CREFC 2023: Cautious Optimism in the Face of a Market Reset
January 16, 2023
By Joe Rubin
Despite the most difficult commercial real estate lending environment since the global financial crisis, the CRE Finance Council (CREFC) January meeting had record attendance. This was not 2008 when CMBS issuance dropped by 95% and CREFC (then CMSA) was forced to review attendance and room reservations twice daily to make sure the meeting would stay in the black (I was the treasurer then and remember those calls well). Instead, the hotel was packed inside and out with people networking, having business meetings, attending conference sessions, and glad to be in the Miami sunshine.
As usual, the conference sessions were filled with great content and commentary from the industry’s leaders. Here are a few conference themes:
- Honesty. The conference speakers did not sugar coat the turbulence in the commercial mortgage market in 2022, nor did they predict a quick recovery in 2023. Everyone recognized the extraordinary impact of higher interest rates on the real estate sector and the corresponding impact on the lending market. CMBS and CLO issuance dropped like a stone in the second half of 2022 and most predicted even fewer deals this year. Banks, while healthy, have pulled back until they can more accurately assess the risk of new loans and deal with enhanced regulator scrutiny of their commercial mortgage exposures. Because banks are less willing to provide warehouse lines, the debt funds and mortgage REITs have less capital to lend and less leverage to support their required returns. Lending continues, but looking forward there is nothing to suggest the transaction volumes enjoyed by conference participants in 2021 and early 2022 will return any time soon. The current uncertainty has legs.
- All Roads Lead to the Fed. One of the great drivers of that uncertainty is the Fed’s battle with inflation and whether rates will continue to rise through 2023 or begin to fall at some point during the year. While a few speakers expressed hope that rates will fall as the year progresses, most felt that the Fed will stick to its word and do what it takes to bring inflation back to 2%. This message was echoed by a representative of the Fed at the conference. Several panelists reminded the group that hope is not a strategy, and we must plan 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: the Fed’s accommodations during the past fifteen years of low CPI hugely inflated asset values, and its response to higher CPI growth causes value destruction.
- Valuation is Everything. One of the most difficult challenges as we transition to a higher interest rate environment is estimating that fall 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 was noted that two appraisals on a recent deal 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, and that is certainly going to push down values, but it’s too early to know by how much. Every valuation today is guesswork. From the investor perspective, knowing the right price to pay now and estimating the value at exit is next to impossible. For lenders, convincing a credit committee to put money out when collateral values may drop can turn into embarrassing conversations. Without price discovery there is no liquidity, and the first step is the capitulation of sellers as they realize their properties are worth less and there is no financial engineering available that will solve the problem.
- All Eyes on Refis. The focus for most lenders this year will be less on new originations and more on monitoring debt maturities and debt service coverage on existing loans. With over $400 billion in loans coming due in 2023, working through each situation with the borrower will be a full-time job. Due to value uncertainty and stricter underwriting standards, loan-to-value ratios are likely lower today than when the loan was originated. As loans mature, it will be difficult to refinance the outstanding balance without a cash infusion, as is already common. The good news is that many of the properties have good cash flow. But a borrower with multiple assets can only fund so many refinancings. When will they run out of cash? And how many capital calls can a sponsor or private equity fund require of its investors? The market is watching for that tipping point when we shift from extensions to workouts. Lenders can’t kick the can down the road when their cost of capital is high. Instead, expect them to proactively require cash sweeps and other structures to avoid future defaults. Perhaps the market will finally appreciate the benefits of amortization, which has been practically non-existent for the last decade.
- Long Covid: The Office Sector. At prior conferences, panelists often did their part for the real estate industry and spoke optimistically about the recovery of the office sector. Those days are over. While encouraging everyone to go back to the office, there was a clear realization that the sector is in big trouble as tenants adjust their space needs in a hybrid workplace environment and older buildings become increasingly more undesirable. Lenders have already been staying away: office loans in CMBS issuances dropped over 50% in 2022 and banks did not appear ready to jump in. The only office loans getting done are secured by spanking new buildings chock full of amenities and plaques listing environmental and wellness certifications all around the lobby. While office loan delinquencies have not increased, many panelists projected a rapid rise in loan workouts, especially for office loans maturing this year. Buildings that are old, have upcoming lease expirations, ignored the call for carbon reduction, and are located in out-migration markets are replacing B-class malls as the most undesirable commercial property sector.
- Don’t Panic! The great news about the CREFC conference was that the large crowd was realistic but not depressed despite the dour outlook for 2023. We are not in a financial crisis jolted by a sudden event and the current difficulties were not the industry’s making. Employment remains robust, overall leverage is reasonable, and the banks are healthy. Some viewed higher interest rates and the reduction in values as a necessary return to a market-based economy that will ultimately attract more capital to the sector. And all were confident the industry will work through this transition, not without some pain, and come out stronger on the other side. We’ve been through worse. Once interest rates stabilize (albeit much higher than before) and valuations become clearer, liquidity will return and deal volume will rise again. But we’ll need a new mindset to get there. As one panelist said, there must be capitulation before conviction. Until that happens, lenders are still lending, just gingerly picking their spots. Multifamily and commercial real estate remain a good credit asset class.
Kudos to all at CREFC for enabling 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.