What Will the CRE Lending Environment Look Like in 2019?
Top 8 Take-Aways from the 2019 CREF Conference
San Diego, CA February 2019
It was great to visit with many of our lenders at the 2019 CREF Conference in San Diego last week! After gathering our Loan Originators and discussing the tone and topics at the conference, here are some of our most important take-aways:
Backwards Baseball: Last year the general feeling was that we were in the “9th Inning” of the CRE cycle. This year, lenders felt that we are in the 7th or 8th inning (strange game we are playing!). My take on this is that since Chairman Powell announced that the Fed will slow its pace of rate hikes in 2019, the CRE market will continue to behave much like it did in 2018, yet lenders still recognize that we are probably closer to the end of the cycle than the beginning.
Cautious Capital: At the 2017 conference, our life company lenders seemed to have unlimited capital to deploy. In 2018, they said they would be happy lending the same amount as the year before (the same allocations). This year, most life companies had a, “proceed with caution” attitude and few life companies were looking to deploy more capital than they did in 2018 (although most are happy to keep production consistent). CMBS and Agency originators, as well as debt funds, will continue to have unlimited appetites. Although not many banks were present at the conference, our sense is that bank underwriting will tighten in 2019, reflecting their increasingly cautious outlook.
Treasuries Rose: Now Leveling Off. A good indication of where lenders think interest rates are headed is the cost of forward commitments. For as little as 2 bps/mo. added to the interest rate (beyond the first 90 days which are free), our life insurance companies will offer forward commitments to the end of this year. Said differently, for an additional 12 basis points in rate, our life companies will lock in a rate today which will fund in this December (assumes 3/1/19 application to 12/1/19 funding). That’s pretty amazing when you think about it! Several of our borrowers with loans maturing in 2019 have expressed interest in taking advantage of this amazing opportunity.
Spread Headwinds: All CRE debt spreads will face competition from the corporate bond market. Whether you subscribe to the theory that corporate bonds yields are increasing due to the mention of the “R” word, or the theory that increased rates are the result of corporate America stressing their balance sheets with more debt to address robust growth, commercial real estate mortgage spreads will face increased competition from the corporate bond market. Don’t count on CRE debt spreads to decline anytime soon. As of this writing, most 10-year spreads to treasuries range from 130bp – 170bp depending on a number of factors.
Market Prices Unch: The gap between cap rates and long-term borrowing costs is at its narrowest point since 2007. For many multifamily investments this gap is non-existent or negative. Lender underwriting is strained as there just isn’t enough cash flow to service higher levels of debt. As a result, most acquisitions will either be: all cash, involve substantial down payments, be in secondary markets where cap rates are higher, or be storied/value-add deals where the spread between cap rates and the cost of long-term money is largely irrelevant. Buyers will be forced to invest more cash in deals until sellers adjust to the new pricing reality (or until long term rates come down). Life insurance companies will continue to finance acquisitions because the rest of the market has come back to their level of conservative underwriting and they have superior pricing over these competitors.
Pivot to Debt Funds: We heard at the conference that there are now ~150 “debt funds” in the marketplace (a substantial increase from a year ago) and a declining number of CMBS lenders. I define Debt funds as those unregulated, private-equity lenders which include mortgage REITs, sovereign wealth funds, and general pools of debt aggregated from private sources. Debt funds provide non-recourse, interest-only bridge, heavy renovation, and construction lending for medium to large sized projects, and they generally absorb more risk than traditional lenders (and they are paid for it). Spreads in this space have come down considerably over the past year, but costs remain extremely high relative to traditional financing sources (origination fees, exit fees, LIBOR caps, lender’s legal costs, outsourced reviews, etc.). Debt funds will continue to be a popular source of financing for ground up construction, value-add, and storied deals as long as demand for this sort of capital remains high. Based on the number of originators, my guess is that spreads will continue to drop, costs will come down, and the amount of risk they take will go up – all good news for borrowers in this space.
Property Types: It seems as though industrial remains the most desired property type in spite of worldwide trade tensions. Industrial demand is being fed by our increased desire to shop online rather than to going to the store – which shifts demand from retail storefronts to warehouse distribution properties. However, lenders still love well-located, grocery-anchored neighborhood shopping centers. Several lenders shared concerns about certain multifamily markets which have seen significant new supply. Office and self-storage properties are favored but hospitality properties are not.
Opportunity Zones: Lenders are taking a ‘wait and see’ approach to opportunity zone funds and their capital needs. One concern is that investors will overpay for real estate in secondary locations simply to avoid paying taxes. Another concern is that these investment vehicles will end up looking a lot like syndications, which lenders generally dislike. The opportunity zone landscape is still very cloudy and there is still a lot to be learned and studied in this area. My guess is that traditional lenders will be very hesitant to fund land acquisitions in opportunity zone areas, and that traditional construction lenders will be hesitant to fund construction projects in these areas. However, one thing is for certain: some capital source will see this demand and try to fill the gap.
Taken as a whole, it looks like abundant equity capital is chasing very few deals (which make sense due to narrow margins) so there is a push to make deals make sense through value-add deals. Lenders are responding to this demand by shifting toward new and innovative debt products.