Meet the New Normal in Commercial Real Estate Investment
For most of the last 15 years, the real estate and real estate capital markets have benefited from crisis management. The Federal Reserve, by keeping interest rates very low and generating demand, ensured asset valuations could keep climbing. Recently, in reversing course and sharply raising the federal funds rate, however, it has signaled that its assistance has a limit.
As a new normal comes into view, many real estate sponsors and investors will revisit their capital strategies to adjust accordingly. More flexible financial arrangements such as preferred equity and mezzanine financing can help vent the pressure building on assets that were financed at low rates and higher values. If sponsors, investors and lenders can step up cooperation and postpone exit plans to better position projects for changing conditions and opportunities, perhaps more severe outcomes can be avoided.
In 2022, the real estate and real estate capital markets suffered their third major disruption in just 15 years. The Global Financial Crisis, the COVID-19 pandemic, and recent inflation rates at 40-year highs are the proverbial black swans of finance. The first two comprise a crisis era for real estate markets that triggered the Federal Reserve’s strong response in an effort to avert greater economic turmoil, until last year when inflation roared to life and ushered in a problem real estate markets haven’t grappled with for years: liquidity draining out of the system.
The rise in interest rates over the last year and resulting market disturbances have already produced some troubled assets. As liquidity from banks recedes due to regulatory and internal underwriting constraints, buyers wait to try and take advantage of that distress, private equity assembles debt funds to go after vulnerable borrowers and assets, and pressure increases for owners to get more inventive to adjust their capital stacks. This is especially true for those with maturing or variable-rate loans, as well as funds facing mounting redemptions from investors.
Loan extensions, workouts and forbearance agreements are typically the first line of defense and can provide critical relief, especially for properties with otherwise strong fundamentals. Should persistent inflation lead to a sustained period of higher rates during which asset valuations drift lower, other capital strategies such as mezzanine loans and preferred equity may become more desirable. In some cases, this will be required to reduce the senior loan-to-value ratio to persuade senior lenders to remain in a project. In others, it may be better to seek alternative capital.
Mezzanine loans and preferred equity have been the go-to subordinate financing for owners in need of additional funds to restructure and/or recapitalize their projects with an eye to obtaining more workable terms from banks on senior loans. Both, especially preferred equity, offer customization flexibility that can benefit all stakeholders. Mezzanine loans are widely viewed as more standardized, less complicated and, as a result, more marketable.
With mezzanine loans, tax issues are less daunting than preferred equity, which tends to have more variables. As debt, however, mezzanine loans can raise issues of approval from and coordination with senior lenders, never mind other issues such as relatively short-term maturity and monthly principal payments.
Preferred equity typically offers more flexibility than mezzanine loans, including the potential for the capital provider to structure its return in numerous ways and/or for the sponsor to realize additional time and liquidity to stabilize its project. Preferred equity tends to be more expensive, but as the real estate markets adapt to the new normal, increased flexibility afforded by preferred equity may be worth it for projects that need more time to regain their footing. Moreover, competition among nonbank lenders may put some downward pressure on the cost and other terms of preferred equity and mezzanine capital.
Until last year, real estate investors were accustomed to a tonic of low interest rates, ample liquidity and rising asset valuations, as the Fed held interest rates down and purchased hundreds of billions in commercial and residential mortgage-backed securities. Now, the era of seemingly limitless stimulus may be gone for good, as inflation has exposed its limitations. Real estate markets, as a result, could be adapting to the new financial environment for some time.
To return to an equilibrium that fosters sustainable investments and returns not so tethered to cheap money, it appears the real estate markets will need to be liberated from a fair amount of senior debt. Such liberation can come fast, to the detriment of equity holders, or slow. Investors obviously prefer the latter, and how best to achieve that to ensure future returns will be a key challenge in the new normal.
Joseph Sellars is a senior attorney in the real estate department and real estate finance group of law firm Ballard Spahr.