The CREFC Annual Conference: Balmy Breeze or Tempest Ahead?

The mood was noticeably changed at last week’s Commercial Real Estate Finance Council (CREFC) Annual Conference. At the January conference, the house was packed and attendees were ready to party, hopeful that interest rates would start to decline and more confident capital would revive the flow of multifamily and commercial real estate transactions. Yet many in January expressed concern that the recovery would be slow. And they were right. Attendees came to the June conference optimistic yet sobered by lack of deal flow in the last six months. Most market participants didn’t appear to have much to do, except perhaps the surveillance teams and servicers who are frantically monitoring the status of the more than $6 trillion of outstanding commercial mortgage debt.

While all the panels were fine -- as in every CREFC event -- there wasn’t all that much to talk about. Professionals in the industry today are akin to sailors in the doldrums: waiting for that breeze to carry them forward, while at the same time praying those fresh winds don’t turn into a violent storm. It’s not easy for lenders to know that while about $1.5 trillion of loans will be maturing, most can’t jump in and finance those deals. Most attendees seemed frustrated and concerned, but certainly not downcast. The veterans are a resilient group who have been through lending cycles before.

Here are a few themes that emerged from the panel discussions:

Let’s Make a Deal

Lending is as tough today as most remember at any time in their careers. Regulators and credit committees are scrutinizing deals, focusing on collateral valuations, leverage, and cash flow trends. In addition, there is intense focus on the sponsor, even though some excellent sponsors have been giving back properties. Since borrowers aren’t paying off loans unless they absolutely have to, typical payoff volume is a trickle and there isn’t as much fresh capital to lend. And continued volatility of interest rates has made it difficult to price loans, putting borrowers in the position of not knowing their cost of funds until the last moment. All of this means few transactions are likely in the second half of the year. So how will that $1.5 trillion be refinanced?

The Commercial Mortgage-Backed Securities (CMBS) market was created out of the savings and loan crisis to bring liquidity to an illiquid mortgage market. With new issuance volumes remaining low and investors highly skittish, it does not appear that CMBS will be able to fulfill its mission in the absence of more traditional balance sheet lending. Investors are more focused on their existing bond portfolios than new deals, tracking underlying loan performance and nervous that servicers will allow loan extensions, prolonging the receipt of low interest rates and elongating duration.

Banks are in the hot seat after the March mini-crisis and regional banks are particularly exposed to commercial real estate risk. Panelists said that while banks are eager to lend, they will no longer take syndication risk, and therefore not do as many large loans. Like CMBS investors, management is more focused on monitoring their loan books, and negotiating with borrowers on upcoming maturities in the hope of avoiding foreclosures. Management is also awaiting the release of the so-called Basel III Endgame proposals in June, which could increase capital requirements by 20%, making lending less profitable.

Life insurance companies are cautious but trying in grabbing market share where banks are retreating, and can handle some larger loans. But it’s worth noting that the insurance companies are doing more lending for their third-party asset management accounts than for their own books. 

If they have funding, the big winners to pick up market share are private lenders, the multitude of debt funds increasingly eager to provide core, value-add, and construction lending. The problem for borrowers is the higher interest rates funds charge. That could mean that even as interest rates eventually decline, if the traditional lenders don’t step back in borrowers may continue to pay higher rates to the alternative sources of capital, eating into their yields and cash flows. Borrowers should also keep in mind that many debt funds are affiliated with equity investors and developers, and, unlike traditional lenders, more than willing to foreclose if things take a turn for the worse.

Despite all these tough market conditions, lending is still happening across markets and property types, except for the office sector, which is a very hard sell to any credit committee right now. One mortgage banker told me that there were no takers on a New York City office refinance offered to ninety lenders.

Boots on the Ground - Loan Performance 

The good news – there is always good news – is that the industry entered this mess with the wind at their backs. The last decade has seen robust growth of net operating income and loans have been well underwritten. One panelist’s analysis showed that since 2016 weighted average CMBS loan-to-value ratio (LTV) was below 60% and weighted average debt service coverage ratio (DSCR) was above 2.0x, but of course recently higher interest rates have caused debt coverage to fall.

Despite falling property values, many borrowers still have significant equity in their deals to protect. Others, depending on property type, market, tenancy, and a host of other factors, will not find it worthwhile to fund debt service on floating rate loans or the capital required to resize the loan when it matures. It is too early to know which scenario will ultimately be more prominent, but panelists were alarmed at the number of property givebacks so early in the process. Others noted that in prior cycles, loan performance metrics significantly lagged the events that trigger them, perhaps by several years. Defaults hit their highest point four years after the end of the Great Recession. Accordingly, it appears we are in the “in between” time before workouts really gain steam, so expect delinquency and default rates to rise over an extended period. But we may not have to wait too long for the winds to arrive; one panelist cited a Trepp report indicating that 35% of 2023 and 2024 CMBS maturities will be challenging to refinance. And a poll of participants at one panel suggested a 26% - 50% payoff rate, not statistical but indicative of their frame of mind and concern. Unlike during the pandemic, there will be no government stimulus and regulators haven’t hinted at any accommodative actions to quell the gathering storm.

The Rest of 2023

The panelists urged the industry to take a measured approach to the problems it faces. Some felt there was too much “hysteria” in the system, at times promoted by distressed investors who want to shake things up. Given the positive ride for commercial real estate since the Great Recession, many property owners will be incentivized to invest to maintain their properties and provide returns to their investors. Each deal has its own story, even in the office sector, despite the universal impact of higher interest rates.

Lending will continue at a slow pace as lenders pick their spots, and momentum is seen for five-year fixed-rate loans. Floating rate loans are off the table for most until the cost of the hedge becomes economical. But lenders remain cautious, and so do equity investors, as asset valuations continue to fall. It is unlikely to see any significant return of capital for the rest of the year. Continued negative leverage in most investments is unsustainable and can only be solved by a further correction in capitalization rates and property values.

We note that right after the conference ended the Fed announced a pause in rate increases in June, but between the lines was a reasonable probability of one or two more rate increases before the end of the year, which would bring the Fed Funds rate to 6%. That additional 50bp rise in rates would accelerate loan delinquency, defaults, and workouts, and extend the withdrawal of capital from commercial real estate. 

Optimism is hard in an environment where interest rates may still trend upward, floating rate debt is more and more difficult to hedge, loans are maturing at a fantastic rate, and there isn’t much capital to meet that demand. We are more likely to be in the calm before the storm than about to get a lift from any favorable winds. Yet CREFC members are a resilient bunch who realize that while the next couple of years will be tough, the industry will make it through to the next up cycle. Enjoy the doldrums while you can.