Choppy Capital Markets Equal a Choppy Deal Flow

BREAKNECK. DRAMATIC. VOLATILE.

That’s how a stable of experts described the commercial real estate capital markets environment over the last part of 2022, as the Federal Reserve appeared poised to continue its progression of rate hikes largely unabated.

“We haven’t seen this much volatility in the financial markets since the global financial crisis, and it’s very difficult for lenders, buyers and sellers to gain a handle on the proverbial rules of the game when treasuries have more than doubled since the early part of the year,” says Abby Corbett, Global Head of Investor Insights at Cushman & Wakefield. “In fact, we’ve seen over 20 days in which treasuries have moved more than two standard deviations, a threshold not previously seen since 2009… This sort of environment is difficult to underwrite and diffi-cult to price.”

That volatility has extended to the debt and equity space as well, with investor sentiment rapidly shifting and income growth prospects slowing. So all of this begs the question: what deals are getting done and how?

The answer, like so much of what’s happening in the current macroeconomic environment, is complicated.

“Well-financed, seasoned borrowers with existing banking relationships have generally had better access to lending through local and re-gional banks,” says Marcus & Millichap’s John Chang. “Other lending channels like CMBS and life companies have become less active. Many borrowers had been opting for variable rate financing until the forward looking indexes like the SOFR began to aggressively rise in recent months and the gap between variable rates and fixed rates narrowed.”

Jeff Adler, vice president at Yardi Matrix, says the deals that are closing seem to have assumable debt on them that allows the buyer and seller to both reach their goals.

“Other deals are harder to get done given current debt costs and reluctance of sellers to take a 20-25% price cut from values earlier in the spring of this year,” he says, noting debt is available from the GSEs, but at higher costs. New deals are made less feasible due to the higher cost and more restrictive terms of construction financing, even as inflation on construction costs slows. Adler says he expects rescue capital and mezzanine debt to fill gaps in the capital stack.

According to Miguel Jauregui, Director of Capital Markets at SAB Capital, “deals are definitely getting done,” especially in the net lease space.

“We have seen a lot of owners looking to cash out and take advantage of the current cap rate environment, but of course the other side of the coin is they sell and then they have to buy in the same environment,” he said. “That being said, there are still ways to structure the deal and lenders are being as creative as they can be to get deals done because they’re sitting on dry powder.”

Jauregui says creative financing options to get deals across the finish line include structuring in longer amortization, using interest only loans, or incorporating “very favorable” prepayment penalties.

“I’m seeing a lot of clients considering going with a big loan, as almost a bridge to when interest rates are going to be lower,” he says. “I’ve even seen three year terms proposed, which is typically reserved for a bridge loan — but in this case the banks are doing three year terms and people are considering them because the goal is to refi in three to four years. They’re sucking up a high interest rate and saying you know what, it’s temporary – but I’m still getting a solid asset as a good basis.”

According to Jonathan Chasson, CFO of Brixton Capital, the sharp uptick in interest rates caused a “large disruption” in transaction vol-ume in the last two quarters of the year, and “the first two quarters in 2023 do not look any brighter.”

“Commercial real estate investors have an expectation of a minimum investment return on their equity,” Chasson says. “When interest rates go up, either the cashflow available to be distributed to the equity holders decreases as more cashflow is used to pay the higher inter-est cost or the required amount of equity needed to close on the deal increases as the lender reduces the amount of debt the specific prop-erty can support (as the loan is constrained by cashflow), or both.”

As a result, repricing and price discovery is slowing deal flow. Buyers realize they can pay less for a property than before the Fed’s recent string of rate hikes, while sellers have been slow to drop their asking prices. In addition, bank regulators have increased their reserve re-quirements on commercial banks, reducing their ability to lend in real estate.

The result is “many banks are lending only to their best clients,” Chasson says. “Investors who do not have a great banking relationship are pushed to more expensive forms of debt such as a debt fund or can’t find any debt.”

Chasson’s colleague Jim Hamilton, vice president of acquisitions at Brixton, said trades are occurring – but most were awarded several months ago “and have gone through the price reduction wash cycle.” In many cases, he says, such deals only closed because the buyer had motivation like a nonrefundable deposit or a 1031 exchange.

“We haven’t seen a lot of multifamily or retail deals where we say, wow, that’s a really good price,” he says. “And that’s an indicator that the deals that are getting done are the result of what’s been happening for the last six months and eventually got to the finish line for some reason. In office, it’s a totally different thing. Very few deals are getting done.”

Cushman’s Corbett notes that deals are continuing to close, but says it’s “much more complicated to get a deal across the finish line.” She says for sellers, the key is to recognize that bids aren’t stable and also may not be there for long, since conditions, assumptions and sentiment have shifted so significantly.

“Liquidity remains constrained, and there are a lot more buyers on the sidelines than there are those actively looking to execute right now. We’ve also seen the profile of both buyers and sellers changing,” she notes, adding that preferred equity, gap equity and gap debt are popu-lar approaches right now. “Public buyers and investment advisors have moved to the sidelines in many cases, while private, generational wealth has increased relative share, many of whom are eager to achieve dependable and attractive yields in markets and submarkets with long-term prospects. Some all-cash buyers who come across compelling opportunities are also opting to buy right now with plans to re-finance with lower leverage later.”

“Everything is taking longer,” according to Zack Holderman, Senior Vice President at CBRE’s US healthcare and life sciences capital markets group. “Our team has had the most productive year on record, as have many other debt and equity institutions. Any transaction de-pendent on leverage should anticipate delays as those lenders who are active are being much more selective and diligent in their pursuit of new opportunities.”

DIFFERENT ASSET CLASSES

The financing gap has impacted asset classes differently, experts agree, with multifamily and industrial projects attracting what Chasson calls “a decent amount of debt” for the right deal. Multifamily investors are able to attract bank debt and agency loans, though at higher in-terest rates, while the availability of debt for retail and office deals remain scarce with most lenders requiring some form of recourse on those loans.

Hamilton says Fannie and Freddie are the “only games in town” right now for multifamily: “there are no bridge debts available, no bank debt especially without recourse, no CMBS and very little life company financing,” he notes.

“There will be two catalysts (for deals) in the multifamily space,” Hamilton says. “One will be some kind of debt-driven capital event where the seller has to refi or get out. The other is going to be seeing some fundamental cracks in the performance of assets – maybe more tenants not paying rent, maybe they’re moving out or doubling up.”

And the sector is beginning to show some signs of distress: merchant builders, Hamilton says, are reacting to changes in the market faster than other investors because they set their cost basis before the pandemic.

“They’ll make money on their deal even if they sell for 25% less than they thought they’d have in April 2022,” he says. “They also have short-term floating rate construction financing. They’ve reacted to the market much quicker, and their motivation is to get out much faster and recycle capital into new deals. You’re starting to see those deals price at more attractive rates. But the problem is, if they’re bigger deals the institutions still aren’t playing.”

On the retail side, Hamilton predicts assets will have to re-price.

“What used to be a 5 cap deal is going to have to be a 7 cap deal,” he says. “And sellers have to adjust to meet the market…interest rates are probably not going down dramatically.”

Deal flow has even slowed for the life science asset class, a pandemic darling, according to Holderman.

“We are hearing from our clients that investment sales transaction volume will decline heading into 2023,” he says. “The dynamic of a lot of development and conversion work in the queue, owners/investors building portfolios with strong equity partners or balance sheets, sof-tening debt capital market, and constraints on the tenant fundraising side signals slowing in sales volume.”

That’s not to say deals aren’t getting done, but Holderman says that’s less a result of market dynamics than unique circumstances. For example, his team recently closed a competitive, large sale-leaseback for a San Diego company that’s utilizing the proceeds to fund an expansion of their manufacturing side of their business. Other current deals include non-strategic assets for one investor’s portfolio that will be opportunities for others, he says.

LOOKING AHEAD, A MURKY PICTURE

In a November interview, Cushman’s Corbett said she hoped to have more clarity on the Fed’s path in the first quarter of 2023, which would in turn imbue stability into the financial and debt markets And from there, I think we’ll see a lot of buyers eager to act on some of the rela-tively attractive yields out there,” she says, especially where high-quality assets trading at relatively elevated cap rates are concerned. “Sellers, however, will likely remain reluctant in these early stages, unless they are in some necessity-based sell-side position.”

Corbett says flight to quality will remain a key theme in this cycle as risk is priced-in more cautiously across the quality spectrum. She thinks high-quality assets in good locations will continue to hold up well and draw investor interest.

According to Yardi’s Adler, most market participants are gearing up for a tough 18 months, however.

“There will be a limited number of transactions than need to get done for specific reasons — current floating rate debt, shorter-term maturi-ties, struggling lease-ups,” he says.

Holderman said the next year is likely to provide big opportunities for forward-thinking borrowers, capital partners, and consultants to re-inforce their businesses as the market turns.

“Structured finance has been a big part of my career and we are consistently being asked to advise, both from an investor and capital pro-vider perspective, on what structured products will be attractive (and potentially necessary) as we navigate the coming months,” Holderman says. “Many of the variable rate loans placed over the past handful of years required hedging to protect interest rate exposure. The market was accepting of shorter duration index caps that will be burning off over the next several months and borrowers will be faced with expen-sive, if available, replacement instruments, remargin calls or refinance needs. Those partially completed business plans will look to the structured finance solution to provide adequate time to execute.”

“Looking forward, if the Fed slows the pace and size of its rate increases as they have telegraphed, lender spreads should begin to come in and borrowing rates should stabilize,” Chang predicts. “This should alleviate some of the pressure on the expectation gap and enable buyers to tighten their underwriting criteria. Nonetheless, it appears that the low rates and elevated liquidity that benefited the market in 2021 and the early part of 2022 may not return for some time.”