Q&A | Matthews™ Capital Markets Experts
As the economy recovered from COVID-19, the demand for commercial loans increased. Multifamily mortgage lending is seeing an increase in demand and record levels of capital. The Mortgage Bankers Association (MBA) projects commercial real estate and multifamily mortgage lending will break $1 trillion for the first time because of a 13 percent increase in 2022. This record-breaking number comes from various factors, such as a constant uptick in property values.
In this Q&A, Matthews™ capital market agents provide their specialized insight on current CRE investment trends and factors impacting capital markets today.
1. Tell us about your end-of-year outlook in terms of commercial real estate investments and capital markets trends.
The Fed’s hiking of interest rates has caused a disconnect between buyers and sellers that has resulted in transactional volume slowing down. It has also caused interest rates on loans to increase significantly, making it harder for deals to underwrite. I am already seeing refinance deals run into coverage issues and advising my clients to not wait if they must refinance in the next six to eight months.
The run-up in rates this quarter has resulted in less equity being returned to sponsors who are seeking maximum leverage on refinances. For the purchase business, market participants are not stretching loan dollars as far as they were when compared to the beginning of the year. The lender landscape remains fragmented given the volatility experienced in the bond markets. Certainly, intermediaries with access to a wide array of debt and capital sources will be critical to navigating the market moving forward.
For permanent financing, our placements have shifted to capital providers who are using lower debt coverage/debt yield metrics and are underwriting to the actual note rate offered instead of a stress rate. Our clients have found value in these sources to improve proceeds and enhance returns on both refinance and purchase transactions across almost all product types.
As bond yields continue to move and shake, lenders will adjust rates accordingly. We’ll continue to track the providers offering the lowest cost of capital, however, changes to a lender’s sizing parameters (ex: 1.25 dscr to a 1.20 dscr) and the ability to extend interest-only offerings will be important in determining the best fit for assignments that need permanent solutions as rates continue their upward trajectory. Couple this with the large trend of consolidation we’re seeing in the market (US bank purchasing Union – Washington Fed purchasing Luther – and a while ago look at Pacific Premier purchasing the hometown hero, Opus) we expect the regional bank/credit unions with smaller balance sheets to make changes to their programs to gear up for Q1 2023 originations and fight for market share since many have been sitting on the sidelines and have adopted the common “wait and see” approach towards new deal submissions.
Interim financing through our debt fund relationships played a bigger role in our origination volume this quarter as the banks stepped back. We helped active owners and operators tap into their sitting equity by arranging fixed 18–36-month full-term interest-only notes without any prepayment penalty provisions to allow for repositioning flexibility in the future.
These solutions are twofold:
1) Return dormant equity that will be unhindered by prepays, holdbacks, interest reserves, etc. with full-term interest-only payments to mitigate the impact on cash flow
2) Provide a bridge to gap the borrower to a more favorable interest rate environment in 18-36 months to hedge against rate risk and position the sponsor to refinance into a permanent solution down the road when rates improve.
Our debt fund relationships who remain well capitalized through this period of volatility will be a clear winner as we continue to come across more “Bridge to Bridge” situations going into Q1 2023. The sharp increase in rates has made it difficult for borrowers in the market to refinance existing bridge debt maturing next quarter. We continue to add more of these sources to the arsenal and utilize these providers as rescue capital to extend payment schedules for deals that fit the profile.
2. Tell us about other factors impacting capital markets at the moment.
Inflation and our central bank are the largest factors impacting the capital markets side of the business now. The November meeting marked the Fed’s sixth consecutive rate hike this year and the fourth straight three-quarter point increase pushing short-term borrowing costs to a new high since 2008. Keeping inflation in check is part of the Fed’s dual mandate. At the time of writing, the last YoY CPI print barely beat expectations, coming in at 7.7 percent just shy of the expected 8 percent. We had Fannie deals floating in the pipeline that benefited from the downward swing in bond yields in reaction to the print which was nice, but the reality is that 7.7 percent YoY is still a high number. For reference, the Fed’s target inflation figure is around 2 percent.
After digesting the minutes from the November meeting, we don’t expect the Fed to pivot any time soon. JP Conklin at Pensford Financial Group articulates the situation extremely well, better to let off the brakes too late than too soon. If the Fed signals a pivot, they risk allowing inflationary fears to creep back into the market. We’ve had two similarly positive inflation reports this year that quickly turned out to be pump fakes in subsequent months.
The main takeaway is that rates will be higher for longer than anticipated and the Fed’s monetary policy decisions will be heavily influenced by all upcoming inflation data markers. As the markers improve over time (increasing the overnight lending rate, supply chain issues subsiding), it will pave the way to taper the frequency of hikes – then ultimately a pause.
We all miss 3 percent rates, but this is a cyclical business. It will take time, but the market will adjust. Zoom out thirty years on the benchmark 10 Year Bond and you are looking at yields in the 6-7 percent range. Coming off the floor of some of the lowest rates in history in 2020/2021 seems to be distorting the market’s memory. Nevertheless, these are the periods where credit boxes begin to adjust and some lenders in the pool tend to become more selective. Intermediaries with deep lender relationships formed through years of real transaction volume will provide the best certainty of execution for those transacting during this period.
3. Which sectors do you think will be most active?
We hosted back-to-back meetings for two days straight with our lender partners at the Western CREF in Vegas poolside at the Aria in September – they all echoed a similar sentiment. Multifamily will remain the industry darling followed by retail with decent tenant credit profiles, self-storage, and industrial product. We are seeing capital readily available for almost every product type except for office. The fact remains that store openings exceeded store closings in 2021 and 2022 while the office sector is seeing its highest vacancy rate this millennium. Unless it is a trophy asset, office product has become increasingly difficult to finance conventionally given the current climate.
4. Which property sectors are still feeling the effects of the pandemic? How are they currently being impacted?
Office vacancy rates are still feeling the effects of the pandemic as many companies are still allowing employees to work from home. There have been steady increases in occupancy over the past few quarters, but office occupancy may never reach the levels they were before the pandemic.
Hospitality is starting to see an uptick, however, both hospitality and office classes will need to adjust to changing times. I forecast major conversion projects in the near future.
5. How is transaction activity faring with rising interest rates?
Transaction volume is ticking down. As the 1031 pool shrinks, we will likely continue to see a slowdown. Institutional buyers have already put pencils down for the year. However, now more than ever, investors cannot return to their same “local lender.” We live by the mantra that no lender is equal in a down market. As such, our volume has increased as clients turn to brokers for creative solutions.