The ability to find debt and equity financing for acquisitions and new development has been deeply affected by the coronavirus. Heading into 2020, there was plenty of inexpensive capital available to real estate investors and developers. The once wide field of potential lenders has shrunk significantly over the past nine months. And as for equity availability, it will be important in the coming months to be patient and diligent.
REBusinessOnline recently spoke with Gary Sopko, senior vice president – structured finance/investment sales of Lee & Associates and principal at Baden Advisors (an affiliate of Lee & Associates) via video conference about his company’s approach to investment sales, debt financing and equity placement for commercial real estate clients in the midst of an unprecedented year.
Sopko interprets what the lower loan volume across the board means for the commercial real estate industry, trends he’s seeing and his role in educating borrowers/clients on how to navigate this challenging time.
Changing Lender Pools
At the start of the pandemic, a variety of lenders were still ready, willing and able to lend; however, as the pandemic continued and shutdowns spread, the lender pool shrunk. Many private debt funds had to suspend lending for a time as their warehousing lines were frozen. Banks, experiencing uncertainty in the market, temporarily curtailed their new business activities.
“In the last six months, several banks, small and large, have pulled back, not only in their underwriting, but more importantly, their interest in developing new relationships,” says Sopko. “I’ve had several banks say, ‘We’re not taking on any new clients at this time. We’ll work with the clients that we do have, but we’re not interested in expanding our client base. Pension funds and life companies also pulled back by reducing advance percentages and increasing loan spreads. On top of that, everyone’s lending and underwriting parameters have become more stringent because of the uncertainty of the marketplace, due to COVID-19.”
Furthermore, COVID-19 has made it more difficult for advisors, such as Sopko’s group, to underwrite a loan upfront, as it has become harder to determine pricing spreads, loan amounts and general terms and conditions of loan structures that a client might expect in the marketplace for a specific project, acquisition or refinance. The underwriting from lenders has changed so significantly that Sopko’s group finds they are in almost daily conversations with lenders in order to best advise clients and to understand changing lending parameters and practices.
“With several lenders moving out of the market, the remaining lenders have taken advantage of the low supply/high demand,” says Sopko. “We found that the spreads and base rates floors have increased during this time, notwithstanding the fact that the interest rate benchmarks have changed little over the last nine months.” This makes for an unfortunate trifecta for borrowers: fewer lenders in the marketplace, more restrictive loan covenants and underwriting parameters and, finally, higher pricing.
And yet financing and deals are still happening. One example is the availability of construction loans, which also have become much more restrictive regarding terms and conditions. Sopko explains that working with lenders through the pandemic and closing deals, “takes a tremendous amount of communication to achieve what you’re trying to accomplish.”
Special Considerations by Asset Type
Industrial has long been a favored property type for investors and lenders, slowed only by the development process. Although municipalities and third-party professionals aren’t as responsive as they were pre-coronavirus, industrial remains a favored asset class, Sopko says.
Multifamily is also still in favor with lenders, particularly in the Northeast and in major metropolitan areas, as well as suburban multifamily, where market rentals are in high demand and well received by the lending community. Still, Sopko points out, the terms and conditions will be somewhat less attractive than they would have been two years ago.
Office deals are evaluated on case-by-case. Few lenders are involved in suburban office development, unless it’s a single tenant, build-to-suit. When it comes to financing, tenant mix is very important. The basic office questions remain: Are these tenants paying rent? Have they asked for concessions or rent forbearance? Regardless of the circumstance, cash flow is always king.
Value-add or opportunistic financing for suburban offices right now, will probably be very difficult to impossible.
Equity and the Elusive COVID Discount
Are there well capitalized investment groups sitting on the sidelines looking to buy distressed commercial real estate deals? Sopko explains that it is a little too soon in what he’s calling the “COVID cycle” for distressed property to come to market: “That’s probably going to take several more months, at least, and the opportunities that will come to the market first will be assets that nobody wants to buy except under the most advantageous of circumstance (read: very deep discount).”
With the hope for vaccines glimmering on the horizon, Sopko doesn’t think the COVID discount will manifest in any real form. As he explains, “There’s always distressed debt someplace, but it just doesn’t come in the volumes that everybody expects. Furthermore, you’re going to have great demand and probably not the supply that everybody is expecting.”
Sopko notes that volume is down, but it is unclear whether that’s something particular to do with CMBS or just a reflection of lower volume throughout the debt markets.
But the potential downsides of a CMBS loan give Sopko pause. “If something happens with the asset that has a significant negative impact on cash flow, the borrower has very little, if any recourse with a CMBS loan. Everything is based on the initial underwriting. I repeatedly caution first-time prospective CMBS borrowers to realistically weigh the advantages and disadvantages before pursuing this funding source,” advises Sopko.
Educating Clients & Extending Timelines
In the past four months, Sopko sees much of his time going towards helping clients become better educated themselves and managing unrealistic expectations. Where is the debt market right now? How much can they reasonably expect to borrow and at what rates? How much longer of a closing/completion timeline can clients expect? These are just some of the considerations that have to be addressed.
Longer times are simply part of the equation now. “A deal that could have closed in 60 days a year ago now takes 90, maybe even longer. If it took 90 days, now it takes 120.” Development deals must reassess previous construction timelines, since municipalities and title companies have slowed their response times due to COVID-19. These entities are dealing with the challenges that everybody else is (resulting in slower municipality approvals and title reviews).
Investment Sales Slowdown
Commercial real estate sales are down significantly for 2020. In addition to volume being lower, the timeline for sales is also taking longer. Even well capitalized companies have not been able to transact as quickly as they want. “Though they don’t face as many of the challenges that, say a private investor has, they still are relying on the same third parties to assist with the efficient speed at which they can close.”
“The biggest issue facing commercial real estate today is just the uncertainty that COVID-19 has brought to the marketplace. You just can’t get around that uncertainty,” says Sopko. Sellers are reluctant to sell and are waiting for things to get back to normal, betting that by waiting, asset values will rise. Others are waiting for the other shoe to drop, wondering if it might not be better to sell now at what they perceive to be a discount, rather than endure a further decline in asset value down the road. One thing is quite certain at the moment, the pandemic has created great uncertainty in the commercial real estate market, uncertainty that will continue for the foreseeable future.