To say the outbreak of the COVID-19 pandemic took many in America, and around the globe, by surprise is certainly an understatement. The necessary government-mandated response to combat the virus sent shockwaves throughout the financial system. The stock market and oil prices plummeted, and availability of investable capital has become (and remains) scarce as fears of massive unemployment and the shutdown of production factories have grown. A system of robust financial markets that most people take for granted had come to a momentary halt.
The Federal Reserve stepped in by both lowering the target federal funds rate and pledging to buy billions of dollars of Treasuries, investment grade corporate bonds, mortgage-backed securities as well as other securities, in addition to its massive Small Business Administration funding program, to ensure that there is sufficient liquidity to allow individuals and businesses to weather the storm caused by this unprecedented time.
Much of the medi proclaimed “all-time low interest rates,” which may be true for someone looking to finance consumer debt or take out a mortgage on a home with a loan guaranteed by a government or related agency. Commercial real estate, however, has been a different story.
Commercial real estate lenders have been more hesitant to lend, in large part because there is greater uncertainty in the economic outlook than usual. While this uncertainty may prove to be an opportunity for equity investors with cash on hand to capitalize on distressed assets, lenders are not compensated for upside and are all too aware that they can partake in the downside. Many local and regional banks in New York City and the surrounding areas have have taken a “wait and see” approach. The banks that have continued to lend are, in most cases, requiring some form of payment reserves held in escrow, lowering previously high loan-to-value thresholds and, in some instances, are asking for some degree of recourse. Just a few months ago, this would not have been the case. This trend ultimately will apply downward pressure on equity returns.
Other lending markets that rely on off-balance sheet financing, such as the CMBS market, have experienced capital calls and a shrinking pool of investors in the capital markets. This has resulted in a complete shutdown of new CMBS issuances and freeze in new CMBS loan originations. It is worthwhile to note that off-balance sheet financing has funded a large portion of hospitality, retail and office assets across the country, and significant challenges may exist in the near term for owners who are looking to refinance those assets.
Private lending has seen a surge over the past few years due to increased demand for real estate as a safer, target asset class. Until the pandemic, this trend has allowed many active operators looking to buy and renovate properties to find attractive short-term or “bridge” mortgage terms. This surge has been fueled in part by the fast-growing CRE collateralized loan obligation market, which, similar to CMBS, relies on off balance sheet financing and has experienced the same temporary shut-down. Other debt funds with private capital have more flexibility and discretion over their investment decisions, so while they have been willing to lend, they face much less competition and have begun to ask for higher rates at lower maximum leverage points. Active operators looking to execute a “value add” business model may find it difficult to source attractive financing terms.
While there has been much doom and gloom as of late, a few asset classes that have maintained relatively active lending markets including industrial warehouses, medical office, multifamily and select retail and office. These loans will likely include some of the same strict requirements mentioned earlier. The real estate capital markets have effectively halted investment in most retail and hospitality assets and, to some degree, office, as these asset classes have seen a disproportionately negative impact as a result of consumers staying home and avoiding shopping and travel.
Uncertainty is always present in markets. This global pandemic has made this fact more salient and top of mind for lenders and equity investors alike, which has led to a broad reticence in the lending markets. Although often at the forefront of our daily thoughts, the commercial mortgage market pricing happens within the confines of supply and demand. While demand for loans may have remained at levels similar to before this pandemic, the supply of loans available has seen a sharp decline. The lower supply of lenders likely gives those who are active more negotiating power and may allow them to offer lower leverage at higher rates. It appears thus far that, for commercial real estate borrowers, when they have been able to secure financing commitments, they have been asked to pay a higher “price per pound” of debt.
Andy Weiss is a commercial mortgage broker at Dansker Capital Group.