Perspective Is Everything in the Capital Markets

The conference season for commercial real estate finance professionals begins every year with time for leaders to gather, collaborate, talk policy, educate, and prepare for the year to come. January and February feature the two major conferences for the finance set: first the Commercial Real Estate Finance Council in January and then the Mortgage Bankers Association Commercial Real Estate Finance conference in February. Between the two conferences, nearly 10,000 industry professionals have now gathered in Miami for CREFC and San Diego for MBA to kick off 2024.

Several themes have emerged from these conferences to tell a more realistic story of today’s market conditions beyond the dramatic headlines of major news outlets. It seems these major media outlets are fashionably piling onto CRE fundamentals and generating much consternation. Several major names investing in the office space are abetting this narrative that CRE is falling apart. But we must ask ourselves, are these conditions the proverbial tip of the iceberg or more the six blind men describing an elephant?

Yes, office is having major difficulties, however…

We are seeing skilled entrepreneurial operators buying at significantly below replacement cost and at a meaningful discount to the last sale in major cities across America, including Los Angeles, San Francisco, Denver, New York, and others. All major cycle shifts will have losers before winners. The pain will be a lesson, the aftermath an opportunity.

Adequate capital availability

Unlike the rough years following the GFC, liquidity remains available for borrowers. Insurance companies and the GSEs are continuing to originate debt at reasonable fixed rates, debt funds remain opportunistic, and rescue capital in the form of mezzanine debt, preferred equity, and participating loans is available, and as a bonus…

Resurgent CMBS

According to CREFC, 2023 CMBS originations totaled $39.3 billion. Last year, CMBS originations were as low as in 2011, in the depths of the GFC, when only $30 billion originated. In today’s market climate, many borrowers are looking to secure shorter term loans than a traditional 10-year financing in hopes of refinancing down the road in a lower rate environment. Always resourceful, the CMBS industry has pivoted to now providing five-year fixed-rate debt. A major change from the CMBS traditional 10-year fixed-rate financing model, and one that bodes well for their originations this year.

Orderly management of troubled assets

So far, insurance companies and CMBS special servicers appear to be in control of their response to defaulted properties, which are nearly all office assets. Though the industry is understandably concerned with the actual value of these loans/assets, they are prepared to muddle through.

Multifamily bridge loans

Bridge loans to this sector were based on a set of assumptions that in general are not panning out. The red hot and rising rents of the post-COVID era are cooling, new construction deliveries are diluting the market, and investors who purchased at peak values in recent years are suffering the impact of higher rates. But, as a senior life company executive shared with me, these projects have an equity problem, not a debt problem. Translation: Lenders to this space are not troubled about debt investments in this sector.

CRE portfolios of smaller banks

Unfortunately, most small and mid-size banks providing capital for real estate are dead in the water. This will take time to work through and may need to ultimately involve government intervention. The U.S. economy is dependent on these institutions cycling capital through the economy via their lending to CRE—both construction and permanent loans. Bank deposits have suffered with depositors moving funds elsewhere into higher yielding investments. So, while many of their loans can’t be paid off, institutions are unwilling (or unable) to take losses by selling these loans at a discount. This creates conflict and reduces their ability to fund new loans. An important, but more an ongoing process…

Regulatory issues

Both MBA and CREFC as organizations have a firm handle on critical legislative issues, and these were discussed at both conference. Three of the more important issues include Basel 3, with the pushback (as Basel 3 relates to banks globally) that the CRE regulation does not make sense in this context for U.S. banks. Next is legislation introducing additional levers for affordable housing finance. Lastly, finding reasonable solutions for property insurance and managing the push/pull between free markets vs. legislative forces.

New opportunities for capital providers

The challenges faced by banks and the market are in part being mitigated by other capital providers. For the construction financing space, debt funds have assumed an outsized role. Though their interest rates are relatively unattractive, they represent an alternative for shovel-ready projects. For investors with high variable rate debt, the insurance industry has responded with lower-rate fixed-rate debt with three-to-five-year terms. Though nascent, there is capital available to finance the resetting of challenged property assets.

So, depending on where you are in the CRE Finance world, the current environment appears to be leaning towards the six blind men and the elephant.

Mark Ritchie is a principal at Gantry.