We have reached the halfway point for 2023, and what a year it’s been … so far.
The first six months of the year brought hasty interest rate hikes, confused capital markets, volatility industrywide, new lender underwriting parameters, and a lot of unanswered questions about the future. Yet, despite all these factors, lenders who were in the market and active (primarily life companies and agencies) found a way to get capital out the door efficiently, to get a head start on their annual allocations. We were seeing sales transactions move forward (albeit at lower levels compared to 2022) and had proactive borrowers getting ahead of pending maturities 12 to 24 months out, not knowing what the future held. In addition, after a slow end to 2022, lenders were focused, hungry, and eager to start the year off, for the right deals. Financing activity was relatively elevated given the circumstances, and lenders were able to place dollars. That isn’t quite the case anymore.
Reality has set in, and finding financing right now, whether it be for construction, acquisition or refinancing, has become more challenging. Sourcing debt isn’t as straightforward as it was, and borrowers can’t get everything they want from just a small stable of relationship lenders. So, what’s causing lenders to pause right now? Let’s look at each source of capital.
Banks. This one is straightforward. We all know the banking system has been facing extreme scrutiny, especially the regional banks, which represent some of the most active banks in commercial lending. The Fed increasing short-term rates, a lack of payoffs due to lower sales volume, higher reserves for riskier-rated loans and low deposits have all created a liquidity crunch for the banking industry. This slowly started at the end of 2022 but grew exponentially through the first few months of the year. Unless you are a top, long-standing customer, getting accretive terms or even quotes from the banks has become very difficult.
Life companies. Life companies were large benefactors of banks being out of the market early in the year as they were seen as the best source of liquidity in the capital markets space for development and existing assets. This lending source doesn’t have to worry about deposits and isn’t as tied to the fed funds rate, so it has more flexibility to continue lending in today’s environment. In addition, life company allocations for 2023 were slightly lower than in 2022 for many lenders, in some cases by even as much as 20%. The pause in the life company space is primarily driven by allocation constraints, and the ability to invest in alternative vehicles, primarily corporate bonds that are yielding strong returns without real estate risk.
Debt funds. Not by choice, but debt funds have had a difficult first half of the year. Warehouse lines were being pulled and became much more expensive, and securitizations were few. A combination of these factors (and floating rate indices increasing significantly) have driven their costs so high that making terms pencil for borrowers can be difficult and non-accretive. Spreads are in the 300-500 basis point range, with SOFR now pushing over 5%. With that said, debt funds have significant dry powder to place and are actively trying to get deals done. If borrowers have a deal where they can take on a high cost of capital for higher leverage, the availability is there.
CMBS. Conduits have the capital, but their cost of debt with spreads pushing 300-350 bps over the corresponding swaps makes it difficult to work. There have been few securitizations this year and pricing on those remain elevated, resulting in higher yield requirements for CMBS lenders. A lack of flexible prepayment and no direct loan servicing make it hard for borrowers to take on this cost of capital, even if they can push loans to value.
Agencies. Agencies are active and trying to get as much business done as possible – a slower investment sales market is the only thing holding them back right now. They are one of the best sources of liquidity for multifamily, and they are only about 33% of the way through their allocations for the year. They can offer rate buydowns, preferential pricing for energy-efficient affordable housing programs and can typically stretch the highest for proceeds and interest only.
Another way to illustrate the current environment is by using a recent case study from a financing the Essex team is currently working on. The marketing process included reaching out to 120 different lenders (banks, life companies and debt funds) only to produce four (really 3 ½) quotes on a deal that would have seen 10- to 15-plus term sheets 12 months ago. That is the reality we’re facing right now.
So, what is the best way to navigate this current environment? Casting a wider net, being comfortable going outside of existing lender relationships, and considering any and all options if a financing decision is imminent. As mortgage bankers, we are finding ourselves having to double the number of lenders in our marketing processes with hopes of getting the same number of quotes, if not less. It takes persistence, having the right relationships and being able to craft the right story to get lenders to the table. Appetite and requirements are changing daily with lenders dipping their toes in and out of the market on a consistent basis – it is important to be up to speed with real-time information on who is active.
This could feel a little bit like the dog days of summer for the capital markets world, but we are hopeful that lenders will shift back to their normal habits of having a year-end push toward the end of summer. Commercial mortgages are a very important piece of lender investment portfolios, and the overarching demand for more exposure to commercial real estate is still a significant driver despite current economic conditions.