Cautious Optimism in Commercial Real Estate Capital Markets
Despite the dramatic job losses and business decline following March stay-at-home orders across the country, actions by the federal government have enabled the capital markets to carry on—albeit with lower deal volume than in early 2020. To discuss the impact of the novel coronavirus pandemic, KeyBank Real Estate Capital’s (KBREC) Daniel J. Baker, Head of Commercial Mortgage, joined a panel of industry experts in a recent Real Estate Journals webinar earlier this year.
Multifamily Data Has Some Bright Spots Amid Turmoil
In addition to KBREC’s Baker, the “Critical Capital Markets Update” webinar panelists included:
- Moderator Todd Phillips, CFO, RE Journals
- Willy Walker, Chairman and CEO, Walker and Dunlop
- Simon Ziff, President, Ackman-Ziff Real Estate Group
- Patrick Minea, EVP Debt and Equity, NorthMarq
- Chris Ludeman, Global President, Capital Market, CBRE
Capital markets activity has continued
Upon reviewing current conditions, panelists agreed that the capital markets have been very active because of low interest rates and favorable spreads. KBREC has been engaging with its asset management clients and pursuing numerous new originations.
In the first months after the onset of the pandemic, most asset classes performed better than expected. Deal volume was lower than the previous year or early 2020 but did not halt. Liquidity in the debt markets was a concern, but they have begun to thaw. Regional and local banks have been very visible in the marketplace, while life insurance companies are being highly selective and focusing on their best customers.
Given the decline in business and consumer travel and entertainment, much hospitality and retail debt is in forbearance. Hedge funds and other short sellers are setting their sights on hospitality and retail debt as the pandemic sinks the sectors into distress.1
If a property lacks a grocery store anchor, mortgage brokers must be resourceful and turn over every stone. For example, one firm recently closed a $24 million shopping center transaction in which the lender was a tenant in the property.
On the positive side, core properties with long average lease terms are attracting the most private capital. Assets that were under contract before the stay-at-home orders and business disruption occurred have, for the most part, continued to close at their pre-pandemic prices, although deal volume and velocity are down.
Industrial properties have continued to perform well, with strong cash flows for underwriting. However, lenders are avoiding airport and port co-location properties on the expectation that trade will decline significantly, making it difficult to secure loan bids. In a recent survey conducted by the Society of Industrial and Office Realtors, industrial specialists reported that 49.7% of transactions are proceeding on time, as compared to 45% for all property types.2
For the right projects, lenders are available and interest rates and spreads are attractive. One panelist cited several recently closed loans in the $20 million to $40 million range and funded by four completely unfamiliar credit unions and regional banks offering very attractive rates and terms.
Pandemic creates unique market conditions
Where the current situation differs from the global financial crisis of 2009 is the hemorrhaging in the hospitality and retail sectors, as well as the $300 billion to $400 billion of equity capital in the market right now. In 2009, hotels and retailers weren’t necessarily missing rent payments, but liquidity had evaporated.
Another difference, noted one panelist, is that in 2009 retail landlords wanted national credit tenants. Today, some of the largest retailers have been requesting – and receiving – concessions. According to a report from Datex Property Solutions, as of mid-August, national store chains had paid 77 percent of their rent, while mom-and-pop shops had paid about 69 percent,3 taking into account the rent-relief agreements many of the stores had.
From KBREC’s perspective, another noteworthy difference is that pre-pandemic underwriting across the board was much more responsible than in 2008-2009, so the CMBS market was less “frothy.” Most lenders were quick to establish a 90-day forbearance and are likely to restructure some debt in the next 90 days. As CMBS returns, KBREC completed multiple securitizations in the second and third quarter, albeit with smaller pools than in the past.
Federal action fuels multifamily capital flow
When business activity came crashing to a halt in March, the Federal Reserve made the historic announcement that it would purchase CMBS—including multifamily CMBS—issued by the government-sponsored entities. As a result, the multifamily sector avoided a liquidity crisis and interest rate spreads tightened.
Spreads for multifamily debt range between 250 and 350 basis points, depending on the dynamics of the deal, noted one panelist. Capital is plentiful, although in some instances agencies are asking for six to 12 months of reserves for principal, taxes and insurance.
KBREC has also been actively originating loans, but with added due diligence. KBREC bankers have been seeking details of borrower rent rolls and how many tenants have been furloughed. However, the low interest rate environment and interest reserve requirements could enable an owner to cover debt service even with as little as 65% occupancy. And, while it seems that the multifamily market should be in worse shape than it is, collections continue to be strong.
Long-term leases support office underwriting
While the office sector has been less active than multifamily, many life insurance companies and banks continue to lend to office borrowers. Despite the move to remote work by most companies this spring, office tenants tend to have long-term leases that support underwriting, noted the panel. Supporting this view, one firm had just closed several office transactions—including one for approximately $100 million and another in excess of $200 million, both with strong tenants.
Questions persist about the post-pandemic office market. While vacancies clearly will rise in the next year, the panel did not anticipate a long-term decline in office occupancy. In the short term, the need for social distancing space will balance out greater adoption of remote working. In the long term, there is consensus that companies need the office to foster a shared culture, in-person collaboration and productivity.
Expect unfolding price discovery
Capital is available for many deals, but price discovery will be ongoing for some time, noted the panel. Cashflow durability is a challenging question: will federal stimulus keep rent rolls alive?
As markets have re-emerged in such countries as China, Germany, Korea and Japan, the price differential for core products with cashflow durability before and after the stay-at-home orders is 0% to 5%. For value-add products, the differential is more like 10% to 15%, or even 15% to 25% if the project needs significant capital.
One panelist suggested that buyers remain patient as price discovery could continue into fourth quarter, and sellers could take even longer to become realistic about pricing.
The servicing perspective
For loan servicers, hospitality and retail properties have been the first to require workouts. Life insurance companies lack a uniform approach, which means all-hands-on-deck servicing teams are investing significant time to address each loan on a case-by-case basis, according to one panelist.
With the forbearance period enacted through the CARES Act complete, lenders’ responses going forward will depend on the asset type and borrower specifics. Given that hotels are operating businesses, for example, lenders are unlikely to want to own them and will instead work with borrowers as best they can.
Despite some signs of life in the markets, investors may grow more skittish as uncertainty surrounding the pandemic recovery, as well as the economic and political outlook, persist. While the banking system is much better capitalized now than in 2008, the failure to pass a second stimulus bill could jeopardize liquidity and lead to a landslide of defaults in consumer debt.
The financial markets will be incredibly challenging over the next six to 12 months, but those who stay focused, work hard and are creative could emerge in a stronger position than before the pandemic. As difficult as the global financial crisis was, many successful firms, intermediaries, developers and entrepreneurs arose from that catastrophic era.
Moving forward, KBREC’s view is that a borrower’s approach with their lender can go a long way toward managing through difficult times. Relationships are more important than ever in the current environment, and the right financial advisor can be critical in gaining access to capital and closing deals.
To learn more, contact your KBREC Mortgage Banker, or reach out directly to Dan Baker.