By Taylor Williams
After months of disruption and uncertainty, commercial lenders throughout the country and the Northeast are eager to deploy funds, creating an environment in which borrowers are somewhat insulated from economic and geopolitical forces that threaten to derail the recovery.
With interest rates still at historic lows and investors of all types looking to recoup returns unexpectedly lost to COVID-19, there is tremendous liquidity in the market.
There’s also the simple fact that lenders are for-profit companies with expenses to cover. As the saying goes, if “they’re not lending money, they’re not making money,” and they’re losing market share. As a result, sources say, lenders are competing among themselves to finance deals. When lenders compete, borrowers win.
“The overall level of capital flowing into the U.S. commercial real estate market is equal to or greater than where it was pre-pandemic,” says Matt Swerdlow, director of capital services at New York City-based intermediary Ariel Property Advisors. “Right now, there’s more capital than deals, so borrowers can get better spreads, higher proceeds or less structure just because the availability of capital is so broad.”
“Despite the fact that we’re in a post-pandemic market, it’s heavy competition for deals, which has done nothing but make us sharpen our pencils in terms of rates,” concurs Mike Cleaver, managing director at Emerald Creek Capital, a New York City-based bridge lender.
In Cleaver’s view, the fact that capital markets maintained healthy liquidity throughout a global crisis — minus a 60- to 90-day pause in the beginning — suggests that the lending community has learned from past mistakes.
“It’s very different from 2008, when there was no liquidity,” Cleaver says. “The banking industry and the overall attitude toward debt and leverage changed after that. Investors want to avoid being overleveraged when things come to a halt, so they’ve kept more reserves. As a result, when the pandemic hit, many investors were still well-capitalized.”
To be sure, COVID-19 unquestionably dealt the U.S. capital markets a unique set of challenges. The pandemic destroyed parity between certain property types and imbued high levels of risk — sometimes perceived, sometimes real — in certain assets, including office, retail and hospitality.
In addition, the pandemic forced many lenders and investors to temporarily sideline themselves and prompted the federal government to hurl trillions of dollars of relief and stimulus money into the economy, setting the stage for an inflationary period.
But there is a positive byproduct of the multiple months of frozen capital, tabled deals, periodic panic selling and hyper-elevated scrutiny on certain deals. Up the chain, from consumers to tenants to landlords to lenders, everyone is trying to make up for lost time. For investors, that means capital is plentiful and cheap, and that’s enough to drive deal volume.
According to the latest data from Real Capital Analytics, the total investment sales volume across all U.S. commercial assets in the second quarter was $144.7 billion, a 176 percent increase over that period last year. With the exception of office (92 percent), every asset class saw at least triple-digit growth in its total sales volume between the second quarters of 2020 and 2021.
Inflated Fears?
The U.S. consumer price index rose by 5.4 percent between June 2020 and June 2021, its highest 12-month increase in 13 years. But the extent to which headlines and reports of inflation are impacting confidence varies from one investment firm to the next. The degree of concern is also a function of what kind of assets said investment firm holds in its portfolio.
“Investor confidence is still strong despite reports of inflation, and though it’s certainly on their radars, we haven’t seen investors make major moves based purely on that threat of inflation,” says Swerdlow. “At the end of the day, investment in real estate is a natural hedge to inflation itself.”
“To the extent we hear about inflation, it’s more about how that may be inducing capital into the real estate sector as a hedge,” adds John Randall, partner at Los Angeles-based direct lender PCCP LLC. “This is why cap rates for quality assets with the ability to increase rents or favorable escalations are particularly attractive. With that said, many clients are focused on real estate tax inflation, which is often the largest operating line item.”
Yet some lenders and borrowers do see rising prices as a concern that is, at the very least, worth monitoring.
“Many of our clients are definitely concerned about inflation and the potential of increasing interest rates as a result of it,” says Adam Sasouness, co-founder and managing principal at New York City-based Dwight Capital. “There’s a lot of money in the system right now and not a ton of places to put it. That problem, in conjunction with dirt-cheap rates, is definitely creating a bubble.”
With that logic in mind, Sasouness says that generally speaking, his firm looks at current cap rates in a larger context when doing its underwriting. Dwight Capital primarily focuses on bridge lending and Federal Housing Administration/Housing & Urban Development (FHA/HUD) loans for multifamily and healthcare assets.
“We’re trying to remain disciplined while still keeping up volume,” he says. “We see similarities in the national multifamily market right now to the New York City multifamily market before the rent stabilization laws were changed a couple of years ago, which didn’t end well for guys that were not long-term owners.”
Cleaver of Emerald Creek Capital also notes that real estate has historically served as a hedge for investors against inflation and thus hasn’t been a major concern for his firm’s clients.
“Any rate hikes should correlate to higher economic activity, which in turn correlates to higher rents, particularly in the multifamily and industrial sectors,” says Cleaver, adding that he believes that this trend will continue in the long run.
Even so, the mere threat of an overheated and inflated economy can also be a catalyst for interest rate hikes. And although the Federal Reserve appears content to stand pat for the moment, the nation’s central bank has been known to reverse policy without warning, particularly when political pressures are involved. The Fed is currently targeting a short-term federal funds rate of 0 to 0.25 percent.
“The fear of inflation is real,” says Kathy Anderson, founding partner at New Jersey-based mortgage advisory firm Progress Capital. “Since the onset of COVID-19, the Fed has committed to increasing the money supply by $6 trillion to support its stimulus plan, which is more than three times what was spent to bail out the economy during the Financial Crisis [of 2008]. If this trajectory holds, higher interest rates will be the bubble-popping pin.”
Anderson adds that borrowers in her firm’s key markets are hustling to refinance their properties and lock in historically low rates and avoid rate uncertainty for the next seven to 10 years. This activity further bolsters the overall level of liquidity in the market.
Indeed, demand for long-term, fixed-rate debt should rise under current conditions, assuming rate hikes are still a ways off. Demand for this type of financing is likely to sustain healthy deal volume in the short term, Randall says.
“Our deal volume is currently exceeding expectations due to a low-interest-rate environment and a steady return to an open economy,” he says. “Right now, there are very attractive fixed-rate options available at some of the tightest all-in historical rates.”
PCCP recently provided a $62 million senior construction loan for a 282,737-square-foot distribution center in Philadelphia that is preleased to TJX Cos., the parent company of T.J. Maxx and Marshalls. The borrower, DH Property Holdings, broke ground earlier this summer and expects to deliver the property in the third quarter of next year.
Other Concerns
While hard evidence of inflation has only recently begun to surface, other factors have weighed on investors’ minds during the first two quarters. These include the rollout of COVID-19 vaccines, potential changes to the U.S. tax code, the expected expiration of federal unemployment benefits and vacillation in the 10-year Treasury yield, among others.
In terms of public health, investors have recently signaled concerns over the spread of the Delta variant, especially in countries whose manufacturing and supply chain operations are key pieces of the U.S. economic infrastructure. On Monday, July 19, these fears precipitated the largest single-day drop — about 700 points — in the Dow Jones Industrial Average since October 2020.
As of mid-July, about two-thirds of U.S. adults had received at least one dose of the coronavirus vaccine. The Biden administration previously stated that its goal was to have 70 percent of the American people fully or partially inoculated by Independence Day.
Movement in the 10-year Treasury yield is also very important to some lenders, particularly those that price their loans off the benchmark rate. As of mid-July, the rate stood at 1.32 percent, up from its sub-1 percent mark that prevailed during the early days of the pandemic, but still considered incredibly low by historic standards.
“Property buyers view the low yield of the 10-year Treasury as a big positive,” says Cleaver. “And since these are still some of the lowest rates the market has experienced, real estate investors have been motivated to act.”
While the low yield of 10-year Treasury bonds reflects a flight by investors to a risk-free security as a hedge against economic turbulence and uncertainty, commercial real estate borrowers stand to receive lower rates and tighter spreads on their loans as a result of the suppressed yield.
Should the benchmark rate begin a steady ascent in the second half as the economy moves deeper into recovery, borrowers will face higher costs of capital, though sources say the short-term fluctuations don’t move the needle much in terms of demand for financing.
“In 2018, the 10-year crested over 3 percent, so it’s all relative,” Swerdlow points out. “Investors are looking to lock in those rates when those drops occur, so that may spur some activity in the lending arena, but it’s not like people who are on the sideline are all of a sudden becoming more active because the 10-year Treasury went down 10 basis points.”
Swerdlow adds that Ariel’s clients are generally more concerned about potential changes to tax laws — either abolishment of or change to the 1031 provision or a hike in capital gains taxes — than anything else. While the Biden administration has been widely linked to both of these measures, no major changes have thus far been announced or enacted.
Other sources agree that this is a legitimate concern, as evidenced by the frenzied pace at which 1031 deals are closing throughout the market as a preemptive measure against legislative changes.
“Commercial assets continue to trade at historically low cap rates providing tremendous liquidity chasing acquisitions to satisfy 1031 exchange requirements,” says Anderson of Progress Capital. “Owners are weighing the benefits of refinancing to recapture equity versus selling and dealing with 1031 exchange challenges, such as low cap rates and limited inventory, or paying capital gains taxes.”
The Final Takeaway
Despite this diverse set of potential concerns, the overall sentiment is positive. Investor optimism is buoyed primarily by the widely held belief that the worst of the pandemic and its economic ripple effects are behind us, says Paul Fried, head of equity capital markets at Greystone’s New York City office.
“Investors do see that there’s a lot of money circulating through the system that needs to find a home, and they have expressed concerns about price bubbles for certain assets,” he says. “But overall, investors now view the pandemic as a receding issue and are anticipating strong rebounds in the urban markets. For that reason, we expect to see significant transactional activity in the second half of the year.”
Fried also says that the relief efforts and aid packages that were devised in response to COVID-19 have played an important part in fueling the recovery, but that markets haven’t always priced in those positive impacts.
“Most investors aren’t fully acknowledging the impact that Fed stimulus money had in supporting the economy during the pandemic,” he says, noting that the potential for a rate hike is hiding in plain sight. “We don’t dismiss the impact of higher rates on deal activity, but those adverse impacts could easily be offset by investor belief in strong economic growth and pressure to deploy capital ahead of that growth.”
In the end, lenders will continue to lend and investors will continue to invest. For the simple fact of the matter is that with the exception of securities like Treasury bonds and saving accounts that are backed by faith in the financial solvency of the federal government, all investments carry risk. Navigating shifting interest rates and legislative updates from new political regimes is part of the job.
In those ways, the current cycle isn’t really different from any other.
— This article originally appeared in the June/July issue of Northeast Real Estate Business magazine.