CRE Finance May Have Hit Bottom in 2023. What’s Next?
A look at where debt and equity capital is going in 2024 due to recent rate moves
If you were waiting to hear a collective sigh of relief from commercial real estate capital markets, then you probably heard it on Dec. 13, 2023.
On that day, Federal Reserve Chairman Jerome Powell announced that the federal funds rate — the benchmark, short-term interest rate — would remain at 5.25 to 5.5 percent for the foreseeable future, and indicated that as many as three rate cuts could be in store in 2024.
Within hours, the 10-Year Treasury — the benchmark, long-term interest rate used in most commercial real estate transactions — fell below 4 percent for the first time in six months (after reaching 5 percent in October). The immediate drop of the 10-year Treasury, combined with the concomitant rate pause in Washington, pointed to commercial real estate capital markets having hit the proverbial bottom with only one direction to go in the new year.
“I think we’ve reached an inflection point where cap rates and capital markets are starting to catch up with each other,” said Mitch Sinberg, senior managing director at Berkadia South Florida. “I’m seeing transactions start to simmer again. Now, we haven’t seen them close yet, but with rates coming in as much as they have over the last 45 days, we’re starting to see a lot of activity on the acquisition side.”
For the CRE debt and equity landscape, where capital lives by the slimmest of spreads and dies by the slightest price movements, the new interest rate paradigm signals an awakening of sorts after a chaotic 22 months.
“Just having the 10-year back or at just inside 4 percent means that long-term, fixed-rate financing has a 5 [percent] handle, and not a 6 [percent] handle, so it’s very psychologically meaningful for a lot of market participants to have these more reasonable expectations of where they can access long-term debt capital,” said Chris Lentz, executive director of equity, debt, and structured finance at Cushman & Wakefield.
Access to capital is everything in CRE finance, but where the money goes once it’s been raised, loaned, and borrowed is more of a mystery. That’s primarily because over the last 12 months there hasn’t been much movement from which to base prognostications. For much of the past year, capital markets have been stagnate, with industry-wide transaction volumes falling 54 percent annually through the third quarter of 2023, according to CBRE.
Accordingly, capital stacks — the financing structure of all CRE transactions — have been in a state of stasis, largely due to the interest rate uncertainty and the intertwined nature of debt and equity in the makeup of any deal, which resembles a caduceus of capital.
Senior debt — usually a large loan from a bank, life insurance company or debt fund — receives the first payments from the proceeds of any asset. Mezzanine debt — riskier debt — sits just below the senior portion.
As common equity and preferred equity sit in the first loss position, and below the debt, those investment dollars have tended to expect higher returns — typically through cap rate spreads — for their elevated risk. As such, a spread of roughly 250 basis points over the 10-Year Treasury has generally provided the measuring stick for equity cap rate indexes.
But with the 10-year as elevated as it has been, and debt markets hampered by the liquidity pullback across regional banks since the collapse of Signature Bank in March, the increased cost of equity financing, coupled with the lack of pricing transparency, has slowed the appetite of those investors in 2023.
“Real estate yields are priced as a premium over Treasuries or low-risk corporate bonds. In today’s higher interest rate environment, investors expect higher yields from real estate,” explained Maureen Joyce, head of U.S. real estate asset management and equity portfolio management at Barings, a global investment manager. “We focus on cost basis, too, as an equity investor. With higher cap rates, the result is a repricing of assets. That new lower basis now feels better for new acquisitions.”
As for debt, higher interest rates since March 2022 have given lenders increased spreads, or profits, on their loans to borrowers.
“Normally, when you see interest rates tick up, you see spreads come down to remain competitive, but with regional banks and others no longer lending, we have seen this phenomenon that made it more profitable as real estate debt investors,” said Danielle D’Ambrosio, head of real estate debt asset management at Barings.
In fact, debt markets have experienced an opportunity to capitalize on higher yields in ways not seen in 15 years, according to Ryan Severino, chief economist at real estate investment firm BGO.
Consider: The federal funds rate sat below 1 percent from October 2008 to June 2017; the 10-Year Treasury essentially traded below 3 percent from July 2011 to July 2022. By comparison, Powell raised the funds rate 11 times by 500 basis points since March 2022, while a nervous bond market has kept the 10-year above 3 percent since August 2022.
“I think debt investors saw a good opportunity, certainly from a risk-adjustment basis, to say, ‘If I’m worried about interest rate volatility, and the pricing of the interest rate itself, but I can be a higher place in the capital stack and get a pretty attractive yield out of this’ … that’s not a bad place to be,” said Severino.
For the first time in a long time, as strange as it sounds, the capital stack seems to be safe. But this begs the question: Which will be more popular for capital markets in 2024 — debt or equity?
Swimming with sharks
The first rule in understanding debt is that any lender just wants to be paid back, ideally with interest.
Commercial real estate debt is largely originated by banks, but since the 2008 Global Financial Crisis, debt origination from other sources such as life insurance companies and private entities that manage institutional capital, high-net-worth capital and overseas capital has grown.
Others, like Churchill Real Estate, a New York-based debt and equity real estate investor with a $6 billion portfolio, manage super senior leverage, or what is called “sleep at night capital,” the financing positioned in the safest portions of the capital stack.
Justin Ehrlich, managing partner at Churchill, noted that debt is more attractive than equity entering 2024 because borrowers should be able to achieve “equity-like returns,” and bridge lenders, private credit funds and REITs can leverage short-term, repurchase agreements at attractive rates that ensure good returns relative to their risk placement in real estate deals.
“Then you have the debt that wants to make the levered, double-digit returns,” said Ehrlich. “These guys are manufacturing returns through leverage, and they can get those rates right now because banks have pulled back and have given debt funds and mortgage REITs the ability to set outsized rates on loans they are providing because banks are absent.”
Ehrlich added that the debt funds are in a unique position to capitalize on these higher yields, as they’d normally be competing with banks on loan volume, but are now mainly competing with each other amid an industry-
wide liquidity pullback, allowing private credit to name its spread to desperate borrowers.
“In 2024, the banks will have to deal with a lot of the difficult loans that they have, and the regulators that are inside them, so it will give the private credit lenders the runway to take on the majority of that business,” Ehrlich said.
The consensus appears to be that if credit is available, even private credit, there will be ample investors and borrowers out there to make that capital go to work.
Shawn Townsend, managing principal of real estate credit at Blue Vista, a Chicago-based real estate investment firm, said that his firm is “bullish” on having attractive lending opportunities in the first-mortgage realm, specifically refinances and acquisitions, in value-add and core-plus real estate projects.
“We’re looking at really tremendous opportunities to increase our exposure to the debt space,” said Townsend. “We expect there to be a shift in market share, and we think private capital will pick up more market share in this cycle than the other segments. That means better yields, better credit, and more conservative leverage will be the profile for the next 12 to 24 months.”
On the equity side of the equation, things are a little murkier, to say the least.
Because equity is financed by private capital, this capital comes from investors aiming to make higher returns than what lenders expect to receive on their debt loans. As such, equity investors populate the real estate risk spectrum — there are equity investors devoted to the core, core-plus, tertiary and value-add investments, many of whom could be characterized as institutional equity investors. If they’re putting their money into a deal, they want to know their exit cap rate and exit value years in advance. Anything less, and they’ll walk away with their money, and likely their pride.
“Over the last 24 months, we’ve seen institutional equity sit on the sidelines, and make sure they weren’t getting into a continuing declining environment,” Berkadia’s Sinberg said in late December. “But, now, especially over the last 30 days, we’re seeing institutional equity come back into play, and that was not the case in 2023. They’re tiptoeing in, but we think we’ll see them come back in a big way in 2024.”
But there are also the riskiest gamblers, called opportunistic equity. These investors are looking to make multiples on their money and choose projects specifically for the outsized returns inherent in distressed capital stacks. For these investors, distress is not a dangerous word. If anything, it’s an enticement.
“We see a big opportunity in earning equity-
like returns working with borrowers who need to recast their loan,” said Daniel Carr, co-founder and managing partner of Alpaca Real Estate, a private equity real estate firm. “When their old loan was maybe 75 percent [loan-to-value] and their new loan is 55 percent, that 20 percent gap is probably going to be filled with equity or preferred equity.”
Two places in the capital market widely considered appropriate for equity in 2024 are construction lending and new development financing.
“It’s still more attractive to develop from an equity perspective than it is to buy, as you get a better return on cost profile,” said Townsend, who emphasized that this phenomenon is driven by a lagging transparency on values. “If you’re developing an asset, you control the variables and can generate a good return on cost, versus getting in a bidding war on an asset that drives your cap rate down because of a wider bid-ask spread.”
Barings’ Joyce said that construction lending could be an attractive space for equity in 2024, especially to fill gaps at an attractive basis for brand-new assets emerging from construction.
“Those three-year loans are often construction loans, so as those construction loans mature, there could be an opportunity to step in and provide that gap equity,” said Joyce.
Others, like Josh Zegen, co-founder and managing principal at Madison Realty Capital, take a more contrarian approach. Zegen said that the settling of interest rates will drive demand for equity next year, but the development market, for the most part, is still “locked” due to elevated interest rates.
“The long-term rates have come down, but floating rates are still very high,” Zegen said. “Typically construction lending is at floating rates, so that will take some time to settle in before people are building in a big way.”
By now, it’s clear both debt and equity will experience increased activity in 2024. But where this money goes will be the determining factor in the near-term health of CRE capital markets.
No assets are more in need of rescue capital than those financed by debt originated under the quantitatively eased Obama administration in 2013 and 2014, or those built by cheap, floating-rate dollars pegged to the sub-1 percent, emergency interest rates of the early pandemic.
The culprits most guilty of partaking in this floating-rate loan extravaganza are primarily multifamily developers and syndicators — Tide Equities, Nitya Capital, Western Wealth Capital — and their problems have been widely publicized. But the common thread of these ownership groups and other developers is that they used floating-rate, short-term debt to lever themselves amid a pandemic-era buying spree, and now they can’t make capital calls two to three years later at the higher interest rate underpinning their maturity timeline. They need to recapitalize, and they need fresh debt and equity to do it.
“The typical profile of a multifamily deal and CLO [collateralized loan obligation] loan that was placed during this peak cycle over the last several years is higher leverage, north of 75 percent or 80 percent, with future fundings for value-add rehab,” said Jeff Erxleben, president of debt and equity at lender Northmarq. “Most of the collateral is good real estate, it’s well performing, it’s just an issue of having a capital stack that doesn’t work.”
Erxleben explained that the underlying cost of capital for so many of these CLO loans was tethered to the secured overnight financing rate (SOFR) — the interbank lending rate — at a spread of 300 basis points or higher. So now that SOFR sits at 5.31 percent, these loans are maturing at an 8 percent or 9 percent clip when they were underwritten to perform when SOFR was less than 1 percent.
“Then there’s [interest rate] cap replacement cost, and they’ve increased substantially, so that’s a trigger event for CLO loans,” added Erxleben. “Those cap [replacement] costs are significant, so when you see cap costs roll off, or there’s been some modification done to the loan, ultimately there will be a sale, and I think those buying opportunities will be pretty good.”
Floating-rate multifamily portfolios are not alone in their requirement for rescue capital. Debt lenders made billions of dollars in office loans 10 years ago at 4 percent interest rates, and are watching in horror as their fixed-rate loans are coming due amid an apocalyptic office landscape.
CBRE forecasts the national office vacancy rate will peak at 19.7 percent in 2024.
“You have a maturity cliff of properties that you thought were safe, like office, that need to be worked out,” said Barings’ D’Ambrosio, who emphasized no lender is alone here. “So some of your liquidity is tied up in old problems, yet you really want the liquidity to take advantage of this unique market that you have today on the debt side.”
Several premier office properties have already been sent to special servicing, and are either nonperforming maturity defaults or imminent maturity defaults.
These include Aon Center at 200 Randolph Street in Chicago and its $677.5 million nonperforming debt; Gas Company Tower at 555 West Fifth Street in Los Angeles and its $465 million in nonperforming debt; 1100 Wilson Boulevard in Arlington, Va., and its $249.9 million nonperforming debt; and IDS Center at 80 South Eighth Street in Minneapolis and its $182.5 million in performing, matured debt, according to CREDiQ, a CRE data research firm.
“Equity will be very challenging coming into [office] deals,” said Zegen. “While the interest rate environment will become more of a known than an unknown, the absorption, the demand of tenants, the three-day, hybrid work environment … . The jury is still out on what that looks like in terms of the demand for office. It’s not just about interest rates.”
Others with the investment capital handy to rescue these assets don’t appear to be champing at the bit to rescue the capital stacks of that particular asset class.
“We like investing at a reset valuation in assets that have strong underlying tailwinds,” said Alpaca’s Carr. “Plenty of office buildings in New York will go into foreclosure, or rent-stabilized housing is going into foreclosure, and I have no idea how to solve that so we won’t invest there.”
Still, as thousands of properties across the CRE landscape struggle to meet debt service coverage ratio and debt yield thresholds, the long-awaited reservoirs of debt and equity capital so often missing in 2023 appear ready to come to the rescue.
“I wouldn’t call it major distress. It’s a resetting of basis,” said Sandy Schmid, director of acquisitions and development at StarPoint Properties. “There’s so much capital on the sidelines — that’s going to stop prices from free falling.”