Debt blues
CBRE, one of the top players in the world of commercial real estate recently posted its key takeaways from the 2023 West States CREF Conference. What a time to follow loan activity! I’ll do my best to paraphrase a few of their notable bullet points, many of which I’m also encountering as I speak with lenders and struggle through financing options on my own projects. My added thoughts in bold italics.
Mid-2024 is the consensus time frame for interest rates to stabilize and moderate. Until then, I would expect lending conditions to continue worsening even if the Fed pivots prior. With inflation stubbornly high and the 1970’s serving as a guide to inflation spiking again and again following the big peak, the Fed will likely remain vigilant on rate levels.
Over $1T of commercial loans maturing in each 2023 and 2024. With a lot more to come thereafter, making the “higher for longer” narrative all that more important to maturity risk and the impact on broader CRE markets.
Floating loans issued late cycle will require significant “cash-in” on refinances. So painful to ask borrowers and/or their investors to re-up more equity into potentially underperforming deals and thereby forgo cash that could otherwise be more wisely deployed in better risk-adjusted days ahead.
Interest rate caps have been effective tools to shield floating rate loans from rising rates, but will soon be a net cost to borrowers as they reset at much higher rates. Another hidden cost to doing any kind of deal (or holding on to a deal post-refi) in today’s high interest rate environment.
With yields typically in the low-to-mid 6% range and all-in capital costs in the 8.5% - 10.5% range, equity is struggling to pull the trigger on new deals. When unlevered returns are slipping and levered returns are at nearly identical levels, who wants to invest in CRE, especially when the risk premium spread compared to gov’t and other credit debt is at all-time lows.
Non-recourse lending is sitting at the 45% - 55% level and recourse is closer to 55% - 60%. Banks also wants significant deposits to go with modest leverage construction loans. Likely a byproduct of banking crisis earlier this year and high-yield money market options finally available to depositors. Banks aren’t reacting fast enough and want to take deposits hostage in exchange for issuing new loans. While some banks will tell you their true cost of capital is closer to the Fed Funds rate, most banks are still paying sub 2% on deposits and now charging upwards of 8% on debt. The spread needs to shrink or the deposit flight will continue, putting banks in an even worse position to lend.
Institutional equity remains on the sidelines yet still eager to deploy into mezz and preferred equity strategies at the 13% - 17% levels. Common equity is too risky in the face of i) a recession, ii) slowing, stabilizing or negative future growth, iii) sky-high interest rates and iv) construction costs and op ex that continues to rise. No surprise they don’t want to be in a first loss position. I’m hearing this challenge from sponsors more and more these days. Equity is as much as a problem (if not more) as debt in today’s capital environment.