Risk-Off: Caution Reins as the Cost of Capital Rises

Key Take-Aways

• The end of the cheap debt regime of the last decade has upended the commercial real estate market, casting doubt about real property values. As result, the tolerance for risk among investors and lenders has plunged.

• As investors and lenders move to the sidelines, focus has shifted to assessing existing portfolios, identifying current or future troubles, and formulating solutions.

• With commercial real estate values eventually resetting lower, investors who exhibit discipline and persevere through this turbulent time will be situated to take advantage of attractive opportunities in the future.  

The era of plentiful and attractively priced debt and equity capital that drove the commercial real estate market over the last several years has come to an end. And with it, the certainty of property values.

Since the Federal Reserve began to aggressively raise the federal funds rate at the beginning of the year, the U.S. 10-year Treasury yield has climbed more than 100 basis points to around 3 percent. What’s more, the Secured Overnight Financing Rate has risen to 229 basis points from virtually zero since the beginning of the year, and nearly 160 points of that increase has occurred since mid-June alone as the yield curve turned negative.

Despite these changes, many sellers continue to demand prices for their assets that reflect the market eight months ago, which is fueling a bid-ask spread.

Combined, these variables are having a material impact on the commercial real estate market as the number of property sales fell for every category in the second quarter from a year earlier, ranging from a decline of 8 percent for apartments to 54 percent for hotels, according to MSCI Real Assets.

As a result of this abrupt shift in the financing environment, commercial real estate lenders, sponsors and equity providers are playing by new rules, with risk avoidance topping the list.

We believe that eventually property values will reset lower to mirror the higher cost of capital, but until that happens, lenders and investors will be subject to a choppy and uncertain financing market. Therefore, caution and discipline are in order. Here are a few suggestions that can help lenders and investors calculate and reduce risk:

• Now is the time for underwriters and investors to review and stress test their portfolios against deteriorating conditions that not only take into account the higher cost of capital, rising capitalization rates and fundamentals, but also recession. Are the loans or properties becoming bad risks due to higher payments on floating rate debt, declining NOI or approaching lease expirations, for example? An equity provider we’re familiar with is trying to sell part of its positions in projects to reduce its risk, while another has replaced a general partner that was not performing. We’ve also seen lenders sell off troubled loans to prevent a further erosion of capital.

• Underwriters should also assess current opportunities with a much more conservative and critical eye to ensure that the loan terms are properly aligned with risk. Providing debt of up to 70 or 75 percent of an asset’s value may no longer be viable for many deals in the current cap rate environment when considering debt yields and debt coverage ratios. Those advance rates are more likely to now be 65 percent or even 60 percent. Underwriters should also require increased reporting, reviews, interest reserves and other controls to enhance a lender’s position, particularly if a deal has hair.

• Underwriters should approach construction loans with a high degree of caution. In addition to analyzing monthly expense and stabilization projections, the decision to make a construction loans should equally weigh a project’s specific location in a submarket, the sponsor’s financial wherewithal, experience in tough economies, and the possibility for construction material shortages or delays to push back completion and stabilization dates. Lenders that take the same approach to construction financing today as they did a year ago may find themselves with a half-built project that they have to sell for pennies on the dollar.

• Investors that typically target an 11 to 12 percent investment return using 70 percent leverage have seen their cost of capital rise by more than 200 basis points. If sellers are unwilling to adjust prices, those borrowers have limited options: Move to the sidelines and do nothing, or inject more equity and accept a lesser return. As evidenced by the decline in investment sales, many have chosen the former. Ultimately, this lack of activity will exert downward pressure on prices.

While we expect the current conditions to play out for the foreseeable future – and perhaps worsen – there is a silver lining: The tumult is setting the stage for attractive commercial real estate opportunities to emerge as over-valued and highly leveraged properties fall into distress. Investors that exhibit caution, patience and discipline to avoid taking undue risks today will position themselves to take advantage of those opportunities tomorrow.