Adapting to a Shifting Market and Mitigating Uncertainty

As an alternative lender originating loans for a variety of commercial real estate projects nationwide, our firm has seen a wide range of scenarios. More specifically, transactions involving loan modifications, workouts, flexible capital structures and properties in transition. Through these experiences, one thing has been clear: Regardless of the market landscape, successful lenders and sponsors must be exhaustively prepared to work within any type of unique scenario. But as the market potentially moves toward becoming less robust in the near future, and short-term lending under special circumstances becomes more pervasive, how will firms adapt to avoid the turbulence that so many felt throughout 2008’s Great Recession?

Sponsors and investors will need to carefully consider their ongoing and future projects. Deals already under a high level of scrutiny will be even more rigorously analyzed in tandem with local market fundamentals and future forecasts. This will make it more difficult to find attractive deals, and the quality of each transaction may suffer, leading to more high-risk assets and increasing the necessity of due diligence on all sides.

In a weaker market environment, the focus will shift to understanding which industry players have staying power and which have foreseen a downturn from atop the current cycle’s precipice. Borrowers will need to place even more importance on working with a real estate-oriented lender with deep experience in asset management. The shortcomings of alternative lenders that have grown too fast, have not handled their capital well, have struggled to locate viable sponsors, or can’t meet the demands of incoming capital will be highly accentuated. It will be even more essential for these platforms to fortify their infrastructure and technology prior to lending against significant projects.

Even in today’s market, which is still vigorous despite early signs of tightening, there are many lenders getting into the space without the necessary experience or real estate proficiency to correctly manage capital for sophisticated sponsors. If the market slumps, these types of firms will have continued difficulties, and ultimately may not survive. The strongest lenders will be those that understand the idiosyncratic nature of commercial real estate assets and that prepare for the unforeseen. A lender with appropriate real estate expertise understands that a property’s location and cost basis with relation to the sponsor’s business plan — as well as to comps in the surrounding market — is paramount. For these reasons, lenders must prepare beyond a planned exit strategy and cushion each deal with fiscal and chronological fail-safes to combat potentially diminishing market conditions.

Another critical aspect of each and every transaction is the origination process itself. In a changing market, borrowers will seek lenders that employ a tested process that ensures swift execution. By outsourcing various procedures over the course of an origination for a transitional property, overall performance will suffer, leading sponsors toward those with proven methods and more familiarity with these unique situations. Some lenders pay less credence to the overall process with the intent of making loans on transitional properties as quickly as possible, attempting to capitalize on those they hope will default so they can someday own the asset.

Heading into a less substantial landscape, properly allocating capital will be an arduous task for those without the proper infrastructure or real estate fundamentals to handle special situations, especially as it relates to transitional properties that require a greater degree of flexibility and creativity. These possible circumstances may also raise questions around how best to handle a default situation, in which case lenders must find a feasible path forward. The national market is already seeing an increase in defaults compared to three to four years ago, and this trend will only progress further in a market downturn, making it vital for lenders to increase their adaptability.

In 2019, many interpret our environment as similar to the period prior to last decade’s Great Recession. While there are some parallels to draw, we have learned several lessons that will help those in the commercial real estate sector cope with potential instability. For instance, we have a greater understanding of the necessity of having in-depth real estate knowledge and the foresight to successfully insulate projects from a down market. While the Recession saw more restrictions on capital in the market, today we see an abundance of cash flow; while this makes it seem like everyone can prosper, the reality is that there are more entities taking on risk despite being aware of the historical implications — making appropriate precautions even more important. Lenders must operate with enough of an interest reserve to weather the storm, and all must be aware of which markets have the most potential to bounce back quickly.

While the commercial real estate market has been relatively stable for over a decade, we are at the tail end of the cycle. An eventual downturn may be inevitable, the degree of which is unpredictable; however, we in the space can engage in the necessary steps to increase the chances for project success and for the sustainability of our businesses in the face of the unknown.