Debate during the CRE Finance Council meeting

Despite the toughest commercial real estate lending environment since the global financial crisis, January’s meeting of the CRE Finance Council (CREFC) saw record attendance. It wasn’t in 2008 when CMBS shows dropped 95% and CREFC (then CMSA) was forced to review attendance and room bookings twice a day to ensure the meeting would stay in black (I was the treasurer then and I remember those calls well). Instead, the hotel was filled inside and out with people networking, having business meetings, attending conferences, and being happy to be in sunny Miami.

As usual, the conference sessions were filled with great content and commentary from industry leaders. Here are some conference themes:

  • Honesty. Speakers did not sugarcoat the turmoil in the commercial mortgage market in 2022, nor predict a rapid recovery in 2023. Everyone recognized the extraordinary impact of rising interest rates on the real estate industry and the corresponding impact in the loan market. CMBS and CLO issuance fell like a rock in the second half of 2022 and most expected even fewer transactions this year. Banks, while in good health, have held back until they can more accurately assess the risk of new loans and face intense scrutiny by regulators of their commercial mortgage exposures. Because banks are less willing to provide warehouse lines, debt funds and mortgage REITs have less capital to lend and less leverage to support their required returns. Lending continues, but there is no indication that the transaction volumes that conference attendees will enjoy in 2021 and early 2022 will return any time soon. The current uncertainty has legs.
  • All Roads Lead to the Fed. A big driver of this uncertainty is the Fed’s fight against inflation and whether rates will continue to rise through 2023 or start falling at some point in the year. While a few speakers expressed hope that rates will come down over the course of the year, most felt that the Fed will keep its word and do what it takes to bring inflation down to 2%. This message was echoed by a Fed representative at the conference. Several panelists reminded the group that hope is not a strategy and that we must prepare for the new long-term reality of higher interest rates, which are still below their historical norm. Perhaps the great irony of the current situation is that changes in asset values ​​are not included in the consumer price index (CPI) measure of inflation: policy adjustments The Fed over the past fifteen years at a low CPI have dramatically inflated asset values, and its response to rising CPI growth results in value destruction.
  • Evaluation is key. One of the most difficult challenges as we move into a higher interest rate environment is estimating this decline in property values. There were few transactions in the second half of 2022 and the bid-ask spread between buyers and sellers remains wide. It has been noted that two valuations of a recent transaction resulted in drastically different values ​​simply because the capitalization rates used were so far apart. Higher rates and the risk of uncertainty are putting upward pressure on cap rates, which will certainly push values ​​down, but it’s too early to tell by how much. Every valuation today is guesswork. From an investor’s perspective, knowing the right price to pay now and estimating the value at exit is nearly impossible. For lenders, convincing a credit committee to disburse money when the value of collateral may drop can turn into awkward conversations. Without price discovery, there is no liquidity, and the first step is for sellers to capitulate as they realize their properties are worth less and there is no financial engineering available that will fix the problem.
  • All eyes on Refis. This year, most lenders will focus less on new originations and more on monitoring debt maturities and covering debt service on existing loans. With more than $400 billion in loans maturing in 2023, resolving each situation with the borrower will be a full-time job. Due to value uncertainty and tighter underwriting standards, loan-to-value ratios are likely lower today than when the loan was made. As the loans mature, it will be difficult to refinance the outstanding balance without injecting cash, as is already common. The good news is that many properties have good cash flow. But a borrower with several assets can only finance a limited number of refinancings. When will they run out of money? And how many capital calls can a sponsor or private equity fund request from its investors? The market is watching for this tipping point as we move from extensions to workouts. Lenders cannot give up when their cost of capital is high. Instead, expect them to proactively require remittances and other structures to prevent future defaults. Perhaps the market will finally appreciate the benefits of depreciation, which has been virtually non-existent for the past decade.
  • Long Covid: The office sector. At previous conferences, panelists have often done their part for the real estate sector and spoke optimistically about the recovery of the office sector. Those days are over. While encouraging everyone to return to the office, it has become clear that the sector is in deep trouble as tenants adapt their space needs in a hybrid work environment and older buildings become increasingly more undesirable. Lenders have already stayed on the sidelines: desktop lending in CMBS issuances fell more than 50% in 2022 and banks seemed unprepared to step in. The only office loans that are granted are secured by new buildings full of amenities and plaques listing the environment and well-being. certifications all around the hall. Although delinquencies on office loans did not increase, many panelists predicted a rapid increase in loan restructurings, particularly for office loans maturing this year. Old buildings, whose leases are expiring, which have ignored the call to reduce carbon emissions and which are located in emigration markets are replacing class B shopping centers as the most undesirable commercial real estate sector .
  • Don’t panic! The big news from the CREFC conference was that the crowd was realistic but not depressed despite the gloomy outlook for 2023. We are not in a financial crisis shaken by a sudden event and the current difficulties are not the fault of the industry. Employment remains robust, overall debt is reasonable and banks are healthy. Some saw higher interest rates and the reduction in values ​​as a necessary return to a market economy that will ultimately attract more capital to the sector. And all were convinced that the industry would go through this transition, not without pain, and come out stronger on the other side. We’ve been through worse. Once interest rates stabilize (although they are much higher than before) and valuations clear up, liquidity will return and trading volume will rise again. But we will need a new mindset to get there. As one panelist said, there must be surrender before condemnation. Until that happens, lenders continue to lend, just picking their places carefully. Multifamily and commercial real estate remain a good credit asset class.

Kudos to everyone at CREFC for allowing the industry to creatively and thoughtfully discuss the economic environment and its impact on real estate debt capital, as we work together through the market reset.

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