ForumPLUS 2019 Debt & Equity Outlook
Cheap debt has become the lifeblood of the commercial real estate capital markets, but the caution signs ahead should not be disregarded.
It is a gross understatement to say that industrial is a hot asset class right now and that, subsequently, financing for this category is flowing fast and furious.
But Clifford Booth, CEO of the Dallas-based Westmount Realty Capital, has his own approach to the industrial market. In his particular niche, he finds that capital sources—namely on the equity side—are getting a bit skittish. Instead of investing in the large distribution centers that can accommodate the Amazons of the world, Westmount is focusing on multi-tenant light industrial properties in secondary urban markets—properties that are often seen as obsolete or having a limited use.
Booth, though, doesn’t subscribe to that theory; he says these buildings appeal to a wider range of tenants. Not all companies need high ceilings or other upgrades. “Our buildings are much less about the rapid velocity of turning goods around, but more about touching the goods and doing some kind of value add,” he relates.
The problem, Booth says, is that not all equity sources understand this business case and he often has to embark on a crash course to educate them. They especially don’t understand it when these facilities are located in markets like Milwaukee, Indianapolis or Columbus, OH.
The bigger issue is that lenders, anticipating an end to the cycle on the horizon, are fleeing to quality. As a result, Booth says a lot of equity providers are moving into the debt space and those that remain in equity are definitely “a little more finicky.”
None of this is to say that equity has retreated from the market. For example, David Blatt, CEO of New York City-based specialty investment bank CapStack Partners, points to a rise in more equity vehicles, which do not have the traditional institutional, private equity profile. “These smaller funds are targeting the individual investors, which is a hugely growing space.”
WHAT HAPPENED TO THE DEBT MARKET?
Nonetheless, Booth’s story resonates; it’s the flip side to a larger trend that is dominating the CRE debt and equity markets. The strong flow of financing has become a highly sought-after piece of the capital stack. There is no flight to quality here and no need to painstakingly educate a skeptical lender, although underwriting standards have remained fairly intact. Instead, this is a story about a market flush with new providers competing for deals, and providing pricing to match.
This trend has had an impact on many segments of the capital stack, including some of the traditional ones such as CMBS.
“Smaller equity funds targeting individual investors is a hugely growing space.”
David Blatt CapStack Partners
When all was said and done, CMBS conduit originations posted a poor showing in commercial real estate lending for the third quarter. At 14.6%, the category captured the lowest share of the four major lender types, according to CBRE, and was down substantially from its 36% share a year ago.
It is a turnaround from the CMBS market’s strong activity at the start of this year, and the slowdown may be attributed to the volatility in the equity markets. Indeed, it’s debatable whether CMBS’ year-end total will meet the $87.8 billion that was originated last year. Why? In part because growing competition from other debt providers in the alternative space is taking a toll.
Some hundred-plus of these lenders have come into the market, according to Preqin. It has found that private real estate debt funds had a record fundraising year in 2017, and 2018 looks on course to match those record levels, pushing real estate debt dry powder past $50 billion at the end of 2017 to stand at a record high of $57 billion. It also reported that the average fund size for the first three quarters of 2018 was $526 million, a record high for the strategy.
These funds are providing bridge and gap financing, and all kinds of more structured debt, says Brian Stoffers, CBRE Capital Markets’ global president of debt and structured finance. In general, borrowers feel as though the debt funds are a good option, especially when they look at the servicing of those debt vehicles, which can be more favorable than under the CMBS architecture, he says. He adds, though, that the new CMBS loans are being structured in such a way that the post-closing experience should be better for borrowers.
But most salient of all for borrowers, Stoffers continues, is that “pricing has come down dramatically with debt funds. That’s probably because of the sheer volume of their business and the fact that there’s a lot of equity behind the firms that want to place money and get decent risk-adjusted returns.” These companies have lowered their spreads in order to meet the competition because there is so much supply, he adds.
In fact, it is alternative lenders that are punching far above their weight. This category, which not only includes debt funds but also such entities as REITs and finance companies, accounted for 27% of loan closings in the third quarter, up from 16.4% in Q2 and 13.1% a year ago, according to CBRE. These lenders are also filling a gap left by traditional lenders with their aggressive placement of construction and bridge assignments.
“Pricing has come down dramatically with debt funds, probably because of the sheer volume of their business and the equity behind them that’s looking get decent risk-adjusted returns.”
Brian Stoffers CBRE Capital Markets
There is little sign today that liquidity will dry up. Not only are multiple funds entering the market but the fund size for these strategies continues to scale up, as two recent deals illustrate. These are LaSalle Investment Management’s decision to buy a majority stake in the $1.2-billion debt fund business of Latitude Management Real Estate Investors and AXA Investment Managers’ move to acquire a $9.4 billion portfolio of US commercial mortgage loans from Quadrant Real Estate Advisors.
Latitude provides short term, floating-rate loans against middle-market CRE assets with a focus on originating bridge loans for value-add and transitional properties. “Latitude’s lending model targets a differentiated market segment that has enabled them to grow significant share in the value-add, transitional asset space, while avoiding the risks associated with development lending or higher leverage strategies,” says Jason Kern, CEO of LaSalle’s Americas private equity platform.
As for AXA Investment Managers, its pending acquisition helps fulfill its commercial real estate senior loan mandates and turn the main focus of its real estate debt platform from Europe to a more global one, according to Isabelle Scemama, CEO of AXA Investment Managers-Real Assets.
DEBT PARTNERS WITH DEVELOPERS
Debt funds are also teaming up with developers in many cases to build the assets they want, if they cannot find suitable ones to buy, says Richard Kalvoda, senior EVP of advisory at the Altus Group. “The developer looks at it not only as getting financing from these alternative lenders during the development stage, but also as an opportunity to transfer the ownership or property without having to carry it themselves,” he says.
The lenders, for their part, come in as preferred equity as JV partners. “It’s a way for them to get into the equity side of the market without having to go out and compete for, or construct, the asset themselves,” Kalvoda says.
So profitable is this game that some developers are starting to lend to their counterparts, says Steven F. Ginsberg of Chicago-based Ginsberg Jacobs. “Many are willing to take a safer position, but one that also allows them to use their skill sets.”
“Development JVs are a way for lenders to get into the equity side of the market without actually having to go out and construct the asset themselves.”
Richard Kalvoda Altus Group
Institutional investment in debt is also rising, especially as certain vehicles become more palatable to investors. When Fannie Mae recently added a REMIC structure to its CAS credit-risk transfer program, REITs responded far beyond expectations, according to Laurel Davis, VP of credit risk transfer.
The GSE had been working for over a year on a way to convert its CAS program to issuing it as a REMIC, or a real estate mortgage investment conduit. Fannie Mae’s solution, Davis explains, was to change the tax selection on the loans as it acquires and securitizes them into an MBS. Once the CAS notes are REMIC eligible, they become debt for tax purposes.
The GSEs also, of course, are providers of plentiful debt on the front end—meaning to borrowers. One example is the recent $800.45 million in financing that Toronto-based Starlight Investments secured from Freddie Mac for a 23-property US multifamily portfolio. It was a complex deal with five-, six- and seven-year loan terms that included both fixed- and floating-rate components and collateral release provisions and varying prepayment windows.
“Given the high-performing nature of the assets and diversity of the income stream, Freddie Mac’s structured solutions group was able to customize an incredibly flexible and attractive debt execution,” HFF senior managing director Matt Kafka said at the time the deal was announced.
HOW SUSTAINABLE IS IT?
A key question for borrowers is whether this bounty of debt will persist. The good news is that the GSEs will continue to lend at approximately the same level in 2019 as 2018, according to the Federal Housing Finance Administration’s recently released 2019 Scorecard. This is a significant signal, as it is each year, of the amount of liquidity expected in the multifamily market. “It’s definitely the headline to watch as multifamily is clearly a very important part of our overall market,” Stoffers says.
The scorecard sets the caps for GSE lending and also outlines the categories that are exempt from these limits. Typically, the exemptions are affordable, rural and manufactured housing, and in recent years, green financing.
GSE lending has been robust for 2019, and indeed the caps and exemptions set for 2018 had been considered sufficient to support market activity. Year-to-date through September, combined Fannie and Freddie multifamily loan purchase volume totaled $90.7 billion, just shy of the record-setting pace of $91.6 billion for the same period in 2017, according to CBRE data. But the FHFA did modify the green exemption in its 2019 Scorecard, which is unfortunate since the platform has been a big performer for both GSEs. Nearly half the units in the Starlight loan, for instance, were financed under Freddie Mac’s Green Advantage program.
“Despite waning interest in real estate debt, there is a record number of real estate debt funds in market seeking more capital than ever.”
Tom Carr Preqin
Another possible development that could affect lending going forward is reports that the White House has plans to limit the federal backstop the GSEs have for the loans they purchase and securitize. The speculation is that with a divided Congress unable to put forward reform for the GSEs, the Administration will seek to do it via its regulatory power. A clearer sign of the Administration’s intentions will come in January when it makes its appointment for FHA director when the current director, Mel Watt, leaves after his five-year term.
DECLINING APPETITE FOR CRE DEBT
Even if the supply of debt remains constant, demand may fluctuate in the coming year as interest rate increases and a lower number of loan refinancings take a toll.
Noting a disconcerting trend in its real estate debt survey, Preqin noted that in June 2018, just 6% of investors said real estate debt presented the best opportunities over the next 12 months. That’s down significantly from the 26% of respondents who said the same in June 2017.
The declining interest could be a result of concerns about a market correction. Investor interest in lower-risk core and core-plus strategies has risen even as 56% have told Preqin they believe markets are at a peak, indicating that there is a shift toward perceived “safer” strategies in anticipation of a downturn. Tom Carr, Preqin’s head of real estate, says that recently investors seem to be looking to target equity investments. Still, he says, “despite waning interest in real estate debt, there is a record number of real estate debt funds in market seeking more capital than ever.”
There are other concerns as well. Rising interest rates are a definite consideration, and the consequences are already being felt among certain categories, such as multifamily.
For the most part, lending agencies have thus far found ways to reduce pricing even as interest rates have moved up over the past year. Cap rates have held firm but given other rising costs, such as construction and labor, more upticks could be difficult for developers to pencil in, especially if rents tighten.
“It’s clear that the Fed is more worried about inflation than their forecasts suggest, particularly against the backdrop of an inflation trajectory that has been steadily climbing higher.”
Heidi Learner Savills Studley
Lenders, too, have their concerns. At the recently held RealShare Apartments, David Schwartz, CEO and chairman at Waterton Associates, said that it’s becoming more difficult to get deals done since the higher interest rates are pushing up borrowing levels and exit caps. Perhaps more to the point, capital is even flooding into secondary markets, creating substantial competition. “It is challenging to put money out, and groups like us are going to do fewer deals.”
The Fed, though, has been clear in its intentions: it will continue to raise the federal funds rate. But at what pace? Heidi Learner, chief economist at Savills Studley, notes that at its recent policy meeting, FOMC penciled in an additional 25 bps of tightening in 2018, another 75 points in 2019, and a further 25 bps in 2020. At the same time, expectations for GDP growth for 2018 and 2019 were revised slightly higher, from 2.8% to 3.1%, and from 2.4% to 2.5%, respectively.
But, she wonders, with no acceleration in inflation, why do we need five additional rate hikes? “It’s clear that the Fed is more worried about inflation than their forecasts suggest, particularly against the backdrop of a steadily climbing inflation trajectory,” Learner notes.
She thinks the Federal Reserve might be worried about the impact of tariffs and fiscal policy changes. “Core PCE inflation is at seven-year highs, and when asked about the impact from tariffs on inflation and growth, chairman Powell responded that ‘we’ve been hearing a rising chorus of concerns from businesses all over the country about disruption of supply chains and material cost increases,’” she says.
It may be too soon to see any negative effects in the economic data, Learner acknowledges. “In order to justify the Fed’s latest forecast, we’ll either need to see more inflation—which would justify rates being tightened above the Fed’s longer-run level—or a more rapid slowing in economic growth. In that case, a further five rate hikes may prove too aggressive.”