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REAL ESTATE MERCHANT BANKING
In their Sept Mid-year update CBRE reported that year-over-year Q2 investment volume has dropped 60%, a conservative number as I’ve seen other research reports indicating that volume has dropped as much as 75%. With the economy doing well, why is the CRE industry in a state of transaction paralysis?
There are several factors that have brought the CRE industry to this standstill but before I address that I’d like to take a moment to reflect for a moment on the US economy.
The overall economy continues to remain resilient as we’ve seen from the recent economic indicators released by the government. Employment, as we saw in last week’s jobs numbers, is stable. The average consumer, with their mortgage rates fixed or flat rents, have been somewhat immune from the precipitous rate increases we’ve seen over the last twelve months, so they continue to live and spend as though little has changed.
As we hit earnings season in the coming weeks, we’ll start to see how businesses are adjusting to the new interest rate environment. With bond yields soaring over the past year, their cost of capital has increased and so the era of free borrowing has ended. Businesses with floating rate debt will see the immediate impact to their balance sheets however, those with existing fixed rate debt, like most homeowners will hold until maturity so a reckoning with higher long-term rates may be years away.
The CRE industry has not been so lucky. Investors and developers alike are exposed to the risk of higher short-term and long-term rates. As well, the Banks, a major funding source for CRE investors and developers, that account for about 40% of the annual debt funding have been firmly seated on the sidelines since the Spring of 22’ with no indication that they are going to enter the lending market in any material way in the near future.
Banks across the size spectrum are experiencing their own liquidity crunch; a number of factors are contributing to it: Many Sponsors extended their floating rate loans in expectation that long-term rates will drop at the end of this year (the recession many predicted has not materialized and we’ve seen treasuries reach 16-year highs); banking regulators have changed the loan reserve requirements and are scrutinizing loan portfolios meaning more bank capital will remain un-usable for new lending; the public debt markets are demanding higher spreads on bank-issued debt and the equity markets have been selling off bank stocks in fear of more failures; increased short-term rates have forced banks to either increase their deposit rates or lose deposits to other banks and money market funds; lastly, the US is implementing the newly approved Basel 3 regulations that will further increase loan reserve requirements in the coming years. In summary, expect to see the banks on the sidelines for the foreseeable future until Borrowers start to meaningfully pay down their loans through either asset sales or refinancing.
The general sentiment that the increase in borrowing costs is temporary is driving CRE owners/seller to demand lower cap rates than what buyers are willing to pay, creating a large bid-ask spread. For buyers it generally does not make sense to purchase stabilized commercial real estate at a cap rate that is yielding less than treasuries, unless there is significant rent growth. However, rent growth in the multifamily sector is generally at 0%, in office no one expects growth anytime soon. Currently industrial and retail continue to see some rent growth but the numbers are diminishing.
I am bullish on rental growth returning to the multifamily market in the near future. Asthe current wave of supply comes to an end, so will the rent concessions and discounting we are seeing from developers looking to fill their properties. As well, with mortgage rates hovering above 7.5% and home prices maintaining their levels, home ownership becomes out of reach making renting much more attractive. (maybe use Austin as an example)
Lastly, let’s look at loan credit spreads. While the real estate sector has performed/transacted normally in a 4.5-5% treasury world, credit spreads are 1.0% lower at this time. A combination of supply of lower rated bonds and higher bond pricing in the future will push up spreads, especially for lower rated corporate and CMBS bonds.
So what’s next, and how long will it take for transaction volumes to pick up? Everyone by now has seen the charts depicting massive loan maturities in 2024. So far in 2023, bridge lenders have been willing to modify and extend terms for borrowers willing to provide something in return, usually additional equity investment in the form of a loan paydown and funding of interest reserves. Some borrowers may opt to take longer term debt and extend their business plan by 5-7 years, though these borrowers will likely also need to fund additional capital into their deals in order to pay-off their existing debt.
The good news is that many of these properties that we’ve underwritten are falling into the Agencies mission driven classification and therefore lending capacity is not constrained. As well, we expect the Life Insurance companies and CMBS to remain active next year.