Will Capital Markets Liquidity Revive?
Fed Policy Tightening Prompts Caution from Lenders — Key Trends to Look for in the Year Ahead
As the Federal Reserve continues its rate hikes to curb inflation, the capital markets have responded with overwhelming caution until there is clarity on when the Fed will stop and where interest rates are likely to settle. Several questions compound this uncertainty, including volatility in the stock market, geopolitical risk, decelerating rent growth, falling home prices, and cap rate inflation. Lenders and investors alike are taking an observant pause to avoid “catching a falling knife,” while using this time to raise funds for what they believe will be impending distress in the commercial real estate market, much like they did in 2020 after the onset of the pandemic. In 2020, the capital providers that took the risk to lend or invest tended to come out on top, while much of the market missed the opportunity, due to an abundance of caution.
A recent client survey conducted by Marcus & Millichap concluded that the availability of financing is a top concern among investors for 2023. While no one has a crystal ball, this report will discuss some of the potential trends that the capital markets may have in store for the coming year. These eight prognostications are based on a few key assumptions, including that the Fed eases up a bit on its pace of rate hikes, the economy weakens modestly — but doesn’t plummet — and there are no other unexpected black swan events or catastrophes.
Margins Compress, Similar to Past Cycle?
Cash Becomes King
Well-Capitalized Investors Can Capitalize on Market Dislocation, while Highly-Leveraged Borrowers May Face Challenges
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Expect higher leverage options to remain less available — particularly for construction loans, renovation loans, and other highly transitional business plans. This is due, in part, to constraints in debt service coverage ratios that are trumping debt yield and loan-to-value limits for the first time in recent history. As interest rates rise, leverage will reduce further, leading to a necessity for price decreases to hit target yields. All cash buyers, or buyers who can take a lower leverage level of “negative leverage,” will be able to acquire assets at lower price points, as they will not be held hostage to the current capital markets environment.
Rescue Capital
Mezzanine Debt and Preferred Equity Capital Will Once Again be?Prevalent and Available for Pending Maturities
A massive $121 billion of maturities in the CMBS/CDO market alone will hit next year in a landscape fraught with volatility and uncertainty. A substantial amount of capital is being poured into commercial real estate funds that are designed to take advantage, expecting a 15 percent to 20 percent-plus internal rates of returns. Mezzanine debt and preferred equity are the easiest placement positions for this capital, as there is no need to seek leverage from outside sources. Expect this capital to initially target multifamily and industrial assets that cannot refinance out construction, bridge, or possibly even maturing perm debt.
This rescue capital will seek to “fill the gap” between the maturing debt positions and where new perm debt is constrained, based on DSCR, for vehicles like agency debt, insurance company debt, bank debt, and CMBS debt. These subordinate debt players will be leverage constrained based on an asset basis and debt yield, rather than DSCR. As the year winds on and the amount of capital chasing these product types is greater than the opportunities available, expect these funds to start considering hospitality, retail, and select office transactions as well.
Courtesy: Special Report, Marcus & Millichap Dec.2022