Where’s the Yield?

The same effect, a shift from primary to secondary market investing and resulting yield compression in secondary markets, is happening on a capital stack level. While investors have piled into equity positions throughout the current cycle, over the last 12 to 24 months the debt side of the capital stack has become increasingly popular.

It is now almost de rigueur for serious equity players to have a debt platform making bridge, construction, mezzanine, or other high-yield private loans. The contemporary thinking is that if one does not want to be invested in an asset at a basis that the market demands, investing via debt allows an investor to enter at a lower basis and trade upside for a smaller, theoretically steady, yield.

In addition to the equity players who have entered the debt markets, many debt firms which geared up for a boom in CMBS lending that did not materialize in the form anticipated have switched strategies to floating-rate private debt offerings. These offerings compete directly with traditional private lenders.

The crush of capital piling into the private debt market has resulted in yield compression in the same way that it has in the secondary geographic and product-type markets. Where 24 months ago private lenders could still command 10 percent yields with 2 points on origination, varying up to 15 percent with 2 points—depending on the asset and its level of distress—long-standing private lenders are now accepting yields as low as 5.75 percent fixed with 1 point at origination. Floating-rate originators are working at Libor plus 250 to 450 spreads, further crowding the field.

The spread between conventional bank debt (5-year) and private debt (1 to 3 year) has shrunk considerably to 100 to 200 basis points. It was only 12 to 24 months ago that a minimum 600-point spread was the market standard. Was that premium driven by the scarcity of capital in the debt markets, or an appraisal of the risks associated with non-conventional lending?

It is possible that private lenders were previously under-supplied with capital and were being over-paid for the risks associated with their loans due to a lack of supply in the marketplace. It is also possible that those now taking the risks associated with debt that does not qualify for a conventional bank loan are being under-compensated for the risks that they are taking.

As much as it is received wisdom that secondary and tertiary markets are the last to rise in an upswing, it is equally well-accepted that the same markets are the first to fall in a downturn. As the premium being charged for participation in those markets is eroded, it seems inevitable to conclude that some players in the market are being under-compensated for the risks that they are taking and will experience losses when the cycle turns.

The equity players that have moved into the debt markets must be careful not to conflate the primary physical geography of their new investment strategies with the secondary capital market position that they are moving into. Moving into the bridge debt market in New York does not necessarily circumvent the non-primary market trap of a late-cycle market because it is in itself a secondary market.

While investors must individually exercise caution, the market as a whole is benefiting from the reduced cost of bridge financing. The above analysis indicates that the cost of buying a commercial property which cannot qualify for a conforming bank loan has become significantly discounted over the last 24 months and investors seeking out these properties are benefiting. The search for yield is filling an important gap in bank debt available for transitional assets. Transitional assets in New York are one of very few asset classes benefiting from a falling cost of financing in the market due to this phenomenon.