There’s an old saying that water finds its level, and usually it means people gravitate toward the like-minded. But there’s another way to take it from physics — that water will move about until pressure and force equalize. It adapts to changing conditions.
That’s what’s happening in the CRE debt market. There’s a lot of ongoing change, with inflation up and then tapering off, the Federal Reserve pushing up its benchmark interest rate to slow the economy, and financing costs following. In response, the industry professionals are trying to suss out the distressed market even as some companies feel the pain. For example, New York City office building giant RXR Realty plans to halt some debt payments on older properties and surrender them to lenders.
However, as Hodes Weill & Associates notes in recent market commentary, debt adapts. “Following a resilient 2021 when lending activity and transactions rebounded from the shock of the pandemic, lenders and borrowers entered 2022 with an optimistic mindset which contributed to record transaction activity in the first half of the year,” the firm says.
CMBS is having some challenges, as KBRA recently said, noting that appraisal reduction amounts (ARAs) are reaching “an inflection point” under weaker property fundamentals, price pressure, and a slowing economy.
“In the coming year, we expect to see more ARAs get triggered due to higher loan defaults as well as increased ARA amounts as property valuations decline,” KBRA said. “In addition, we also analyze their reliability as an indicator of future potential CMBS loan losses, as well as how deals with high ARA exposures can result in a shift in the controlling class.”
And yet, water seeks its level.
“With the traditional lending market proving more attractive than the CMBS market, and active rollover activity, banks quickly filled their allocations,” Hodes Weill wrote. “Many deployed their lending budgets by mid-year. Traditional bank lenders needed to wait for balance sheets to grow to meet CCAR capital requirements or more capacity, or loans to be paid off before new allocations are made. This has created an attractive backdrop for non-bank lenders, especially those targeting transitional assets.”
On top of higher lending rates, borrowing spreads are up 150 to 600 basis points, depending on the specifics of the transaction. NOI is down on many properties with higher rates, and so new loans have tighter underwriting and stricter conditions, like loan-to-value requirements.
The result: real estate debt with yields that stretch from high single digits to lower double ones “represents an attractive risk-adjusted return in the current market environment and an attractive source of relatively stable income from a portfolio construction perspective,” Hodes Weill wrote.
In addition, the need for price discovery and uncertainty about valuations make equity investments a tough call while underwriting debt is easier. Hodes Weill expects “more institutional investors increasing allocations to all forms of real estate debt, especially when evaluated against uncertain equity valuations in the current market.”