Intense Competition Fuels Capital Source Convergence in 2018

By Sanyu Kyeyune

From left to right: Byron Boston, president, CEO & co-investment officer of Dynex Capital; Daniel Baker, executive vice president of KeyBank Real Estate Capital; Jeff Friedman, co-founder of Mesa West Capital; and Mark Williams, managing director of Eastdil Secured.

The boundaries between major capital sources are becoming indistinct, spurred on by the influx of market participants chasing yield. More often, well-established financial institutions are crossing over into commercial real estate through mergers and acquisitions, while debt funds are increasingly taking market share from more traditional financing sources—all to fit different niches within the capital stack. Last night at the Mortgage Bankers Association CREF/Multifamily Finance Conference in San Diego, industry experts representing a variety of capital providers discussed these and other trends reshaping the competitive landscape in 2018.

“Five years ago, we did transactions with 80 different lenders. Last year, that number was 130,” said Daniel Baker, executive vice president of KeyBank Real Estate Capital, which underwrites, originates and distributes permanent mortgage financing through a number of vehicles, including Freddie Mac, Fannie Mae, CMBS, FHA and direct placements. Baker attributed the spike in new entrants to the wealth of available capital coming in from a variety of sources.

“There’s so much pent-up demand from foreign capital providers,” Baker offered as an example, adding that international investors continue to be drawn to debt funds as an alternative financing source. In the past year, he’s also observed that these non-bank groups have responded by tightening their pricing to be more in line with banks. Meanwhile, banks continue to pull back on construction lending amid stricter underwriting standards and concerns of oversupply, creating more opportunities for alternative capital providers.

The draw of U.S. assets

Mark Williams, managing director of Eastdil Secured, concurred that offshore investors continue to be drawn to U.S. real estate assets, due to the market’s strong property fundamentals, comparably low interest rates and relative stability: “Over the past 10 years, volatility has been very low.” But more recently, Williams has noticed a standoff between sellers holding out for rates to go down and buyers wanting to be compensated correctly.

As a result, he said, spreads have continued to compress, especially since the beginning of 2018, with one possible effect being that China will reemerge as a primary source of foreign pension capital as its middle class expands. For Eastdil—which specializes in financing institutional property and portfolio deals for office, industrial, retail and multifamily assets—this trend would be beneficial.

Co-founder of Mesa West Capital Jeff Friedman cited increased merger activity by firms outside of real estate as one of the major shifts in the competitive landscape. Last September, Morgan Stanley announced its acquisition of Mesa’s real estate credit platform. Speaking on a conference panel, Friedman explained how the move enables his company to leverage the financial services giant’s global resources, alongside its own, existing domestic relationships.

“What we offer is an alternative to the banks, but we’re starting to become an alternative to life companies, as well,” noted Friedman, whose firm provides borrowers with higher-leverage, non-recourse, short- to medium-term mortgages for acquisitions and recapitalizations. When Friedman established Mesa in 2004, there were only a handful of competitors in the market. Today, Friedman noted, there are more participants providing tailored financing solutions to a more diverse group of stakeholders: “What a debt fund can offer is current income and downside protection.”

Pricing struggles

While increased capital inflows are driving down the cost of non-bank financing in the U.S., banks are unlikely to respond by loosening their underwriting standards, Baker claimed, which is a net positive for the credit quality of new loans. But they may increasingly struggle to achieve favorable pricing, he cautioned, adding that the industry should keep an eye on agency lenders. “(The agencies) had a record year, at around $80 billion (in loan originations) in 2017, and they’re also vying to offer fixed-rate products,” said Baker. “The life companies are some of Freddie Mac’s biggest buyers.”

So what does this all mean for the commercial real estate lending market in 2018? Among capital providers with varying risk appetites, the consensus seems to be that gradual shifts are unlikely to have material effects on transaction volume but the decade-long bull run that we’ve been on may start to lose steam. “If we see rates continue to rise and cap rates rise drastically,” warned Baker, “then the market could cool. But I don’t anticipate a huge correction.”