By Taylor Williams
After eight interest rate hikes totaling 450 basis points over the last 10 months, courtesy of the Federal Reserve’s war on inflation, commercial borrowers can only hope that the fundamental law of gravity — “what goes up must come down” — will start to become reality in 2023.
But the economic clarity that the commercial lending community seeks is muddied by conflicting agendas. On the one hand, the nation’s central bank has made some headway in taming inflation through the rate hikes. The Consumer Price Index fell from an annual rate of 9.1 percent in June 2022 to 6.5 percent in December, but is still well above the Fed’s 2 percent target rate.
On the other hand, expansionary fiscal policy such as the $1.2 trillion infrastructure bill signed into law in late 2021 and the $1.7 trillion omnibus appropriations bill passed in December 2022 could undermine the Fed’s efforts to curb inflation, say some economists. The U.S. national debt stood at a record $31.5 trillion as of press time due to the cumulative effect of recessions, wars, tax cuts, the COVID-19 pandemic, and excessive government spending. The ratio of U.S. federal debt to GDP as of press time was 120.3 percent.
Against that backdrop, direct lenders and financial intermediaries across the commercial real estate industry do anticipate some slowdown in the frequency and magnitude of short-term interest rate hikes in 2023. But for borrowers seeking to refinance their assets or in need of acquisition or construction financing, hope and expectation aren’t much to hang their hats on.
Patience is a Virtue
Borrowers are looking for outside-the-box solutions to reshape their capital stacks, such that the impacts of numerous interest rate hikes can be minimized. For those that can afford to do so, the simplest solution is also the most effective: just sit tight.
“The ‘hurry-up-and-wait’ strategy is still relatively rampant, especially with borrowers that are institutional companies,” says Igor Zhizhin, president at American Street Capital, a Chicago-based mortgage banking firm.
“For clients that are in floating-rate products and feel comfortable with a potential addition of 75 basis points and are pursuing a sale or refinancing in the next 12 months, we advise avoiding the urge to refinance for the next six to nine months,” he continues. “For those with loans that are set to mature in the next six months and aren’t willing to take on floating-rate interest risk, we suggest refinancing into two- or three-year fixed terms.”
Zhizhin points out that for highly liquid borrowers, simply doing nothing for the next 12 months is better than attempting to refinance into long-term fixed solutions in anticipation of more rate hikes in the future. That’s because the majority of fixed-rate loans carry exorbitant prepayment penalties.
By enduring some pain in the short run, borrowers hope to put themselves in positions to secure long-term, fixed-rate debt in 18 months or so, when rates have presumably come back to earth. Zhizhin refers to this solution as “mini-permanent debt,” which is designed to give most — not all — borrowers opportunities to simply remain on the sidelines.
“Over the long run, especially for borrowers whose business plans have timelines of seven years or more, the benefits of eliminating interest rate risk by refinancing now are really going to come home to roost when rates come back down,” explains Zhizhin. “Getting a 10-year, fixed-rate loan today would likely be in the mid- to high-6s. You have to weigh that against starting in the mid-5s in one to two years and not being able to get out of it without a hefty and prohibitive prepayment penalty.”
“Everyone is pushing for fixed-rate debt with bank balance sheet or fixed-rate life insurance products versus conduit financing with defeasance or yield maintenance and structured prepayment,” concurs Charles Penan, executive vice president at Aztec Group, a Miami-based intermediary. “There’s always some debt maturing and some transactions happening. But unless an owner has an acute need to transact today, we’re advising them to wait. The question is for how long?”
“Based on our conversations with lenders, we do expect rate hikes to plateau or even decline by the end of 2023 — though that doesn’t mean spreads will go down,” Penan continues. “So, if a borrower is comfortable at a 6 percent interest rate, we advise the borrower to roll with it, because nobody knows what the future holds.”
When Waiting Isn’t Feasible
To hedge against market volatility, borrowers that are not able to simply “wait it out” must be willing to accept equity infusions or shifts to short-term debt structures. That means giving up a percentage of ownership of an asset or paying higher interest rates over the next 12 to 36 months.
But that willingness to be flexible in the short term could save millions in interest payments later down the line. Further, outside of those basic avenues of relief, borrowers have little recourse but to sell their properties, presumably at discounted prices in some cases. Otherwise, they risk defaulting on their loans and possibly going into foreclosure.
“We are seeing and hearing about recapitalizations and restructurings. We expect to see more of that in the coming months as a lot of borrowers can now foresee a need to address those scenarios,” says Ross Pemmerl, chief credit officer at UC Funds, a Boston-based lender that primarily plays in the value-add multifamily space.
“Across the board, leverage on permanent takeout loans will be less due to higher interest rates, which creates gaps in the marketplace,” continues Pemmerl. “Borrowers facing maturities will need to explore some different capital solutions from that permanent execution they had originally envisioned. An infusion of mezzanine debt or preferred equity will likely be two popular avenues to fill that gap, but we should also see a sharp increase in shorter-term, bridge loan executions utilized to ride out the current market.”
Ben Kadish, president and founder of Chicago-based Maverick Commercial Mortgage, agrees that demand for short-term financing is currently driving deal volume across the commercial real estate lending arena.
“There’s a lot of money being raised to provide that type of gap financing between the first mortgage and the new loan,” says Kadish. “But you still have to pay debt service, and cash flows are tight right now for a lot of owners.”
“At the same time, these owners aren’t going to try to refinance until they’re at risk of default or foreclosure,” Kadish continues. “So, they have to bring new equity to the table, even if they’re able to keep the property. This could come from their own pocket, a capital call with investors or by bringing in a new source of preferred or mezzanine equity.”
In essence, many borrowers are seeking short-term, fixed-rate debt vehicles so they can live to fight another day. Fixed-rate debt is not as abundant as it has been in the past. So, to replace that, 2023 could be the year for bridge lending, sources say.
“The bridge lending community has a great opportunity right now in terms of helping borrowers with cash problems with assets that are not heavily levered — even if they are more conservative in their underwriting than they have been in their past,” says Kevin O’Grady, managing director at Concord Summit Capital, a Miami-based intermediary.
O’Grady cautions, however, that the opportunities behind this trend could fluctuate significantly from market to market.
“Bridge lending is built around the soundness of the exit strategy, and exit cap rates are still very strong in certain markets and asset classes,” he explains. “You have to have some courage to go this route because you’re basing your model on exit-strategy values. You must believe that cap rate expansion will be minimal in markets that are still demonstrating strong demand, such as Sun Belt states and the Southeast.”
However, while bridge lenders tend to provide the term length — one to three years — that borrowers currently want, these debt providers charge significantly higher interest rates that also frequently have floating-rate structures. As such, there are some solvency concerns surrounding bridge loans that were originated prior to the onset of severe inflation and that are maturing this year.
“On the multifamily side, there’s a lot of chatter about what will happen to deals that were purchased in the last 24 months with high-octane bridge financing,” says Jeff Erxleben, president of debt and equity in Northmarq’s Dallas office. “Today, the interest rate on a bridge loan for a multifamily acquisition is probably 300 to 400 basis points above SOFR (Secured Overnight Financing Rate), contingent on leverage, and that’s a significantly more expensive cost of capital.”
Negative Leverage Prevails
About a year ago, SOFR became the new index by which loans with short repayment periods, including bridge and construction financing, were priced. At that time, the base rate was close to zero; at the time of this writing, it stood at roughly 4.3 percent. As a result of this movement, some borrowers now find themselves negatively leveraged on properties they bought or developed 12 to 24 months ago.
“A lot of buyers [12 to 18 months ago] got floating-rate bridge loans with 80 percent loan-to-value ratios for one or two years that they planned to take out with Fannie Mae/Freddie Mac loans or CMBS debt,” explains Kadish. “But the interest rates on those bridge loans doubled from 4 to 8 percent. Borrowers only targeted returns on these deals of 4.5 to 6 percent, so current owners today are now into negative leverage.”
Even for Class A multifamily properties in high-growth markets with healthy in-place cash flows, it’s simply not realistic in this environment to underwrite exit cap rates above 6 or 7 percent — the effective interest rate on many of those loans. As such, the borrower’s all-in interest rate exceeds its exit cap rate, which is the definition of negative leverage.
“Part of why the investment sales market has slowed down is that a lot of deals got done at negative leverage,” notes Rich Martinez, head of agency lending production at New York City-based Greystone. “If you’re a buyer, you know what your costs of debt and equity are, but sellers are still holding out for lower cap rates from a year ago. Now we’re in a period of waiting and discovering where the market is and if it’s settled.”
Sources say that negative leverage is a more workable scenario when a deal has a clear value-add angle. At this point in the cycle of rate hikes, lenders simply do not believe that the kind of rampant, double-digit rent growth that prevailed in 2021 and early 2022 for stabilized properties can be achieved without a value-add component.
“While you can look at some modest level of rent growth on a bridge loan, whether it’s a project in lease-up or a value-add deal, the days of underwriting to 10 to 15 percent annual rent growth and expecting interest rates to be the same for the life of the loan have passed,” says Martinez. “In the past, people were ecstatic to be able to underwrite 4 percent annual rent growth. The recent years where we saw owners get 15 to 20 percent rent growth on renewals — that’s not normal, and it eventually reverts back to the mean, as we’re seeing now.”
“As far as how underwriting has changed from a debt perspective, there’s less reliance on pro forma rents that trend too aggressively,” adds Erxleben. “If you’re making physical improvements that result in direct monetary changes to underwriting, that’s one thing. But if you’re just saying that the market will lift 10 percent [on rental rates], which was real in the past — you’re not getting away with that today.”
For borrowers, these shifts in assumptions brought on by interest rate escalation make it very difficult to accurately underwrite exit cap rates at positive leverage.
“If you’re borrowing today, your best-case scenario in terms of exit cap rates is 5.5 to 6 percent because that metric has to at least equal your cost of capital today,” explains Penan. “Investors might be able to buy a multifamily property at a 4.5 percent cap rate, but no lender is underwriting at that cap rate, which is a big issue in terms of exit strategies. Compare that to just two years ago, when there were no debt-service coverage requirements because every loan made sense at 4 percent with 1.35X debt coverage.”
Dying on the Vine
Unsurprisingly, the ability of owners to be flexible and adapt to market conditions depends on how much time and liquidity they have. Those metrics can vary greatly among the various profiles of commercial borrowers.
REITs and private equity firms, for example, tend to have the luxury of immediate access to capital to materially pay down or pay off most obligations. But the majority of noninstitutional investors have to aggressively manage cash flows, particularly in an inflationary environment.
Volatility further exacerbates the construction and closing of these deals. There’s no guarantee that the initial loan terms a borrower receives will resemble the final commitment offer that a lender puts forth.
“During the past six months, we’ve seen borrowers go under application at a certain rate and level of proceeds. Then, barely 30 days later — which is a historically nominal period of time in which rates are sticky — you have 50 to 60 basis points of movement,” says Zhizhin. “That completely kills deals.”
The equity side of the market also contributes to deals collapsing.
“Equity sources have thresholds for returns. Whatever a specific fund is trying to achieve is harder to do today — period,” says Penan. “To make investors more comfortable, you have to change your assumptions and hope that they’re correct. Otherwise, you have to be realistic and recognize that yields are not as easily manipulated as they once were.”
The challenges of securing equity-based recapitalizations stem from the seismic shifts on the debt side of the market, sources say. Because interest rates were so low for so long by historical standards, deals simply worked more seamlessly. The range of assumptions — or the flexibility of the underwriting standards — made it easier for the numbers to pencil out when all-in interest rates hovered around 3 percent.
Now that the bottom line of all parties is stretched by inflation and skyrocketing costs of capital, underwriting these same deals such that lenders and borrowers both feel comfortable with the execution is a much more daunting task.
This trend reflects the broader uncertainty in the market that appears set to suppress deal velocity and volume this year.
“The interest rates are one thing, but when you’ve got this scenario in which the [lending] community can’t understand where values are going until they know that inflation is under control, you don’t know what your asset is worth and whether it can service the debt in a rising interest rate environment,” says O’Grady of Concord Summit Capital.
At the same time, sources say that some equity providers view the current landscape as opportunistic.
“In the first six to eight months of this year, we should see more equity-infused refinancings in which borrowers aren’t achieving the permanent takeouts that they wanted and maybe had gotten in previous times,” says Pemmerl of UC Funds. “Now, many of these borrowers will actually be forced to find new equity to bridge the gap on that refinancing, whether it’s self-injected or from an outside source.”
“The equity capital is still out there looking to invest — it’s just waiting for more stability,” concurs Erxleben of Northmarq. “We don’t see a huge wave of defaults building in 2023, though there will be opportunities to recapitalize by bringing in senior debt or preferred equity to solve refinancing scenarios. That sort of restructured financing solution could be a theme in 2023.”
— This article originally appeared in the February issues of all France Media regional publications.