Why a Big Capital Crunch Is Coming to Commercial Real Estate

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The commercial real estate industry has become, understandably, fixated on interest rates. The rapid rise of rates, and their sustained elevation relative to the recent past, has upended asset values, bled dry construction loan interest reserves, and frozen transaction volume. The fallout from the precipitous change in prevailing interest rates has been well dissected.

What is brewing on the horizon, however, is another storm that is both related and entirely its own. 

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The fallout from the sudden increase in rates is impacting new loan origination in a variety of ways. Even in the case where loan-to-value (LTV) caps are consistent, net proceeds are being impacted negatively because asset values are dropping. Additionally, proceeds are being suppressed below the LTV caps due to debt service coverage ratio (DSCR) constraints.

Because rates have moved up so much faster than net operating income (a result of both the rate rise outpacing rent growth as well as the increase in expenses due to inflation), assets cannot meet the coverage ratios necessary to achieve their existing loan balances. Further exacerbating the situation, volatility and uncertainty are pushing lenders to look for a greater margin of error by widening spreads and reducing LTVs. The consistent thread here is that less capital is being made available for any given project.  

While the above factors are impacting the national lending market, New York is at the center of this storm. Locally the effects of the capital availability constraints have been magnified because of an unfortunate confluence of events. 

The Housing Stability & Tenant Protection Act of 2019 and the COVID-related work-from-home policies are having a lasting negative impact on multifamily and office asset values, respectively. The two primary asset types in the New York City real estate ecosystem are experiencing steep declines in value then, just as the local lending community experiences a wave of anxiety on the tail of two prominent local bank failures. 

The prevailing sentiment inside the banks, as well as their capital position, are further compounding the purely arithmetic suppression of capital availability. All lenders are concerned with their real estate exposure and are looking to pare it back by allowing attrition from the loan book to outpace new origination. Since attrition is anemic, so is origination appetite. In parallel, bank capital is constrained by the fact that loans are not being paid off. 

Further reducing the availability of capital for lending is the need for growing loan loss reserves. Last, as highlighted by the failure of Silicon Valley Bank, banks are unable to tap capital reserves held in fixed-rate securities for fear of having that portfolio marked to market. Overall, many banks, particularly the regional players, simply do not have the capital available for new loan origination. 

Many loans cannot refinance at their current balance today. This is forcing many, if not most, loans to either get pushed over into a post-maturity holding pattern or receive a cash injection. This phenomenon is widely attributed to the decline in asset values and the impacts on DSCR of rates that are sharply higher than they were at the time that maturing loans were originated. A largely overlooked cause of the crisis, too, is the simple unavailability of capital in the marketplace. That is, a large swath of the banking community is simply not making loans. 

Even with the hoped-for lowering of rates this year, we appear to be on the precipice of a severe capital crunch. As owners are forced into sales and lenders are forced into the disposition of assets they have acquired through foreclosure, the resulting demand for capital from buyers seems poised to face a severe imbalance relative to the available supply. 

As loan extensions start to burn off, those seeking to refinance will also be competing for the same limited capital pool — further exacerbating their plight. Even as rates come down, their gradual descent will not immediately correct for the illiquidity of reserves held in fixed-rate securities, the paring back of loan books, or the need for loan loss reserves. It is only suppressed loan transaction volume that is papering over the paucity of available capital and a very painful deleveraging process that is hovering on the horizon.

Andrew Dansker is the founder of — and a mortgage broker at — Dansker Capital Group.