The Commercial Real Estate Finance Council (CREFC) Annual Conference took place in Washington D.C. last week and the best way to describe the mood around US commercial mortgage markets was “measured optimism.”
As participants debated where we are in the current real estate cycle, there were differing opinions about where opportunities exist for debt and equity investors. Using the hackneyed baseball analogy, some thought we were in the late innings, while some think we are already in extra-innings.
Everyone we spoke to offered that now is a time to be careful – “risk-off” in trader-speak. Most agreed that overall CRE fundamentals are stable, while some acknowledged concerns around older malls and retail centers, the lodging sector and overbuilding of luxury apartments and condos in certain markets.
Among the different constituents in attendance (banks, Wall Street/capital markets, non-bank lenders and investors) there were notably different outlooks:
- Banks: For the most part, banks are sticking to their knitting though they will compete for deals they really want. In local markets, they can cherry pick the best deals, though they have ceded ground to the agencies for multifamily lending. Some of the largest banks are starting to back-off of larger construction deals (or are syndicating out most of their exposure) which has created opportunities for non-bank lenders.
- Wall Street: CMBS conduits are having a bit of an existential crisis. By the time 2017 is over, the much-discussed “wall of maturities” will have been vanquished, without incident we might add. What will be the next source of product? Issues related to servicing and capital markets uncertainties have left the CMBS industry without a clear raison d’etre.
- Private Lenders: Private lenders including REITs, funds and marketplace lenders have created products to address gaps in the capital stack that banks and CMBS cannot fill. The availability of mezzanine debt and preferred equity has helped moderate the wall of maturities when first lien debt would not work in isolation.
- Investors: In this era of excess liquidity, investors are struggling to find compelling investment opportunities. Many equity investors have shifted to the high-yield debt markets, where they are content to collect a relatively fat coupon while someone else bears the equity risk. Undoubtedly some investors are waiting patiently for a macro-economic or geopolitical event to create some buying opportunities. In the one of the more interesting comments of the conference, a national bank lender described a public employee pension fund – traditionally a “core” (stabilized) property investor – that had been funding construction loans on properties they would eventually add to their core holdings. This trend was called “build to core.”
Property Type Commentary
At a high level, leverage remains low and underwriting assumptions are generally in-line with 2016.
- Multifamily: Demand for rental housing remains healthy. As millennials come of age, they want to preserve their job mobility and need to pay off student debt and are thus choosing to rent. However, overbuilding is becoming a concern in “gateway” cities where apartment building completions are at the highest levels in over a decade. Rent growth (though already starting to slow in some markets) is growing faster than wage growth – clearly not a sustainable paradigm.
- Retail: The future of retail was a primary topic of discussion with a consensus that the existing inventory of brick and mortar retail exceeds consumer demand. Some investors remain comfortable with grocery anchored retail, but Trepp recently issued some cautionary commentary.
- Office: A lot of discussion around whether the trends toward urbanization, co-working and telecommuting have made suburban office an obsolete property sub-type. The consensus was that the risk is binary – each property must be reviewed in isolation to determine whether it is viable or not.
A Few Words on Construction Lending
Banks have gotten more conservative in most markets and many have retreated to 60% leverage, required completion guarantees and stricter liquidity requirements. However, in some non-gateway markets including Nashville, Austin, Seattle and Raleigh, the spigot is still open for multifamily development loans.
While some banks are moving out of construction, some are comfortable with mini-perm/bridge, so the there is plenty of take-out financing available. Interestingly, this availability of earlier-stage bridge/interim financing is making construction loan performance appear better than it may actually be.
Outlook for Commercial Mortgage Finance
With inflation remaining lower than the Fed would like, there does not seem to be a compelling reason why long-term rates would jump from the mid-2% range. While the real estate cycle is mature and perhaps due for a correction, there is less leverage in the system than before since central banks have absorbed so much of it. Sales volumes are slowing, for now, possibly constrained by a lack of supply – there is certainly a robust supply of capital to finance good deals.
The markets for CRE finance are dynamic. Different types of lenders enter and exit the market based on a broad range of factors. Modern Funding has relationships with many types of lenders with a variety of loan products across the credit spectrum, so we always have lenders who are actively seeking good projects to finance.