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Cash is King

By: Steve Lewis

The financing market for CRE remains tough, and in fact may be even more difficult than it was a year ago, say SIORs. “Lending is still very challenging and seems to be getting more challenging by the week,” says Landon Williams, SIOR, senior vice president of Capital Markets with Cushman & Wakefield in Memphis, Tenn. “A year ago, instead of having 10 or more lenders for any given deal, we may have had just a few lenders, but there was confidence that we had at least a single lender to make a deal happen. That is still true for the right deals in the industrial sector; but for the office sector, it feels as if the debt markets have almost completely dried up from traditional lenders.”

“Lending is still incredibly difficult, and nobody likes the terms,” adds Conrad Madsen, SIOR, co-founder & partner, Paladin Partners in Dallas. “Term sheets are incredibly limited in the marketplace right now. If you received 10 term sheets 18 months ago, you’re lucky to get one or two today.” Some capital is still active, Madsen continues, but most is still sitting on the sidelines. “Most capital knows the market is going to get a lot worse before it gets better, and is waiting to see those discounts,” he explains.

Gabriel Silverstein, SIOR, managing director at SVN | Angelic, SVN Institutional Capital Markets Chair, Austin, Texas, goes even further. “I think the market is worse than a year ago, and significantly worse than it was 18 months ago,” he asserts. “The Fed started their interest rate rises in June of last year; lending started to slow down going into last summer and really kind of hit the brakes about this time last fall.” Add to that concerns about inflation, he continues, and “you couldn’t make deals work out.”

With a “staggering change” of 18% inflation in construction costs combined with lender uncertainty about how high interest rates might go, “that’s when they panicked and freaked out,” says Silverstein. Brad Kitchen, SIOR, president of Alterra Real Estate Advisors in Columbus, Ohio, agrees. “Many banks have either stopped lending or have increased their interest rates significantly to over 7%,” he says. “They have also tightened their lending terms and underwriting, shortened their fixed rate offering to five years instead of 10 years, and have increased their down payment requirements and have restricted cash out. Some lenders will not offer loans on office buildings at all.”

Many lenders who used to be able to easily find other banks to share in the funding of a loan are having trouble finding other banks, he explains, which restricts the size of loans that they can accommodate. “Mezzanine lenders who are lending money in secondary positions have raised their rates to 12% or more,” he continues. “Times like this are when having good banking relationships helps, because you may not be able to get a loan now unless you have a good existing relationship.” Lenders, he adds, usually prefer owner occupants, but some will still loan to investors — although they are underwriting more conservatively.

“As a general rule of thumb, investors and lenders gravitate towards certainties in uncertain seasons, which is why there is still an appetite for the industrial asset class,” notes Williams. “Lenders are now less willing to bend on location, tenant credit, borrower balance sheet, underwriting assumptions, etc.”


Given the state of the market, have the strategies for finding cash for investments changed? “They have had to,” says Silverstein. “Part of that change has to do with your approach to deals — it’s not just how to go get a loan, but what kind of deal can I justify with what I can find?"

It’s not just how to go get a loan, but what kind of deal can I justify with what I can find?

For example, he notes, the kind of deals that are “hit much worse” are people who need leverage to buy single-tenant, net lease deals. Historically, the spread between the cap rate on a single-tenant deal and the 10-year Treasury tends to hover in the 300-400 basis point range; if the 10-year is at 2%, then that’s 5%-6% cap rates. Still, over the past 12 months, cap rates have risen, but not nearly as much as interest rates, says Silverstein. “The Fed raised rates more than 500 basis points, but nobody is talking about a 10% cap rate now -- they’ve only made up for at best half the rise in interest rates,” he declares.

That, Silverstein concludes, makes you choose a different kind of deal altogether, “or instead of getting a 70%-80% kind of loan, now you’ve got to get a 50%-60% loan.” That lower leverage, he explains, will get you a lower interest rate. His advice, then, is to explore lower leverage for the best terms you can get, and search for deals. “Find more value-add (industrial vs. office, maybe retail; redeveloping or expanding buildings; office to residential or hotel conversions), and rethink how much cash you need to be able to get,” he advises. “That’s why we’ve seen a 55%-60%+ reduction in transaction volume; most transactions can’t happen now.”

“I'm seeing the frequency of syndications and closed funds increase, which allows sponsors to reduce the debt in their capital stacks,” adds Josh Soley, SIOR, president of Maine Realty Advisors, based in Portland, Ore. “For projects heavy on debt, I'm seeing institutions getting more comfortable with longer amortization periods to offset the increased interest rates. Same with longer interest-only periods, whereas loan to value has decreased. I've also seen bank term sheets overcome by other institutional players, such as insurance companies, ESOP & various retirement or pension funds, and other alternatives.”

“We have turned to credit unions, who have been offering more competitive terms and often times will syndicate with other credit unions for larger loans,” Kitchen says, “But even credit unions are having trouble finding syndication partners. We have been trying to lock in 3-5-year fixed rates with the hope that the 10-year Treasury bill will fall in the next 12-24 months, and then I could recast this shorter-term rate into a longer-term fixed rate at a lower rate. In order to do this, I have to get the lender to waive fees if I refinance with them. Another strategy is to raise enough capital to pay cash for the property, with the intent to place debt on the property when rates drop.”

Madsen cites build-to-suits with credit-worthy tenants, or cash flowing portfolios. “Speculative industrial construction financing is virtually impossible to secure in today’s environment,” he claims.

“A more creative option for financing deals outside of the traditional process may be to assume the seller’s current loan,” Williams suggests. “There could be only a couple of years remaining, but that time may bridge the gap to reduced interest rates when it is time to refinance. Another creative option is seller-financing. If the seller owns the deal with little or no leverage, then the seller may prefer to offer the buyer slightly better debt terms than available in the market to achieve a higher sale price.”

Who are the most active sources of financing? “In the office and industrial sectors, what we find is there’s still funding for real trophy, true Class-A product,” says Silverstein. “Life insurance companies and CMBs (Commercial Mortgage-backed Securities) are still lending at very aggressive rates for lower leverage — around 55%-60%. It is out there; some of those life companies are direct lenders for large portfolios — they still need to get the money out.”

But for most of the rest of the world, Silverstein adds, the primary lending sources right now are private money, more “bridge-type” loans. “Banks are very difficult; some are still lending, but they’re very, very selective — most of the time only for existing borrowers and clients, to try and preserve some of those relationships.”

Among alternatives for user-owners are SBA loans — which Silverstein considers “the best sources of money right now.” He notes the loans can be in the mid-sixes. Noting that most of these transactions also include a bank, he says that the bank portion is typically in the 8%-8.5% range, “So the combination will be in the low to mid-sevens as blended loans.” CMB loans for investor-own projects, he adds, are typically in the low to mid-7% range. “Bridge lending, or a reposition story, starts in the 8% range and can easily go up to 12%,” he concludes.

Soley, however, has experienced differently. “I’m still seeing traditional banking as the most common option,” e shares, “with the revised terms I’ve described.”


What is the near- to mid-term outlook? What do SIORs foresee? “The debt markets will almost certainly change at some point in the next year,” says Williams. “Nobody knows for sure what will happen, but I will not be surprised if interest rates increase in the near future. It is difficult to imagine a scenario where they continue to increase for a full year from now. For most owners, if there isn’t a compelling reason to sell (e.g., debt, distress, divorce, death, dissipation of partnership, etc.), then they will likely continue to hold out.”

We are going through a pruning process in the CRE industry that will ultimately force all stakeholders — lenders and borrowers — to become more disciplined moving forward.

Silverstein differs in opinion, stating, “I think we’ve seen some improvement over last 90 days; people feel like it’s pretty predictable and stable now. And the biggest challenge to lending is not whether rates are going up or down, but whether it’s predictable.”

Even though the Fed might raise rates once more this year, he asserts, “we pretty much know what they’re going to do,” and he anticipates more lending in the last quarter of this year. If lenders like life insurance companies make commitments today, he states, they’ll be pleased if rates go lower next year. “Also, a lot of them have allocations they set at the beginning of every year about how much they’ll lend, and almost every lender is out of allocation target,” he observes. Those loans are considered assets, and the companies also “have to answer” to insurance regulators.

Banks are different, he continues, because there is concern the Fed might markedly increase the reserve requirements on banks later this year. “They’ve been trying to hoard cash in advance of that potential rule so as to not be out of compliance,” he says. “Until they comply, they do not want to push more money out the door.” What’s more, he points out, CRE loans are considered the biggest risk for banks today. “A lot of banks actually have commercial real estate loans in excess of all their reserves; if there’s a big problem in CRE it could take those banks down quickly,” he warns.

“Since the yield curve inverted, I've seen banks more willing to disregard the Fed on short-term debt in order to forward their balance sheets and stay competitive in the market,” Soley counters. “They cannot afford for business to cease and competition is still aggressive.”

“I hope that conditions improve over the next 12-24 months, which hopefully will enable me to refinance some of my properties at lower interest rates and maybe even do a cash-out refinance,” says Kitchen.

“’Survive till 25’” is the mantra these days,” Madsen shares. “Most are not too optimistic for the next 12 months, as massive debt maturities will surface and will trigger many properties’ keys being turned back to lenders, which ultimately will bring down many regional banks, especially those overallocated in the office asset class. The ‘B’ & ‘C’ office sectors will be hit hardest, but will ultimately pull everyone down as most funds and lenders are invested in all asset classes. We need these assets to begin trading, so transactional volume picks up and the market starts to get out of the current stagnation.”

Williams concludes with a slightly more measured tone. “We are going through a pruning process in the CRE industry that will ultimately force all stakeholders — lenders and borrowers — to become more disciplined moving forward.”

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This article was sponsored by the SIOR Foundation - Promoting and sponsoring initiatives that educate, enhance, and expand the commercial real estate community. 
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Steve Lewis is a freelance writer and president of Wordman, Inc. He can be contacted at wordmansteve@gmail.com.