By Taylor Williams
The factors and parameters by which commercial lenders and investors underwrite, value and price assets are changing at whirlwind speeds, creating a capital markets landscape that is defined by volatility as the second half of the year unfolds.
Capital markets professionals — as well as regular consumers — seem to agree that interest-rate hikes are a necessary evil in warding off record-high inflation. The Consumer Price Index (CPI) rose 8.6 percent year-over-year in May, the latest data available at the time of this writing. But a lack of clarity on the magnitude of these future rate hikes makes it increasingly difficult for commercial borrowers to accurately gauge risk in their deals and project cash flows at their properties.
The Federal Reserve’s decision to raise the federal funds rate by 75 basis points at its latest June meeting illustrates the impulsiveness and hastiness with which fiscal policy is being crafted. Prior to the release of the May inflation report the previous week, investors had widely anticipated a
50-basis-point hike. Reports of an even more aggressive rate bump crystallized fears of inflation and sent the stock market into a spiral, with the Dow Jones Industrial Average shedding more than 1,000 points in 24 hours.
Meanwhile, another long-term investment vehicle and debt pricing instrument, the 10-Year Treasury yield, is also exhibiting unusual behavior. Historically, when investors believe a recession is forthcoming, they flock to treasury bonds for their risk-free rate of return.
In a quasi-normal environment, this flight to a safe haven would cause yields to compress. But because the going price of treasury bonds is so high due to inflation, yields are actually increasing — the benchmark rate stood at 3.21 percent on June 28, up more than 150 basis points relative to the start of the year. The increased yield is necessary to cover the inflated purchase price of the bond.
At least in Texas, commercial real estate is buoyed by exceptional job and population growth that has persisted during the most severe stages of the pandemic and the extended period of hyperinflation. But even the strongest asset classes, such as multifamily, are experiencing price adjustments as macroeconomic turbulence descends on the lending and investment worlds.
Underwriting Challenges
The net result of these rampant, unexpected shifts in key economic variables and indicators is, in a word, uncertainty. And rather than attempt to navigate what some industry professionals believe is one of the most uniquely challenging capital markets environments in recent decades, some lenders and investors are going into holding patterns.
“Lenders are struggling with underwriting deals accurately right now, particularly in terms of exit cap rates,” says Tucker Knight, senior managing director in Berkadia’s Houston office. “This rising interest rate and inflationary environment doesn’t give them the comfort level or answers that they need to underwrite deals such that they can get out of the loan. When that happens, the market tends to seize up.”
“Lenders are making nonrecourse loans and trying to de-risk them as much as possible, which complicates the equation,” he adds. “Every deal has different yield parameters, equity stakes, exit strategies and metrics, but right now we have multifamily investors buying assets at cap rates that are below their interest rates on the assumption that the rent trajectory will outpace their loan constant. If we really are in the early stages of a financial downturn, that’s a recipe for disaster, because rents aren’t going to keep climbing like this, despite the demand for housing.”
In Knight’s view, the mentality of the commercial lending community is herd-oriented, meaning that even among different shops, word of deals falling apart due to turbulent market conditions could have a domino effect on the entire industry.
Much of this gun-shy mindset is attributable to lenders’ recollections of the Financial Crisis of 2008, he says. At that time, liquidity evaporated from commercial lending markets very quickly due to fears of the collapse of subprime mortgage loans within the single-family housing market — fears that turned out to be well-founded.
Yet many capital markets professionals see little to no parallels between a potentially imminent downturn and the Great Recession.
“This cycle isn’t like 2008 because we’re coming out of an extended period of record-low interest rates, and markets are simply finding a new threshold,” says Dana Deason, president of Deason Financial Group, a mortgage banking firm based in Longview, Texas. “Rates were so low for so long that markets got numb, and everything was working with such a low cost of capital.”
“It looks like we’re going to see further rate increases, so at some point values have to change, and that’s what we should see play out,” Deason continues. “There’s still liquidity in the market. Borrowers can still transact; they just have to accept a higher rate. But with the level of uncertainty we have, lenders are going to underwrite more conservatively, which means more equity in deals, shorter amortizations and higher interest rates.”
Deason has also seen examples of deals that constitute “negative leverage,” in which all-in interest rates exceed closing cap rates. The expectation of sustained, exceptional rent growth is the key variable in that equation, and borrowers taking that route are increasingly turning to bridge debt markets to get the leverage they need.
“When you buy an asset and it doesn’t pencil to a positive debt-service coverage, you’re taking yourself out of some of the conventional financing markets,” Deason explains. “So borrowers have to put more equity down to get
traditional financing or go to the bridge financing market. They take a higher-leverage deal and hope they can operate themselves into a positive yield, then go get their long-term financing.”
However, some borrowers — in particular those that can afford to do so, like institutional players — are steering well clear of this scenario.
“With the rapid rise of debt pricing, institutional capital is looking to avoid negative leverage,” says Noam Franklin, managing director in Berkadia’s New York City office and head of the firm’s joint venture equity and structured capital group. “We therefore expect to see some cap rate expansion, especially in certain pockets of the country, and it will be important for sponsors to underwrite conservatively to attract institutional partners.”
“We believe the institutional capital will remain active in the housing space but will focus more than ever on the experience of the sponsor and track records in those chosen markets, especially for first-time joint ventures between a sponsor and capital,” he adds.
Where Texas Stands
Positive net migration and corporate relocations routinely dominate the headlines in the Lone Star State, ensuring that demand for housing is not likely so subside significantly just because the economy is overheated. As such, Franklin believes that institutional investors will not significantly backpedal from the major Texas markets, but rather alter their strategy to include a more balanced mix of deal profiles.
“A lot of capital sources have expressed struggles in finding value-add multifamily deals that meet their return expectations,” he says. “So many have decided to invest on a barbell approach — deploying funds into both into core plus and opportunistic deals with the hope that these investments blend into value-add returns.”
“Many of these capital sources are starting to get excited again by the value-add space as they are finding sponsors can negotiate discounts and brokers are starting to award deals to groups that might have a lower offer but with a certainty of closing,” Franklin continues. “We believe institutional capital will continue to invest in the multifamily space, including value-add opportunities, knowing that many of the most aggressive buyers might have to take a breather as they assess whether they can raise capital from their usual sources of retail investors.”
This logic behind this shift is further substantiated by the fact that inflation and supply chain disruption have made new construction — the de facto alternative to investing in existing housing product — beyond exorbitant.
“Between construction costs going up and the latest rate increases, loans and deals for new residential product are going to struggle,” says Ray Landry, senior vice president at Houston-based Davis-Penn Mortgage. “So we could see acquisitions drop off in the second half of the year. Rate hikes and fiscal policy are primarily responsible. Prices haven’t come down yet, and it’s still a sellers’ market, but we expect cap rates to start going up and prices to come down.”
As such, the overall volume of capital — whether its’ debt or equity, foreign or domestic, private or institutional — flowing into the Texas markets could subside in the coming months. While that scenario has yet to come to fruition and the Texas capital markets still have strong liquidity, the market mentality is moving in that direction, Knight says.
“We’re not currently in a recession or a capital-constrained market, but people are acting like both are happening,” he says. “There’s still an abundance of capital, but it’s much more diligent and regimented than it 45 to 60 days ago. Everyone is paying attention to the details a lot more punitively now because they don’t want to get caught behind the eight ball if interest rates go up and values continue to go down.”
“The Texas growth story substantiates the exceptional amounts of debt and equity that have been flowing into these markets,” he continues. “But we should see a reduction as we sift through uncertainty and price correction. Capital will continue to flow to pro-business states like Texas. But without question, but the overall level of uncertainty in pricing and underwriting creates trepidation, and some groups are going to push pause.”
— This article originally appeared in the July 2022 issue of Texas Real Estate Business magazine.