Borrowers have been enjoying a robust lending climate in recent years with an abundance of capital chasing too few deals. And despite caution creeping into the market along with rising interest rates, that liquidity appears firmly entrenched.
Exclusive research from NREI’s latest finance survey shows that a majority of survey respondents expect capital sources across the board to have the same, if not more, debt capital available in 2019. Local and regional banks (30.5 percent) and institutional lenders (28.0 percent) were identified as the two sources most likely to increase allocations in 2019, followed by 26.2 percent of respondents who thought life insurance companies would have more capital to lend next year.
“It’s extraordinary. The market is more liquid today in commercial real estate than it has been in any other time in modern history, if not history period,” says Matthew Rocco, president of Grandbridge Real Estate Capital. Two of the factors attracting more capital to debt financing are investors who are seeking portfolio diversification and yield. Real estate debt has become a fixed-income investment alternative compared to corporate bonds or treasuries, and U.S. commercial real estate is a market that both domestic and international investors want to be in even during periods of disruption, adds Rocco.
On a scale of 1 to 10, respondents rated local and regional banks as the most significant source of capital to the commercial real estate sector at a 6.7. That segment was followed by national banks at 6.4 and institutional lenders at 5.8. “There is an abundance of debt liquidity in the marketplace that is really throughout all classifications. We haven’t seen anyone pull back at all,” says Gerard Sansosti, executive managing director at HFF Inc.
Bankers are very focused on serving existing clients, but they continue to put money out and clearly have a desire to grow their outstanding mortgages. Both Fannie Mae and Freddie Mac are coming off a record year in 2017 with combined multifamily originations that topped $140 billion and both have remained active this year. U.S. CMBS issuance as of early August was at $57.4 billion, which was slightly ahead of last year’s pace that ended in total annual issuance at $87.8 billion, according to Commercial Mortgage Alert.
The big wild card in capital markets continues to be the potential impact from rising interest rates. Ninety percent of respondents do expect interest rates to increase over the next 12 months. The Fed has already introduced two quarter point rate hikes in the first half of the year and opinions are mixed on how many more rate hikes are in store over the next year. Most respondents believe the Fed will raise rates two (46.8 percent) or three times (35.0 percent) over the next year. Those that believe the Fed will move more aggressively with four rate hikes are in the minority at 7.8 percent, as are those who anticipate no increase or even a decline in the fed funds rate at 1.4 percent.
Yet the increase in short-term lending rates doesn’t directly translate to a rise in the 10-year Treasury—the key benchmark for setting long-term lending rates. “Treasury rates are much more dependent on economic data, and we have seen the yield curve flatten out over the last couple of years as the Fed has continued to push up short-term rates,” says Sansosti.
There is a slim margin between the two-year and 10-year Treasuries at about 20 to 25 basis points, and that gap could disappear with the next Fed rate hike. What that means for commercial real estate financing is that many LIBOR-based or floating-rate loans are going to quickly exceed the coupon rate of what a fixed-rate loan would be, says Rocco. “Right now we see a favorable transition of product moving from floating to fixed for, at a minimum, at least the next 12 months,” he says.
Gauging the impact from higher interest rates
Respondents were split on their views on how rising interest rates could impact deal flow on both lending and sales volumes. Nearly half of respondents (46.9 percent) think lending volumes will decline due to rising interest rates, while 38.7 percent expect lending volumes to remain flat and a minority of 14.4 percent said lending could increase. Respondents have similar views on the impact of interest rates on investment sales volumes with 45.7 percent who predict that investment sales volumes will decline, remain the same (34.8 percent) or increase (19.5 percent).
Rising interest rates could create an added hurdle in the ability for buyers and sellers to bridge the pricing gap, which many have blamed for slowing sales activity over the past two years. “There is ample liquidity on the debt side across the capital stack spectrum. However, there is still a disconnect between buyers and sellers on cap rates,” says Michael Rotchford, vice chairman and co-head of Savills Studley’s Capital Markets Group. It isn’t likely that new issuance volume will increase until there is an agreement between buyers and sellers on where cap rates should be, says Rotchford. “We might be in a stalemate for another year or so, but I don’t project declining volumes as a result,” he says.
When assessing the impacts of rising rates, a majority of respondents (59.6 percent) anticipate that cap rates will also rise, while 22.1 percent believe they will remain flat and 18.4 percent said cap rates are likely to decline. Consistent with that, nearly half of respondents (44.4 percent) expect that cap rate spreads to interest rates will remain flat, suggesting that cap rates will rise along with higher capital costs. However, respondents are still somewhat split on their views on cap rate spreads with 29.9 percent who think that cap rate spreads could move higher and 25.7 percent who believe cap rates spreads to interest rates could move lower.
“Historically, we’ve seen that, all else being equal, there is an almost one-for-one relationship between Treasuries and cap rates,” says Hilary Provinse, head of mortgage banking at Berkadia. So, as the Fed continues to decrease its Treasury holdings, an increase in cap rates is certainly possible. “That said, if Treasuries increased due to inflation—which also filters through rents and property incomes—the net effect shouldn’t be very large,” says Provinse.
In the prior peak of the market in 2006 and 2007, the average 10-year Treasury was 4.40 as compared to a 10-year rate that is still sub 3 percent today. So, the 10-year is still significantly below where interest rates were in 2006 and 2007, which some believe indicates there is still room for rates to rise. “The key to it is really liquidity, and we see ample liquidity on the equity side of the business, as well as the debt side of the business,” he says. “So, unless there is a significant change in liquidity, I don’t think pricing is going to be significantly impacted.”
Construction, multifamily could take the brunt of a rate hike
Respondents do believe that rising interest rates will have a negative impact on financing for new construction with 56.2 percent who expect construction financing to decline. Nearly one-quarter (26.5 percent) predict that construction financing will remain the same, while 17.4 percent think it could increase. Some are concerned that higher interest rates on top of rising construction costs will make underwriting deals more challenging. According to one respondent, “New construction costs are still well above existing values, making it more difficult to support the property values needed to justify the costs.”
One factor that could spur additional construction lending among banks is new legislation approved earlier this year that provides greater clarity on high volatility commercial real estate (HVCRE) rules. Critics have blamed cumbersome HVCRE rules introduced in 2015 for hampering bank construction lending. New legislation aimed at easing some of the provisions included in Dodd-Frank banking reforms also provided more clarity for banks on how to interpret the HVCRE rules.
“From a construction financing perspective, banks are more hamstrung than they have been in the past by the regulatory environment,” says Rotchford. Yet banks remain committed to construction financing, there also have been a number of debt funds that have stepped into that space to provide additional capital for developers, he says.
Generally, those assets likely to be most negatively affected by higher interest rates are those with the lowest cap rates, such as multifamily and high-quality single-tenant assets, because they are the most like bond-replacements, notes Provinse. Respondents also said that the two property types most likely to be affected by rising interest rates are multifamily at 40.5 percent and retail at 32.4 percent.
One specific concern that respondents cited related to the impact of rising interest rates on multifamily was the high volume of construction loans that would need to obtain permanent financing. “Higher rates could be the final straw in the financial viability of new developments. Costs have increased to levels that have made new construction not worth the risk,” wrote one respondent. Others voiced concerns about the impact rates would have on slowing sales in a market where cap rates are already low and margins thin.
Specific to the impact on retail properties, respondents expressed concerns that higher interest rates would only add to secular pressures by increasing occupancy costs for tenants and negatively impacting consumer spending. “Retail is volatile right now, and if interest rates go up, I believe that retail trade volume will decrease. Buyer and seller expectations are not on the same page right now, and that will only increase with interest rates going up,” wrote one respondent.
Competition fuels more aggressive lending
The common mantra throughout this cycle is that underwriting has remained disciplined. Yet respondents were split on whether commercial real estate lending is repeating patterns from the last cycle with 32.3 percent who said yes, 34.7 percent who said no; and 33.0 percent who were not sure. “In some cases, we have certainly seen some patterns repeat. However, it would be unfair to make that generalization across the board,” says Provinse.
Interest-only terms are increasingly pervasive, credit spreads generally have ground tighter and cap rates are hovering at all-time lows, says Provinse. Yet there does not appear unrealistically aggressive underwriting. Spreads are still higher than they were in 2006, securitization structures have more subordination and there’s not so much excess collateralized debt obligation demand that people are turning to synthetics, she says. “So yes, there’s some aggressiveness and people are right to be cautious, but we’re not yet back in 2006 either,” she adds.
Another reason why nearly one-third of respondents think that lending is repeating patterns from the last cycle could be due to increased competition in the bridge lending space. “There has been so much money that has moved into the bridge lending market that it is causing lenders to stretch and be more aggressive,” says Sansosti. In contrast, other sources such as GSEs, banks and life companies are not feeling the same pressure to put their money out, he says.
Most respondents (45 percent) said underwriting standards will remain the same. However, 39.4 percent do believe underwriting will tighten over the next 12 months, and those who think underwriting will loosen are in the minority at 15.6 percent. Yet those views are slightly more positive compared to a year ago, when 43.7 percent said they expected standards to tighten and 12.0 percent thought they would loosen. “I don’t see a whole lot of speculative developing going on, so I don’t think underwriting standards are going to change,” says Rotchford.
More than half of respondents anticipate that LTVs and debt service coverage will remain the same in the coming year at 53.4 percent and 56.6 percent respectively. Views are split on whether LTVs could increase (21.7 percent) or decrease (24.9 percent). In addition, nearly half of respondents expect the risk premium, e.g. the spread between the 10-year Treasury and cap rates, to increase at 51.7 percent compared to 33.0 percent who predict an increase and 15.2 percent who believe it will decrease.
“I don’t think anyone in the investment space is being paid for their risk or liquidity or term premium. Risk is being priced very cheap right now, whether it is in the bond market, the stock market, the commercial real estate market or the commodities market, because there is just copious amounts of capital looking for investments,” says Rocco.
That being said, specific to this survey question, the 10-year Treasury is about 2.8 percent. Meanwhile, cap rates on top assets might range from 4.0 to 6.5 percent depending on the market and region of the country. So, by and large, there is room between the 10-year Treasury and the cap rate that still provides an ample return or risk premium for investors to consider commercial real estate, notes Rocco. In addition, investors also have the added incentive of the tax benefits of owning commercial real estate and portfolio diversification, he says. “So, right now commercial real estate remains one of the hottest fixed income alternative investments here in the U.S.,” he adds.
Lenders eye challenges and opportunities ahead
When asked what the biggest challenges in financing commercial real estate properties would be over the next 12 months, respondents voiced concerns related to a number of different issues, such as keeping underwriting standards in check, finding deals that make sense and flattening rents and cap rates that will put pressure on market values.
“If interest rates go up, cap rates will have to go up, and properties won’t pencil out unless sale prices come down. Sellers have been in the driver’s seat for so long, it will be difficult for them to adjust pricing down,” wrote one respondent.
In terms of what they are most concerned about in the market today, respondents also provided a variety of answers, such as pricing that is nearing unsustainable levels in both real estate and the stock market; chaos in Washington and competition for financing that has resulted in tighter spreads. “There is a sense of complacency in the market on the part of institutional investors who are paying historically high prices for all asset classes and a correction is coming sooner than people think,” wrote one investor.
Labor shortages also are top of mind, especially as it relates to construction workers. “Should the federal government really fund a major infrastructure initiative, it will suck the limited labor pool for commercial real estate dry, effectively stopping construction or dramatically increasing labor costs,” said one respondent.
Caution could be creeping in due to the mature stage of the current economic expansion cycle. Sixty-one percent of respondents believe commercial real estate is at the peak of its cycle, while 23 percent think it is in recovery/expansion, 7 percent said it was in a recession/trough and 9 percent were unsure. Clearly, it is late cycle. But, that doesn’t mean that there aren’t still good opportunities available for both equity investors, particularly those who have long-term horizons, and debt investors who will partner with quality borrowers and good quality markets, says Rocco.
“By and large we remain bullish, but also aware that it is late cycle. We don’t see a major disruptor or black swan event,” says Rocco. “We believe if discipline remains in the underwriting process, that by default, that discipline will extend this economic recovery longer than history has achieved.”
Survey methodology: In August, NREI emailed commercial real estate professionals requesting participation in an online survey about financing. Overall, the survey received 428 responses, half of whom identified as Owner/Partner/President/Chairman/CEO/CFO.
