Today’s commercial mortgage market is undoubtedly slowing. As expected, interest rate hikes and inflation are influencing the structure, flow and volume of deals.
In a cooling market, it can be easy for investors to halt dealmaking entirely, a common fear-based reaction. This market cycle, however, is different from other downward cycles. Plenty of capital is out there and lenders are still willing to provide financing for the right project. For loan originators, thinking outside the box to find the right project, investor and capital sources will be the keys to succeeding in this climate.
At a time like this, it is important to note that slowing down is not the same thing as stopping. Deal volumes remain robust across certain asset classes, with industrial and multifamily leading the way. MSCI Real Assets reported that apartment sales in second-quarter 2022 totaled $86.3 billion, good for 42% year-over-year growth, while the $35.4 billion in industrial transactions represented 8% growth. These numbers suggest that investors have not so much quelled their hunger as redirected it.
Today, deals are about reformation and selection. It is necessary to look beyond primary markets and traditional capital sources. Smart lending requires observation into the forces that influence how deals are structured, including the socioeconomic, technological and cultural trends that will shape the future of commercial real estate lending.
Primary market risk
Given the higher cost of capital, penciling deals requires more nimble maneuvering. Especially when it comes to dense, primary markets that have compressed capitalization rates, investors at this stage in the market are often looking to take risk elsewhere.
An example of this trend lies in California. The state lost 352 company headquarters between January 2018 and December 2021, according to a study by the Hoover Institution at Stanford University. The study attributed much of this movement to the state’s high taxes and strict business regulations.
Nonbank lenders have been active in the market for quite some time, which provides a deeper opportunity to secure financing when banks become wary of lending in a bearish market.
Some major venture capital firms have moved or expanded their offices outside of California. And this past summer, a UCLA survey of commercial real estate developers, owners and investors showed increased caution in office space investments throughout the state as this sector continues to struggle with the impacts of the COVID-19 pandemic and remote work. It’s worth noting, however, that while the office outlook was pessimistic, the forecasts for retail, multifamily and industrial real estate in California were mostly optimistic.
Various deals have fallen through due to compressed cap rates which, coupled with high inflation, substantially limit returns for investors while creating a sense of unmitigated risk. In short, there is not enough “bang for the buck” in certain asset classes within primary markets, but this sentiment is not ubiquitous.
Secondary market growth
In secondary markets such as South Florida, however, investors have been closing an increased number of deals. They’ve discovered that these areas signal less volatility, higher returns and better overall value.
Secondary markets are driving growth and attracting talented employees for the long term. Companies — including those that fled California — and workers are relocating from major metros to more affordable secondary markets such as Dallas, Phoenix, Houston and Austin, which led the nation in population growth for the year ending in July 2021.
Job talent may be the most in-demand asset of all. According to a Brookings Institution report, attracting young and talented workers has the strongest correlation to sustainable economic prosperity, giving these secondary markets a favorable future.
The pandemic opened these secondary markets to greater attention than they were previously given in the commercial real estate world. Still, there was a question of whether it was a short-term trend or a long-term indicator of greater shifts in our culture. At this point, the answer seems clear, so commercial mortgage professionals can expect to see a continued renaissance in second- and third-tier markets, fostering an enthusiastic lender appetite in these emerging locations.
New priorities
In times like these, attention to detail matters more than ever. Mortgage brokers and lenders are playing an increasingly critical role in ensuring that deals are well curated, precise and ultimately garner strategic success for all parties.
As money moves around and banks decrease their capital allocations, brokers and borrowers must seek funding sources that are behind the market, meaning lenders that offer lower rates given their delayed reaction to the most recent rate hikes. In essence, it all comes down to finding the right fit for the borrower, the asset class and the location.
Given the Fed rate hikes, Q2 2022 saw declining sales volumes among banks. According to MSCI data, the number of commercial real estate transactions funded by banks during these three months fell to about 8,500, down 22% from the same period in 2021. But again, even though deals are down, they are still happening on a scale of widespread repricing and increased negotiation.
Lenders are simply looking for and prioritizing high-quality assets and efficient operators. For instance, many lenders will say no to the office sector given its slow economic recovery. Conversely, plenty of capital sources are willing to finance assets such as multifamily, industrial and “medtail,” or medical retail properties.
Additionally, within retail and industrial, there has been an increase in triple net (NNN) leases, particularly in less dense markets such as Indianapolis and Rockford, Illinois. These lease structures are becoming more prevalent in states like North Carolina and Pennsylvania, as well as those without income taxes, including Florida, Texas and Tennessee.
Triple net leases offer resilience and hedge against impending downturns while creating long-term appreciation for the investor. The NNN structure shifts the ballooning prices for property expenses (including insurance and maintenance) to tenants, giving owners protection and insulation from volatile, short-term market fluctuations. It also shifts real estate tax expenses from the landlord to the tenant, which tend to be larger, creditworthy corporations.
For the borrower, it is a matter of finding the right lender that wants to work within the asset class at hand and is comfortable with a property or business plan. In the end, financing negotiations often influence prices without making or breaking the deal.
Alternative solutions
Today, with headlines of continued interest rate hikes and recession fears, many types of bank loans have been crimped. This is because snowballing, distressed assets in commercial real estate could overwhelm banks and they do not want to become overextended.
Nonbank lenders have been active in the market for quite some time, which provides a deeper opportunity to secure financing when banks become wary of lending in a bearish market. Regardless of market conditions, all lenders must practice the art of “forward looking” at interest rates.
Take credit unions, for example. Due to the fundamentally different structure and purpose of credit unions, rates are not adjusted as often. In an economic climate like this, an alternative money supplier like a credit union can come in handy.
For instance, a private mortgage company recently utilized a credit union as a resource for securing capital at lower rates compared to bank competitors. This was due in part to the credit union’s lower concentration risk. The mortgage company secured $6 million for an industrial park in Irvine, California, at a rate of 3.75% through a credit union.
Unlike banks, which are structured around preserving capital due to their direct enmeshment with distressed loans, credit unions can be more creative in their financing and tend to work in smaller numbers. This provides brokers a great opportunity to capitalize on the alternative framework of credit unions and secure financing at lower rates.
Over the years, there has been a rise in private equity firms, hedge funds, real estate investment trusts and institutional lenders getting into the commercial real estate game. The net influence of these various parties has created a nonbank-centric market, especially when conditions are finnicky.
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Again, it’s not that capital has disappeared or viable investment opportunities are unavailable. Commercial estate, coupled with resilient strategies such as NNN-leased assets and creative capital sources, still provides the strongest hedge against inflation and keeps investor returns solvent.
Assets such as medical office buildings, grocery-anchored retail centers, apartments and industrial parks remain promising, even as the market enters a more clear-cut recessionary landscape. Yes, investors are slowing down, assets are trading at lower prices and lenders are being more selective. But these are symptoms of widespread repricing rather than doom and gloom.
This repricing phenomena will largely result in sellers, who signed contracts with buyers before the sharp rate hikes, to agree to renegotiate at lower prices. The bottom line? The market appears able to adjust at a prompt rate and deals will continue to close, even if more negotiation and flexibility is needed. ●
