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REAL ESTATE MERCHANT BANKING
While there’s comfort in comparing the present high interest rate environment to the economic crisis of 2008, CRE investors are having to work a lot harder in 2022 to get deals done, according to Dekel Capital’s founding principal.
Earlier this year, the Fed declared war on inflation that most recently hit 8%, using its blunt tool, the federal funds rate, to increase the cost of doing business across every sector of the economy, both in the U.S. and abroad. The economic tremors now evident nearly six months into the Fed’s war have me thinking about 2008, the last period of market dislocation when so many were caught off guard by the interconnectivity of the financial markets, which ultimately led to a massive economic earthquake heralded by the collapse of both Bear Sterns and Lehman Brothers.
While it’s hard to know what’s going to trigger the next massive economic earthquake, this time just feels different than what we saw and experienced in 2008.
Leading up to 2008, lending became abundant. In the fixed-rate CMBS market, credit spreads compressed to 80 basis points for loans reaching 80% leverage, while in the bridge lending market we saw leverage on senior loans reach 90% of cost with all-in pricing in the 5 to 6% range. These leverage levels never returned to the CRE lending market, at least not for senior lenders. As liquid and competitive as the debt fund-fueled bridge lending market has become in recent years, the lenders for the most part maintained their underwriting parameters and generally did not exceed 70% leverage. There are always exceptions, but 80 to 90% senior loans were not the norm in recent years. The risk of 70 to 90% loan to cost was appropriately funded by equity funds offering preferred equity or mezzanine loans to borrowers seeking higher leverage.
The banking system neared collapse as assets on bank balance sheets rapidly declined in value and the financial institutions were undercapitalized. As a result, the Dodd-Frank regulation was passed requiring the biggest banks to be stress-tested, with the most recent results effectively halting lending by the largest institutions in the U.S. in April or May of this year. Banks can raise capital by selling stock, issuing bonds or by repatriating capital that they lent. The decline in bank stocks and the increased corporate bond yields have shut the door on banks accessing the bond or stock markets in an effort to raise capital; as a result, they resort to shrinking their book of loans. That has had a ripple effect through the CRE capital markets, causing credit spreads to increase and liquidity to tighten significantly. Unlike 2008, the banking regulators are being proactive in keeping our banking system healthy, but as a consequence CRE capital flows have been constricted.
With liquidity, both debt and equity, drying up after the financial system collapsed in 2008, CRE prices declined spreading the distress throughout the banking system. Yet, CRE liquidity in the debt market today is still generally available from both debt funds and the CMBS market, albeit at pricing that is unattractive to most investors. While current asset pricing does not support the current cost of debt, it doesn’t need to reach unlevered equity returns in order to attract buyers. Similarly, equity capital is still plentiful; fund managers anticipating distress as a result of the pandemic raised additional capital and those that didn’t were able to do so as the COVID pandemic abated.
Lastly, the economy this time around is on more secure footing. Excesses we saw in residential real estate and construction that drove the economy in places like Phoenix, Vegas, Florida and California in 2007 are not the norm today. Instead we’ve seen everything from manufacturing to entertainment and technology and healthcare drive our economy today. Despite these sectors contracting and companies announcing layoffs, it is moderate in its impact at this stage, but still enough to cause the consumer to give pause and reign in their spending. And that’s exactly what the Fed is targeting in order to win its war on inflation.