Challenging Cycles Usher In New Eras

George Mitsanas

Gantry is currently welcoming our summer interns to the world of commercial real estate finance and that gave me pause to think about the current state of the market and what they will encounter during their time with us. This is certainly an interesting time to be entering the industry. For recent generations that have come of age in an era of stable, low rates and a perpetually growing economy after the meltdown of 2008, there is a seismic shift of the landscape happening as we continue forward into a new cycle and, as a result, a new era.

Cycles often define the beginnings of eras, and it is safe to say the cycle we are experiencing in 2023 is truly the beginning of a new era for CRE. There will be requisite, full spectrum adjustments to real estate investment, ownership, and financing strategies moving forward into the 2020s in pursuit of a new equilibrium. Market volatility and higher interest rates are the hallmark of this new cycle, but geo-political turmoil, massive shifts to workstyle and lifestyle changing the use of and demand for real estate, and a new world order post pandemic will differentiate this era that began in 2022 with the sharp rise of rates for the first time in more than a decade.

The sentiment on the cycle we are in right now is that everything is difficult. I prefer to call it challenging. Asset financing goals can be accomplished, but it will require new approaches and often painful but prudent new capital infusions. This cycle will eventually transition to a more stabilized reality. However, unlike previous markets where the spectrum of lenders available to borrowers was enormous, the population of viable funding sources has shrunk dramatically.

Changing landscape

Regional and smaller banks have long been a default choice in CRE lending for many borrowers. For the first time, banks are now retreating wholesale from commercial real estate lending and curtailing loan activity amid deteriorating fundamentals, constricting deposit flows, and aftershocks from the collapses of Silicon Valley, Signature and First Republic banks. The very existence of regional and small banks is in question and, before they return to a normalized lending market presence, we will most likely see government intervention to shore up their balance sheets. This will take time to work through. Their absence has created a demand for new capital sources for many borrowers.

In the absence of banks, insurance companies continue to be the best source for funding higher quality assets with stories and/or low leverage transactions. At Gantry, we work as primary correspondents for several of the nation’s preeminent insurance company lenders. We are recommending our clients to focus on five-year loans or longer, with fixed rates and no call provisions, to ride out the storm. This is not a time for gambling and hoping the storm is going to pass quickly and quietly. With a five-year term, borrowers can let the economy go through a cycle to equilibrium. I continuously hear borrowers rationalizing their desire for shorter term loans because rates are going down next quarter or next year. People in the know forecast rates aren’t coming down for a while. So even as a borrower says it’s not their preference to take on the capital expense of low leverage or conservative debt structures, it’s time to take the deal with an insurance company when its available.

Know this: Insurance companies are looking for higher debt yields of at least 8 percent. They will pursue quality projects with strong rent rolls. They are not excited by nor want to take on tremendous risk. This will mean they will drive harder bargains. They are going to do their own refinance stress test with 25-year amortization at a locked rate and will need to see at least a 1.20 debt coverage ratio. Even if it is harder to get to the appropriate debt service coverage in a five-year model with higher rates, ten-year loans can get the borrower to the right rate. Long-term will rule the day.

Even if indexes drop, there is still a focus on an overpriced CRE market. Currently, there continues to be a disconnect between buyers and sellers. This is why we are seeing a dearth of transactional activity. We are getting closer to the day where price adjustments will be needed unless we see a miraculous and unexpected drop in the cost of capital. Maturities will compel it. Unlike previous cycles where a downturn was caused by changes to the economy, the economy today is strong. This will continue to fuel the higher rate climate, making refinancing a challenge.

Questions about office

When it comes to the transition to a new era, office has a big question mark. Until businesses decide how their workforces will operate nothing will be the same. Remote, hybrid, full time. How this transition plays out will impact the integrity of cash flows long term. It will impact a borrower, but maybe five years later, which is why lenders are conservative even on viable assets. The challenges for major cities like San Francisco, Los Angeles, Chicago, and New York who need to court businesses to return to the CBD will be addressing public safety and homelessness issues.

To our younger professionals, I say this: CRE will survive. They will begin the journey towards a commercial real estate career in what is a volatile market and it is in times like these when commercial real estate professionals shine. Not all will be doom and gloom. For Gantry, deal flow has been good considering the climate, especially for our roster of insurance correspondents. We are nowhere near recent volumes, but we are pleased with the deals we are placing. These current interest rates have eliminated a speculative portion of the market looking to “refinance for a better rate,” and we are seeing real discipline emerge from sponsors seeking to maintain and nurture the value of their assets. This puts a focus on long-term stability, a sweet spot for our producers. This is also an opportunity for financial intermediaries to increase our value to clients who need us to shop and structure loans across hundreds of capital sources to meet situational realities. As in all things, we have to believe the best is yet to come.

George Mitsanas is a principal, Gantry.