Commercial real estate borrowers remain bullish on the financing climate despite some uncertainty about where financial regulation is heading and the specter of increasing interest rates.
Exclusive research from NREI’s latest finance survey shows that confidence remains high that the good times are likely to roll a bit longer.
On a scale of 1 to 10, respondents also identified local and regional banks (6.9) as the most significant source of capital to the commercial real estate sector. That segment was followed by national banks (6.4) and life insurance companies and institutional lenders (5.6 each).
Boston serves as an illuminating example of the kinds of entities active in the marketplace.
According to Ely Razin, CEO of CrediFi, a data platform serving the commercial real estate finance market, pension fund Teachers Insurance & Annuity Association of America was the top lender in the market in the first half of 2017. In addition, a different teachers’ pension fund—the New York State Teachers Retirement System, or NYSTRS—was also one of the top 10 originators of commercial real estate loans.
“The analysis found that pension and insurance companies were significant players in Boston’s commercial real estate market—particularly in the first half of this year, when five pension and insurance providers originated around $1 billion in commercial real estate loans in Beantown,” Razin wrote in a recent column for NREI (See page 47). “Throw in other types of non-bank lenders, such as Los Angeles-based Mesa West Capital, a privately-held portfolio lender with a capital base of over $4 billion, and Red Mortgage Capital, a multifamily and affordable housing lender that’s a subsidiary of Tokyo-based financial services group Orix Corp., and what you get is total non-bank origination that came to about one-third (34 percent) of loan originations in our sample.”
The CMBS sector, meanwhile, has also been healthy in 2017. U.S. CMBS issuance reached $21.2 billion in the second quarter of 2017, according to research firm Trepp LLC—more than doubling the volume achieved in the first quarter of the year.
Year-to-date through August, CMBS issuance has totaled 55.4 billion—up 34.4 percent from the same period in 2016, according to data tracked by Commercial Mortgage Alert, an industry newsletter.
In assessing various financing aspects, respondents identified interest rates as most likely to increase (75 percent). A plurality of respondents (46.4 percent) also expect a rise in the risk premium, i.e., the spread between the risk-free 10-Year Treasury and cap rates. When it comes to two other factors—loan to value ratios and debt service coverage ratios—a majority of respondents expect no change.
Respondents were split on whether underwriting standards might shift over the next 12 months. While 44.3 percent said there would be no change, an almost equal percentage of respondents, 43.7 percent, said they expected standards to tighten. Meanwhile, 12.0 percent said they would loosen. A year ago, sentiment on this question was more bearish with 53.4 percent saying they expected tightening and only 6.7 percent expecting underwriting standards to loosen. Another 39.9 percent said there would be no change.
Interest rate impactsDrilling down further on interest rates, about half of respondents (48.4 percent) expect the Federal Reserve to raise rates twice in the next 12 months. Another 29.4 percent expect one further increase, while 14.2 percent expect three increases. Only 6.4 percent said there would be no changes, while 1.1 percent said there would be four or more interest rate increases in the next 12 months.
So far, commercial real estate pros have had a sanguine reaction to the Fed’s attempts to move rates upward. Since 2015, the Fed has raised rates four times by a quarter percentage point, after keeping interest rates close to zero for seven years. The most recent increase took place in June.
In reaction to the June hike, Lisa Pendergast, executive director of the CRE Finance Council, an industry trade association, said, it “represents another important step in normalizing monetary policy.”
Pendergast warned that aggressive rate hiking going forward could lead to curtailed debt availability in the property markets, but with the economy growing slowly, the Fed seems to continue to exercise the necessary caution.
The increase came as no surprise to real estate investors, noted Ernie Katai, executive vice president and head of production with mortgage banking firm Berkadia, bringing down the risk of disruption to the market. Debt capital continues to be widely available. “The markets have been preparing for a significant period of time that rates would be increasing once real economic growth was evident,” he said.
In assessing the impacts of rising rates, a majority of respondents (58.5 percent) said cap rates will also rise. Consistent with that, nearly half of respondents (48.4 percent) think cap rate spreads to interest rates will remain flat. In other words, a good chunk of respondents expects cap rates and interest rates to rise in lockstep. A smaller percentage of respondents expects cap rate increases to outpace a rise in interest rates. In terms of contrarian views, only 17.1 percent of respondents think cap rates will fall in the face of rising interest rates and just 23.6 percent think cap rate spreads to interest rates will shrink.
In terms of other activity, there is general consensus that the market should expect lending volumes (47.1 percent), investment sales volumes (49.9 percent) and financing for new construction (58.3 percent) to decline as a result of rising interest rates.
Fed balance sheet
Aside from moves on interest rates, there’s another way the Federal Reserve’s decisions could impact the sector. Eyes are also on the Fed’s balance sheet wind down efforts.
The Fed had announced previously that it intended to gradually minimize its portfolio of bonds and other assets, acquired during the financial crisis. Overall, it has $4.5 trillion on its balance sheet that it is now beginning to address.
The first moves will be gradual. The Fed will reduce its balance sheet by $10 billion in the first quarter of its wind down efforts. This amount will rise by $10 billion each quarter until it hits $50 billion.
The Fed, in a statement released in late September, noted that market-based measures of inflation have stayed low over the year. The labor market has strengthened, unemployment is low and job gains have been steady over the past few months.
“We believe the recovery is on a strong track,” Chairwoman Janet Yellen said at a news conference following the bank’s two-day policy meeting.
In all, a slim majority of respondents (51.7 percent) expect the wind down to have no impact on the sector. But just over one-third of respondents (35.5 percent) think it will have a neutral impact. Another 12.8 percent, meanwhile, think it will have a positive impact.
What’s next for Dodd-Frank?
One potentiality that respondents were sweating over was the possibility of some Dodd-Frank Wall Street Reform and Consumer Protection Act rules as they pertain to commercial real estate lending being overturned.
In all, a majority of respondents, 57.6 percent, said they didn’t think the rules would be overturned in the next 12 months.
If the rules are overturned, however, respondents were asked how they thought the changes would impact the commercial real estate sector.
A bulk of respondents wrote that removal of such rules would take the proverbial handcuffs off lenders and enable some better financing options. They expect to see more capital, looser standards and positive growth as a result.
“Increased availability of debt will loosen underwriting and put downward pressure on rates,” was one emblematic response to the question.
Another added, “Lending will come back to reality. Dodd-Frank really hurt a lot of people. It was put together by two career politicians that never worked in the private sector and know nothing about finance.”
But some respondents remarked that overturning the rules could risky.
“I think if overturned, we could be facing another financial crisis allowing for overspending and bad loans,” the respondent wrote. Another added, “It will be back to the wild, wild west of the mid-aughts with capital availability and low lending standards … with the predictable shortening and worsening of cycles.”
Republicans have worked up the Financial CHOICE Act to repeal many of the more stringent financial reforms put in place in the wake of the 2008 financial crisis. But legislators have had trouble making progress with the bill. And currently it’s low on the legislative agenda, with fits and starts on healthcare reform and tax reform bogging down Congress.
Respondents were also asked if Donald Trump’s presidency has had any effect on commercial real estate financing. Responses were mixed, with some saying the administration has increased optimism, while others expressed that it had an adverse impact.
One respondent wrote, “He has created a positive direction, however this has not significantly impacted financing yet. The Fed is the problem, not Donald.”
On the other end of the spectrum, “He has had no impact on anything long or short term. His erratic behavior and dysfunction is now essentially ignored by all fundamental and structural factors in private and public sectors. He has regressed back to a reality TV character and is now a pseudo-president.”
Research Methodology: In September, NREI emailed commercial real estate professionals requesting participation in an online survey about financing. Overall, the survey received 543 responses, half of whom identified as Owner/Partner/President/Chairman/CEO/CFO. In addition, 44 percent of respondents operate in the East, 45 percent in the South, 43 percent in the West and 36 percent in the Midwest. (Respondents could select all regions that applied.)
Source: National Real Estate Investor