Deal Volume's Down, Interest Rates Are Up: Conservative Lending Is The New Normal

Borrowing and lending for commercial real estate deals is hardly dead in the water, but it is not as active as it was only a year or two ago, as interest rates have crept up and transaction volumes are down.

Essentially, there is a more conservative mood in the capital markets, according to the speakers at our Orange County Capital Markets & Investment Forum. Both borrowers and lenders are feeling it, especially as the outlook for rent growth in multifamily is not as robust as only a few years ago.

Despite the more conservative mood, new players are trying to squeeze into the game. One recent development in CRE lending is the rise of large debt funds aiming to take up some of the slack caused by more conservative attitudes among banks and other lenders.

The Bascom Group Managing Partner Jerome Fink, whose company buys value-add multifamily and renovates it, said agency lenders were extremely active about four years ago, and banks were lending at 65% loan-to-value and 250 basis points over Libor. That was the universe of lenders for value-add acquisition loans.

"Today, you see an explosion of lending among the Blackstones and Starwoods of the world," Fink said. "They're out there raising big debt funds. The big banks aren't as aggressive or active as they once were. For one thing, they have debt-yield tests that are harder to get over."

The debt funds are lending at 65% to 75% bridge loans in the range of low-300 basis points over Libor, Fisk said.

KBS Realty Executive Vice President Finance Robert Durand, whose company specializes in office projects with relatively low leverage, said as interest rates have gone up, spreads have come down.

"The market for higher-leveraged deals, which involves transitional assets at 65% to 70% leverage, has gotten very competitive in that last 12 months," Durand said. "As banks have become a little more conservative, a lot of other players have come into that space. It's been an interesting transition to watch."

Farmers & Merchants Bank Senior Vice President and Regional Relationship Manager Kathy Reed said her bank lends across the board, but also has a niche in nonprofit. As such, Farmers & Merchants is not facing such stiff competition from debt funds. 

"Our borrowers are high net worth individuals and smaller developers," Reed said. "From four years ago to today, our underwriting hasn't changed. We're still a conservative, low loan-to-value, 50% to 60%."

Still, there is competition from other banks in the space. "They're giving away on rate, and on LTV, and that concerns us a bit."     

Rialto Capital Director, Commercial Properties Group California Jeremy Griffin, whose company has about $5.5B of assets under management, said in 2012 and 2013, Rialto took a little more leverage in its deals than now, because there was higher projected net operating income growth in those days. 

"We pushed the envelope in a few deals, up to 70% to 75%, but as the cycle has progressed and is getting longer in the tooth, we've ratcheted that down accordingly," Griffin said. "In office and industrial, we cap out at about 65%, and 70% in multifamily, so that means we're talking mainly to banks and a few debt funds that can offer attractive pricing."

Pacific Life Insurance Co. Managing Director of Commercial Mortgage Investments John Waldeck, whose company specializes in large construction loans, said the market for that kind of lending is not so different now than four years ago, though there is more competition. 

"Where we add value to our portfolio isn't in risky, high-yield plays, but in loans that are a little more than an industrial loan that's, say, getting 145 over Libor or less," Waldeck said.

"There are more lenders entering into construction lending, and that's where competition is driving down rates. Now it's less obvious where your next deal is coming from."

Buchanan Street Partners co-founder and President Timothy Ballard said his company has two kinds of customers: large pension plans that have a lot of capital, but are reluctant to deploy it because they are a little worried about the future of the economy, and high net worth investors looking for more opportunistic deals.

"High net worth investors want yields that they can't find in their other investments, so they're eager to be in real estate, and if they can get a 6% to 7% cash dividend, they're excited about that," Ballard said. 

Transaction volume has been falling in the last year or so.

"The institutional investors are cautious. They're defensive and piling up cash," Ballard said.

"The projections are that transaction volumes will continue to drop, because owners are rewarded for not selling. I've seen that over and over." 

LBA Realty Vice President, Acquisitions Mike Johnson said his company, a private REIT, has two funds: one an opportuntistic fund that acquires industrial and office, the other a fund that focuses on core industrial.

"There's a lot of capital chasing the same deals, so it's a challenge to find deals and close them, but we're finding opportunities. We're also realistic sellers." 

Johnson also said there is a massive consolidation going on within the industry.

"On the industrial side, there are core funds that don't sell," he said. "As they acquire properties in one-off deals from private owners, it's that much more product that's taken out of the marketplace."

USAA Real Estate Co. Managing Director Steven Ames said his company has seen a lot of growth, with about $20B in properties under management and funds that cover the entire capital stack. The company has sold about $10B in real estate assets over the last four years, but even so has grown.

There are reasons for caution now, Ames said.

"We're in the second-longest growth cycle in history, about eight years. There's rising interest rates, slowing rent growth, geopolitical uncertainty — a lot can happen quickly to slow down growth. Also, the country has spent the last year watching the train wreck of our politics."

"We're looking for investments that can weather the downturn, because there are always downturns." 

Green Street Advisors Managing Director, Strategic Research David Bragg, whose company does research across the country and in all property sectors and also has an advisory and consulting group, said there is great disparity in real estate valuation now.

"We're seeing retail values declining in the last year, especially in the low-quality mall segment, and rising values in industrial real estate. Those are the two standout sectors."

Cap rates have flattened out in most sectors in the last year, Bragg said, though they have been rising dramatically in lodging, and in the mall sector, which varies greatly according to the quality of the mall. 

For Class-D and C malls, it is likely that many of them will not exist in the near future. The valuation of the top 1,000 malls, by contrast, is strong.

"Our favorite sector, and it has been for some time, is manufactured housing, which is highly fragmented and undervalued. There are a couple of high-quality manufactured housing REITs that we think very highly of."

Bragg said e-commerce, Airbnb and the transportation revolution are key considerations that will affect certain property sectors in the future.

The outlook in terms of asset values for various niche sectors, such as data storage, net lease, self-storage and manufactured housing, are generally better than more mainstream property types, except for industrial, he said. Declining values are expected for malls and office.