at 75% occupancy and barely making debt service, and now you have this regulatory impact of a fine that gets thrown on you. It'll be very interesting to see if people continue to invest in those properties or if they just toss the keys back and move on to something else.

Going into the next year, what are you paying attention to?

Jeffrey Frey

First and foremost for us, it's going to be the financing costs and availability which is driving so much right now.

There's a lot of capital still out in the market that's looking for somewhere to go and we've seen it on some of our deals where you may have a buyer that comes to the table for a particular project but can't get the financing together, and that kills the deal.

So for financing cost and availability, lenders getting back in the market and being active is going to be key. And then the question is going to be from a valuation collateral performance, where are those leverage levels at? Where are those rates at? Because you're finding right now that the rates that are being offered in the market, borrowers just aren't interested in taking a 6%, 6.5% or 7% rate.

Lonnie Hendry

I would echo the same sentiment. Financing both costs and availability is the primary unknown heading into 2023.

It's one thing to have the availability of financing, it's another thing to be able to make it pencil if the rates are too high or the cost of capital is too much; it impacts what you're able to pay. Financing cost / availability and property performance / valuation go hand in hand, because as financing costs go up, valuations have to come down.

It's just math; so we'll see what happens there. I think on the property performance segment as well, we're starting to see some markets that maybe got a little frothy with the super low-interest rate environment.

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