Banking on a Lender: What’s Different This Time Around?
As COVID-19 gathered momentum in the U.S., commercial real estate financing paused. Within the space of three weeks, the debt markets went from a red-hot scene with firms jostling for space — and yield — to a party everyone had left.
Many lenders immediately battened down the hatches and went into asset management —or triage— mode, focusing on the health of their current portfolio and any trouble spots that needed immediate attention.
New transactions that had been signed up pre-COVID closed for the most part, provided that lenders’ ducks were already in a row. After all, the pandemic stripped away the ability to fly to different deal locations, meet with new potential customers or even walk properties. Some unlucky borrowers saw the lender on the other side of the negotiating table re-trade them, or walk away from their deal altogether.
A decade of training
During the Great Recession of 2007 to 2009 it was the banks that retrenched; their risk-taking paired with the collapse of the subprime mortgage market leading to a crippling downturn that culminated in multiple bailouts and the demise of Lehman Brothers. The regulators acted swiftly, implementing a sweeping regulatory reform of the entire banking industry to ensure future market discipline and capital regulation.
Following the 2008 credit crisis, banks were required to maintain strict minimum capital requirements and leverage ratios. Under Basel III specifically, a bank’s tier 1 leverage ratio must be at least 10.5 percent of its risk-weighted assets.
And, for the most part, it worked. Thanks to measures implemented by those regulators in 2008, the banks have so far been better prepared to withstand the blows dealt by COVID-19.
According to a CNBC report last week, nearly all of the largest U.S. banks — including Citigroup, J.P.Morgan, Morgan Stanley, Bank of America and Goldman Sachs — said that they performed well enough on the Federal Reserve’s most-recent stress test to maintain their quarterly dividend. (Wells Fargo, on the other hand said the test will warrant a reduction to its quarterly dividend). A drastic improvement since 2008.
The majority of the lenders who spoke with Commercial Observer for this article did so on the condition of anonymity as they’re weighing in on their competitors.
“The global financial crisis had lots of things going on, but it was ultimately a bank crisis and a strain on balance sheets,” said one head of CRE lending at an investment bank. “What has become evident over the last couple of months is the new capital rules have resulted in banks being fantastically well capitalized. They’re absorbing a really bad, quick moving event.”
The debt funds, whose proliferation buoyed lending post-Great Recession, had a different experience, especially those who were over-levered and heavily reliant on warehouse lines. A prime example of this model as COVID-19 took hold was TPG Real Estate Finance Trust, who eventually was recapitalized by Starwood Capital Group in late May. Market volatility spurred by the virus forced the non-bank lender to sell off $1 billion in assets in order to meet intensifying margin calls.
“This was a tough quarter,” said Greta Guggenheim, the CEO of TPG REIT, on its first quarter earnings call. “We recorded losses of $203.5 million from the sale of our CRE CLO portfolio. There is no way to sugarcoat this. Based [on] the extraordinary disruption to the markets and no timetable for recovery, we made the decision to eliminate additional securities margin call risk, all of it, by selling our entire bond portfolio.”
The firm de-risked its balance sheet using a mix of the asset sale, the Starwood investment, and a voluntary deleveraging of its repo and warehouse borrowings secured by a portion of its first mortgage loan investment portfolio, according to a person familiar with the firm’s thinking.
“How they funded their balance sheet was not great,” the CRE lending head said. “It was okay in a low-volatility environment but in a high-volatility environment the stress was felt and really caused lots of problems…almost to the point of systemic problems. The debt funds’ weakness and their growth in some of the residential mortgage and commercial real estate markets in an unregulated fashion — not regulated the same way we are — definitely was a lesson. I think the [non-bank lending] industry is going to change quite dramatically going forward; how we bank them and how they attract investor capital. They’ll be a lot less competitive.”
Debt fund Ladder Capital, led by Brian Harris, also found itself tapping another firm for liquidity. The firm inked an agreement in early May with Koch Real Estate Investments, an affiliate of the Charles Koch-led Koch Industries, for $206.4 million in senior secured financing, according to a company announcement.
“There has always been concerns around how debt funds and mortgage REITs’ capital is put together…how their balance sheet is funded,” another banker said. “COVID-19 put substantial strain on them. The mortgage REIT industry was probably worst affected by this crisis and some of them will probably never recover. Their market values are a fraction of what they were.”
Officials at TPG REIT declined to comment. Officials at Ladder Capital couldn’t be reached for comment.
Sources that CO spoke with said that in order to continue to exist going forward, any debt funds and mortgage REITs that were once highly-levered will have to run at much less levered levels, which ultimately means slower growth for them. “All that will, I think, push business back towards the banks, which just handled stress tests exceptionally well. Second quarter bank earnings are looking pretty good even despite COVID,” the banker said.
To be sure, both the banks and debt funds are still in the early innings of the coronavirus crisis. In response to loan troubles, many are kicking the can down the road by offering short-term forbearance. And executives noted that the real stress for the industry may be just around the corner, striking in the late summer or the fall, once funds from the Paycheck Protection Program run out.
All debt funds are not created equal
Before the crisis hit, the lending playing field was actually pretty flat. Financing sources competed with one another, often on structure rather than pricing towards the end of the cycle. Debt funds’ beginnings came from hard money bridge lending and their returns once reflected that. But in the two years running up to COVID-19, debt funds — under pressure to deploy capital and continue lending in a hyper-competitive environment — saw yields deteriorate. In order to possess lower costs of capital and make loans at attractive price points, some leaned heavily on warehouse facilities and short-term repo lines from banks.
It’s what got TPG in trouble and over the past few months, lenders CO has spoken with said they had to step in to fund loans that other lenders — including Ladder Capital— had initially started but couldn’t fund.
“If you deal with the debt funds, maybe they had slightly better pricing or whatever pre-crisis,” a senior vice president at a traditional lender said. “And then you go through a crisis like this and you’re like, ‘Well, okay, maybe I need to think about other components of making a decision like that again.’”
Not that every debt fund can be tarred with the same brush. Those who maintained discipline and weren’t over-levered are among the few still lending through the pandemic and able to capitalize on opportunities that arise.
“We understand the businesses of our competitors who have had liquidity problems,” said one head of a debt fund. “Because we managed ourselves prudently, knowing the mistakes of the past, and history tends to repeat itself, I think we were able to see those mistakes brewing. People were being pretty exuberant in pricing over leverage and using these warehouse facilities. We’ve always avoided those types of mistakes. It doesn’t mean they had bad assets or bad loans, they just made a bunch of mistakes.”
The debt fund head went on to say: “Many of our competitors are unfortunately hobbled, and so we can afford to be very deliberate, very choosy about the types of situations we may entertain going into.”
Lending, but still conservatively
“The banks have been great during this crisis, and I think that part of that has been enabled by and a lot of that credit goes to their regulators,” said Andrew Dansker, founder of Dansker Capital Group. “Early on, a decision was made not to classify modifications made during this crisis as TDRs [Troubled Debt Restructures] and the regulators gave the banks a tremendous amount of leeway to work with people and not start to sell off distress loans, which we haven’t seen a whole wave of, and not to take extra reserves and impact profitability in the way that they might have had to otherwise. The freedom that they were given from the regulatory perspective really enabled them to step up to the plate, which they have almost across the board.”
Although nobody expects that leniency from the regulators to go on forever, one banker noted.
“There are certain banks that are hyper client focused, customer-focused,” said Dustin Stolly, a co-head of Newmark Knight Frank’s debt and structured finance practice. “So you might say those banks are more borrower-friendly. Obviously the [Great Recession] was really a crisis of liquidity and over the last dozen years, banks and life insurance companies have had consistent drivers and stayed true to their underwriting criteria.”
That criteria comprises a conservative approach to lending, so sub-65 percent leverage and structural features that are less aggressive than your traditional CMBS loan.
The leverage offered is another big improvement since the Great Recession. As George Gleason, the CEO of Bank OZK recently told CO: “As of March 31, the end of the last quarter, if every loan was fully funded in our RESG [real estate specialties group] we would have been at 50.4 percent weighted average loan-to-cost and a 41.5 percent weighted average loan-to-appraised-value. Going into the Great Recession, we would have had LTVs in the 60s, say 68 percent LTV plus or minus was our typical loan to value and a 71 or 72 percent loan-to-cost basis. So we are roughly 22 to 26 percentage points below that now.”
“Now, have [the banks] jumped all over new business in the last four months?” Stolly said. “No, but they’re servicing their core clients who have an absolute need for financing right now— otherwise those borrowers wouldn’t be in the market at all.”
Stolly said that what he has noticed in some of his debt arranging assignments is that foreign banks have been more receptive to new business than the major domestic banks.
Indeed, while big deals have been few and far between over the past few months, the foreign banks have stepped up for club deals. When Brookfield Properties and Douglas Development refinanced construction debt on 655 New York Avenue in Washington, D.C., it was Crédit Agricole, Standard Chartered, Helaba and BayernLB who provided the $500 million loan. And when SL Green Realty Corp. had to secure a $510 million refinance for The News Building after the building’s $815 million sale to Chetrit Group fell through, Aareal Capital Corp. — a New York-based subsidiary of German financier Aareal Bank — and French lender Crédit Agricole joined Citigroup in the lending syndicate.
“We’re better positioned certainly than the last time around,” said one head of a foreign bank’s CRE. “I think what’s been interesting though is we had fourth quarter disruption in the capital markets a couple of years ago and the bank lending market for commercial real estate, didn’t move a basis point, it just kept plugging through traditional ‘hold on balance sheet’ lending. It was business as usual, while we had probably a quarter and a half to two quarters of dislocation. This time around, CMBS has come back but the traditional bank lending market, like these big balance sheet deals the Blackstones or the Brookfields would get, are much more difficult right now to put together. And a lot of people think they won’t really open up until the fourth quarter.”
“The regionals and then some of the foreign banks have become more active,” he continued. “But their shortcoming is they’ll come in and say, ‘You have a $500 million deal? I’m good for $100 million and you go find the other $400 million.’ There’s still a disconnect there, but it’ll work its way through.”
With regard to who’s stayed the most active during the pandemic, Stolly said “commercial banks and life insurance companies — selectively not all of them — have remained active for their core clients through the crisis. And the GSEs have really filled a pretty meaningful gap and have had a very busy few months. Rates are very low, remarkably low, so [Newmark’s] agency guys have been slammed.”
Another real estate lending executive at a major life insurance company recently told CO that with many lenders on the sidelines, Freddie Mac and Fannie Mae are moving freely within their established loan purchasing pipelines and really dominating the multifamily finance space at a time when the subsector is hungry for liquidity. The lending executive said that they had learned from a sizable brokerage firm that in one week in mid-June, the brokerage put 26 multifamily loan deals under application, 21 of which were taken by the agencies. “They’re on fire,” the lending executive said. “They’re getting really good execution on the securitization side.”
As for the debt funds, “we’re certainly going to see a thinning of the herd,” Stolly said. “As a new normal is reestablished and many borrowers have requested and been granted forbearance for 90 or 120 days, I think there will be far less economic growth and additional strain on lenders — specifically the finance company universe in the third and fourth quarters. Their core business is writing bridge loans and the finance companies are, again, leveraged businesses.”
Stolly said it will be interesting to see how the relationship between the finance companies and their warehouse lenders plays out over the duration of this year as the economy reopens during the initial forbearance period.
“In our conversations with most of them, they’re working through modifications with their borrowers,” he said. “They are also creating war chests for potential margin calls in the future and for the most part they’re preserving capital for that and deals that don’t really have a bridge loan concept attached to them. They’re more focused on cash-flowing deals. The finance company universe hasn’t been tremendously active, they’ve just kind of been preparing for the next leg. And the balance of the year is going to determine what happens. The larger, more well-capitalized players are going to be in the driver’s seat relative to maybe some of the smaller mid-market players.”
While the CMBS market was effectively shuttered during the first weeks of the pandemic, Goldman Sachs and Citigroup were the canaries in the coal mine when they came to market with the $771.8 million GSMS 2020-GC47 conduit deal in May. The offering, which was limited to the deal’s more senior bonds, was met with high investor demand, a mix of cash waiting on the sidelines and a lack of supply buoying appetites. Working in the deal’s favor was a limited amount of retail loans and zero hotel loans.
“It was a great deal to go out and reopen the conduit markets,” said one CMBS executive. “The collateral was relatively sheltered from the impact of COVID and it gave the market a lot of confidence that there would definitely be investor support for good product in good sectors.”
Not only that, CMBS lenders breathed a sigh of relief that they could finally move their product, which had been sitting on the sidelines, waiting to be securitized.
“I think the last time, banks were part of the problem, and this time I like to think we’re part of the solution,” the CMBS executive said. “It was mandated by regulatory reform that banks be very well capitalized so they can weather a storm and so this time around the banks were never really closed. It’s allowed us to manage through this crisis and be patient. A couple of debt funds got stung, but that hopefully came and went and now there’s talk about some non-performing loan portfolios popping up, in lodging and retail. But that said, there’s no comparison between the health of the banking and finance sector now versus the last downturn. Thank God for that, right?”