Commercial Magazine

Bridge Over Troubled Waters

Short-term lenders offer solutions amid volatile banking conditions

By Gary Bechtel

Regional banks have had a roller coaster of a year so far. This past March, the banking sector was sent into shock with the failures of Silicon Valley Bank, Silvergate It would be an understatement to label the commercial real estate market in the opening months of 2023 as uncertain, but it also would be unfair to categorize it as a disaster. The economic troubles that have hovered over the sector throughout the COVID-19 pandemic continue to impact capital markets, leaving worry and a fair amount of chaos in their wake.

Rising interest rates, soaring inflation and lingering fears of a recession triggered a recent banking crisis that involved collapses and government takeovers. The commercial mortgage industry was also under pressure. Capital markets pulled back, reassessed and — in some cases — almost dried up.

“The currently constrained capital market is an opportunity for sponsors to take advantage of fundraising tailwinds. Contraction among traditional lenders is also presenting debt funds with an opportunity to deploy capital.”

Borrowers had already started to seek capital for their real estate projects from a variety of new sources as more traditional sources contracted. This shift opened the door for private capital in the bridge lending space, and investors began turning to bridge lenders last year when they discovered that debt funding was unavailable elsewhere as the ultra-low interest rate environment disappeared.

As the Federal Reserve raised interest rates in 2022 to combat inflation, it pushed many borrowers into scenarios with higher mortgage costs that required larger equity commitments. On the floating-rate side, the Secured Overnight Financing Rate, which is the rate that large financial institutions pay each other for overnight loans, stood at 0.05% at the start of 2022. One year later, it stood at 4.3%, causing mortgage rates to rise dramatically while the costs of interest rate caps are up to 10 times higher. And the 10-year Treasury yield increased from 2.74% in mid-April 2022 to 3.42% a year later.

Conditions across the financial markets shifted dramatically during first-quarter 2023. This included a shift in private lending. Lines of credit were reduced or halted altogether. In fact, some well-known lenders closed shop while many others were barely functioning. General contraction occurred across the financial markets, which worked to the benefit of well-capitalized balance-sheet lenders. More time is needed for the capital markets to adjust and determine a comfortable level of activity. For now, this pause is creating opportunities for bridge lenders to fill gaps in the capital stack.

Gaining traction

Private debt, which is a loan made by a private company rather than a bank, is an investment tool that has been growing in popularity of late. This is because it provides an opportunity to invest in tangible, income-producing assets at a discount to valuation, which gives a margin of safety for pricing compression.

As loan-to-value (LTV) ratios continue to compress, capital sources with dry powder are being overwhelmed with lending requests on high-quality assets in strong growth markets. This provides a tremendous opportunity for the lenders that have adopted a creative approach with their operations. There is a large amount of private debt capital waiting for opportunities, and stronger sponsors with experience in this niche will stand out in the market.

Commercial real estate investors continue to be attracted to private debt because they can find relative certainty within a favored alternative asset class, according to a recent survey from real estate services firm CBRE. Despite economic uncertainty, debt tied to real estate (especially multifamily and industrial assets) delivered higher returns compared to other investment types. Private debt is attractive because it provides short-term, opportunistic capital amid a higher interest rate environment.

CBRE’s survey found that more investors are expected to implement opportunistic debt strategies this year compared to last year, due to the attractive returns amid higher interest rates and tighter financial market conditions. Many investors expect to see pricing discounts of 30% or more across multiple sectors, with shopping malls and value-add office assets expected to offer the greatest opportunities.

In other instances, bridge lenders come to the rescue when borrowers find the traditional loan approval process is taking too long. Rather than waiting, borrowers move to solidify their positions with a bridge loan — short-term financing that is designed for transitionary periods and helps to ensure a project moves forward in alignment with a business plan. As banks and other traditional lenders pause to reassess the market, bridge lenders are often a viable solution because they provide certainty that the sponsor’s business plan can be executed. Bridge loans also have proven useful in cases where a borrower no longer qualifies for a bank loan due to the rapidly shifting market.

Lower expectations

Market turmoil at the beginning of 2023 was cited as a factor in liquidity reductions across the commercial real estate capital markets. Caution and conservative underwriting tend to be a comfort zone for lenders. The volatility and subsequent pullback caused spreads to widen across a range of lending groups, from debt funds to banks and commercial mortgage-backed securities (CMBS). In fact, CMBS issuance was down nearly 80% year over year in Q1 2023, according to Trepp data.

An unintended consequence is that as risk increases, investors seek safer investments such as Treasury bonds. This works to drive down yields and increase prices, which can reduce losses on bond sales. For commercial mortgage borrowers, they could eventually find themselves in a more favorable interest rate situation.

This should not be a surprise. Loan activity was already decreasing at the end of 2022, and projections for this year called for commercial and multifamily mortgage lending volumes to fall by about 15%, according to the Mortgage Bankers Association. The trade group’s forecast assumed “economic weakness at the start of 2023 with a moderation in interest rates and an overall improvement in the economy as the year goes on.”

Banks experienced a record year of commercial mortgage originations in 2022, making $479 billion in loans or nearly 60% of the total origination volume among all capital sources. But these sources are pulling back and even disappearing as they assess portfolio risk and address depository requirements.

Rocky road

Borrowers who face looming loan maturities in 2023 aren’t likely to find many allies either. Trepp estimated this past March that some $448 billion in commercial mortgage debt will mature this year. Interest rate hedges must be extended at much higher costs, delinquencies are expected to rise and market participants will naturally be a bit nervous.

The year ahead will likely include a period when traditional lenders retrench. New capital looks to find a home in the market. The coming year generally looks to be a growth opportunity phase for private lenders that reserved cash and have been operating without leverage. It is expected to be a lender’s market as large banks retreat while small and midsized banks work to stabilize themselves. The recent collapses of Silicon Valley Bank and Signature Bank have stoked caution.

This environment is creating more opportunities for bridge lenders to complete deals that involve higher-quality borrowers and less risk to achieve improved returns. Yields in the high single digits to mid-teens are being realized, depending on the strategy.

Quality loan submissions are increasing while LTVs have decreased due to debt-service-coverage constraints. That said, the market is shifting, with select property types falling out of favor. That alone is a reason to move ahead with caution. Lenders that focus on senior positions and less leverage will be able to withstand a major economic event. This structure has worked well in the past and will continue to give lenders an edge while the market corrects.

Returns for debt funds are expected to exceed those achieved from 2019 to 2022. The wider margins that debt investors are experiencing across risk profiles are being realized because of capital market headwinds and the Fed’s intention to drive down inflation through higher baseline rates. Lenders have an opportunity to seize outsized returns even when lending on collateral that’s been repriced due to factors such as the expansion of capitalization rates.

Market transformations

Leverage on new loans being made today is nowhere near historic averages. This places lenders in more advantageous positions in the capital stack now compared to where they may have been following the financial crisis of 2007 to 2009. Ultimately, the risk-reward trade-off found in the current market is likely better than what lenders experience in typical cycles.

The currently constrained capital market is an opportunity for sponsors to take advantage of fundraising tailwinds. Contraction among traditional lenders is also presenting debt funds with an opportunity to deploy capital. Some lenders have extended their pipelines as interest rates have increased, largely because floating-rate lenders, debt funds and non-debt capital sources have dramatically curtailed their lending activities.

The market also has experienced a transformation among bridge lenders that were reliant on demand for floating-rate products, as well as business models that required warehouse lines or securitization in the collateralized loan obligation (CLO) market. These sources of capital have been weakened by the current market conditions.

Some bridge lenders have responded by adding new products, putting them in a better position to satisfy demand from borrowers and investors who seek lower risk profiles. Even in a higher interest rate environment, there’s an opportunity for growth.

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Those who’ve been in the commercial mortgage industry for more than a decade understand that markets change and adaptations to these changes are required for survival. They also know that, amid the darkness, hope remains and opportunity exists.

Time will tell if the stress being felt across the banking industry results in decreased commercial mortgage activity for the balance of the year. It is a legitimate concern, especially since regional and midsized banks hold crucial roles across the entire banking system and account for much of the capital for commercial real estate loans. To mitigate pain, borrowers will need to explore options they may not have previously considered. One of these avenues will likely lead them down the path to a bridge loan. ●

Author

  • Gary Bechtel

    Gary Bechtel serves as CEO of Michigan-based Red Oak Capital Holdings LLC, a group of capital entities that lends and invests on commercial real estate by raising funds through retail and institutional channels. He leads the company’s investment management leadership teams with direct oversight of all portfolios. Prior to joining Red Oak in 2020, Bechtel served as president of Money360.  Over the past 34 years, he has been involved in all aspects of commercial real estate finance and has closed more than $10 billion in commercial debt transactions.

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