Comments from Freedom:
The author makes very good points but does not consider unleveraged debt funds such as Freedom Financial Funds, LLC (“Freedom”). Freedom does not depend on public markets or banks to fund our borrower’s loans. Instead we use our equity capital to do so. This makes Freedom able to decide independently of market wind shifts how it will invest and it is why Freedom closed new loans in April and May of 2020, when most of our competitors were sidelined.
For a reliable source of capital, call Freedom.
Freedom is Capital Solved.
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Mark Perkowski of Draper and Kramer on how various lender types are reacting to macroeconomic shifts.
Commercial real estate has generally performed well throughout 2022. Apartments are full, warehouses are renting at record rates, and retail shopping centers and hotels are rebounding from the impact of COVID lockdowns. Despite the strong performance, CRE owners are finding the debt market to be increasingly constrained and expensive. Factors within the broader capital markets—such as Fed policy, the corporate bond market and savings account balances—are affecting the loan terms that CRE capital providers can offer. Here are some of the most significant factors.
Money Center Banks
The largest U.S. banks are subject to the Fed’s reserve requirements, which are determined by annual stress tests. The metrics applied for 2022’s hypothetical scenario were especially severe, with the model supposing a 10 percent unemployment rate, 40 percent decline in commercial real estate values and 55 percent decline in stock prices. Although all 34 banks designated as “large banks” by the Federal Reserve passed the test, some then had to take steps to ensure they could withstand such an apocalyptic (albeit unlikely) hypothetical scenario. That entailed the banks reducing lending and tightening credit standards, which has not only had an immediate impact on the largest borrowers—such as REITs, pension funds and debt funds—but also has had a ripple effect throughout the entire commercial real estate sector by raising the cost of capital for all borrowers.
Insurance Companies
Insurance companies employ a very long-term approach to investment and lending. They invest premiums in a diversified set of assets including stocks, corporate bonds, government bonds and commercial mortgages. The investment team evaluates investment options based on relative value and alters allocations based on return metrics. Their CRE mortgage rates are directly impacted by rates in the corporate bond market. Corporate bond spreads gapped out during the first half of 2022 as the market pivoted to a more “risk off” investment thesis. This caused insurance companies to raise the rates on commercial mortgages to match the returns they can achieve in corporate bonds.
The good news for borrowers is that many insurance companies are reluctant to stop lending completely. It takes time to build a pipeline of good loan opportunities, and insurance companies want to remain an active and available source of capital for their best clients. Many lenders will write loans at suboptimal rates (for a short period of time) to maintain relationships with longstanding repeat borrowers and mortgage bankers.
Community Banks and Credit Unions
The primary source of capital for local banks and credit unions is their deposit base. During a recession, savings levels tend to drop; Northwestern Mutual’s Planning and Progress Study 2022 reports the Americans’ average personal savings dropped 15% between 2021 and 2022. This decreases the lending capacity of community banks and credit unions, which prompts them to tighten standards and raise rates. This leads to a natural attrition in loan volume while simultaneously improving credit quality and boosting return metrics.
During times of economic uncertainty, banks and credit unions are more inclined to lend to repeat borrowers with longstanding relationships. They also gravitate towards loans that generate deposits—ideally 10% to 20% of the loan amount. This means C&I loans (operating businesses), and CRE loans with an operating component, become more favored by local lenders during a recession. Examples include owner-occupied industrial buildings, self-storage facilities and high-net-worth borrowers that are willing to store personal deposits with the lender.
CMBS Lenders & Debt Funds
CMBS lenders and debt funds are acutely impacted by capital market fluctuations. CMBS lenders temporarily store loans on their balance sheet until they are packaged with other loans and sold to bond buyers. Debt funds also securitize loans, or they borrow from large money center banks using their loan portfolio as collateral, allowing them to maximize the profitability of their equity investment.
The volatile stock market this year caused a swift drop in demand for securitized bonds, leading to higher spreads. Spreads in the highest-grade tranches were about 70bps higher this summer as compared to Q4 2021. Some lenders have had to sell their loans at a loss (i.e., pay the bond buyers an interest rate higher than the underlying loan) just to get them off their balance sheet. As a response, both CMBS and debt fund lenders have increased their pricing to protect themselves against continued market deterioration.
There may be light at the end of the tunnel, though. Spreads have recently decreased from their highs, and the market seems to be settling. Although a higher rate environment is expected to continue, pricing will stabilize as lenders grow more confident in their ability to offload loans into the secondary market.
Behind-the-scenes factors like Fed policy, bond rates and consumer savings rates have a powerful effect on the amount and cost of capital for commercial real estate. Lenders have become much more cautious in 2022, for now reducing CRE bets or pricing loans higher. But capital is always available for a price, and while the relative free flow of capital of 2021 has ebbed, lenders will continue to seek good opportunities that complement their loan portfolio.