The Surfer Mentality
The latest Senior Loan Officer Opinion Survey by the Federal Reserve, the best early warning system for potential disruptions or significant changes in the CRE debt market, shows that with the exception of a brief period at the start of the pandemic, securing capital for commercial real estate transactions in the U.S. is currently more challenging than at any point since the Global Financial Crisis. In the second quarter, MSCI also reported that regional U.S. banks experienced a significant decline in their market share of new CRE loans valued at $2.5 million or more, dropping from 34% to 25%. This is the largest quarterly decline since 2011, although the data from MSCI doesn't include extensions, which have surged due to a combination of increased maturities and high interest rates. Just before this decline, regional banks had reached their highest share in MSCI's tracking history, at 34%. A decade ago, in Q2 2012, their market share was only 8%.
According to Willis Tower Watson (WTW), the reduction in bank lending offers a chance to bridge the funding void with non-bank capital sources. Jon Pliner, WTW's senior director, explained that “There is a big opportunity for alternative lenders, such as private credit and direct lenders, to take up commercial real estate lending as an alternative to local banks”. WTW point out that delinquency rates are lower than in previous cycles, although its analysts expect distressed activity to increase over the coming years. According to WTW, the most at-risk loans are those originated in recent years, most at peak valuations with variable interest rates.
Funding this gap will not be straightforward. A recent report by Newmark reveals that over a third of the $1.4trn worth of upcoming commercial real estate loans in the U.S. within the next two and a half years are at risk. Specifically, around $626bn of these loans are linked to properties with debt reaching at least 80% of their current market value. This indicates potential difficulties for borrowers in repaying these loans. Nearly half of this debt, approximately $303bn, is owed to banks. Debt funds hold $144bn of these loans, which is a large portion considering their market share. Newmark researchers pointed out that many loans are either in a negative equity position or very close to it, especially recent loans across various property sectors and a significant portion in the office sector.
In Europe, AEW report that borrowing costs have surged to a 20-year peak, although in Q2 2023, both Euro and Sterling borrowing costs have begun to stabilise. This stabilisation is attributed to a pause in 5-year swap rates following multiple rate hikes by ECB and BoE aimed at curbing inflation. Loan-to-value ratios (LTVs) are also very conservative. AEW report that although the latest CREFC financial covenant sentiment survey shows improvement, it hasn't yet translated into a reversal of the downward trend in actual LTVs. Nonetheless, there's an expectation that LTVs will stabilize at 50% by the end of 2023. AEW's comprehensive analysis indicates a cumulative €93bn Defaulted-Facing Gap (DFG) for the 2023-26 period across six countries.
Ares Management's senior leadership, which foresees increased consolidation within the struggling US regional banking sector, also sees an opportunity for alternative lenders. Jarrod Phillips, Ares' CFO, spoke of potential loan portfolio opportunities arising from the consolidation in the regional banking sector. He extended the pull back to larger banks “The broader opportunity is going to be in the larger banks as they wrestle with increased regulatory capital requirements. And I think that is largely going to be a story for alternative credit,” he added. Ares CEO and President, Michael Arougheti, emphasized that the challenges in the banking sector might persist for another year or two, anticipating further consolidation and consequently drive institutional investor demand for debt “We continue to see strong institutional demand for real estate debt due to the general risk-off sentiment in the banking sector and the outsized return opportunities to inject capital at conservative levels with reset valuations”. In the second quarter, the firm’s real estate deployment included $600 million in European real estate equity, and $400 million in US real estate equity.
Regulation is also playing a part in reducing bank lending to those assets that require repositioning. Peter Cosmetatos from CREFC Europe expressed concern that UK banks might face issues providing capex loans due to the Prudential Regulation Authority's Basel 3.1 proposals as it seems that loans for extensive capex will continue to be viewed through the same lens as development finance. This is a problem for borrowers since banks, being key players, offer the most affordable debt. If they can't fund capex, many projects won't be financially viable. Cosmetatos adds that “Banks may struggle to manage obsolescence risks effectively if they are not in a position to drive the repurposing, decarbonisation or other improvement of the buildings they lend against.” Basel III regulatory reforms will increase regulatory capital that banks must hold and whilst enhanced regulatory reforms are primarily targeted at banks, they will indirectly impact the non-bank lending landscape; pushing banks to retreat from certain types of loans will open up a new lending space for non-bank lenders.
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This cash will be needed as rising delinquency rates and special servicing indicators, primarily driven by the office sector, have helped turn investment returns negative. Ray Severino, Chief Economist for BGO, also believes that many investors have yet to adjust the value of some assets, suggesting further returns may be on the horizon.
Some banks are seeking novel solutions. Landesbank Baden-Wu?rttemberg (LBBW), the largest of Germany’s powerful Landesbanken which doubled its real estate exposure last year when it took over Berlin Hyp, has tasked BNP Paribas with reducing risk associated with its real estate loan portfolio. This initiative, named "Project Eagle," is centred around €5bn worth of commercial real estate loans, as reported by Bloomberg. The objective is to mitigate risk by paying a premium to funds, insuring a portion of the loan portfolio against default. In doing so, the funds assume the risk in case the loans face difficulties. PBB for example disclosed a decrease in profits, but whilst losses from risk provisioning have increased, they are still comparatively low when compared to the levels seen during the pandemic. That said, its worth tracking the trajectory as the bank's non-performing portfolio has nearly doubled year-over-year, amounting to €1.1 billion.
In the UK, indications suggest that a significant wave of distress is not imminent, although they do have some problematic loans in their portfolios. NatWest has stated that commercial real estate constitutes less than 5% of its lending. Within its ￡16.9bn commercial property portfolio, offices account for 16%. Lloyds displays a similar proportion of office exposure in its ￡11.5bn portfolio, and Barclays has an even lower exposure. NatWest detailed the credit risk breakdown of its commercial property portfolio, revealing that nearly ￡2.3bn of loans were categorized as "stage 2," signifying underperformance – an increase from ￡1.4 bn compared to the previous year.
New capital is being raised for debt to fill the lending void. In the U.S., the California Public Employees' Retirement System allocated $1.5bn to Blackstone Real Estate Debt Strategies V and $350m to Mesa West Real Estate Income V. Blackstone's debt fund has gathered $3.59bn for various financial activities, including lending and structured debt. Mesa West's fund, managed by Morgan Stanley Investment Management, has raised $1.37bn to provide loans for enhancing or transitioning commercial real estate assets across the US, exceeding its initial $1bn goal.
PGIM analyse the return characteristics of private real estate debt which it finds shares characteristics with bonds, including steady income, predictable returns, and low volatility. They find that its performance is highly correlated with bonds, about 80% and that it offers an ‘illiquidity’ premium. They estimate that since 1978, real estate debt has provided a return of 7.3% compared to 6.5% for the U.S. Aggregate and 7.0% for Corporate Bonds, with similar or lower standard deviation of returns (6.3%). This indicates higher returns without higher risk. They also find that U.S. Aggregate and Corporate Bonds experienced more severe and frequent drawdowns (largest peak-to-trough loss before a return to previous peak levels), compared to core real estate debt since 1978. Moreover, the duration of a drawdown and the period to recovery following a maximum drawdown is shorter for core real estate debt compared to bonds.
"Dequity"is a portmanteau with attributes of both debt and equity currently make the rounds in CRE, however this neologism is by no means new. A paper as early as 1989: “Are the distinctions between debt and equity disappearing” first mentioned this concatenation of debt and equity, however pref equity – its closest incarnation – despite having the easiest fundraising pitch of all time “higher returns than equity without taking first loss risk” will soon be the most overplayed term in CRE due to the challenges in deploying capital. Increasing competition will drive down the cost of preferred equity, and given the typical size of a pref ticket is very small (it only compromises of 10-20% of the capital stack) many investors will be unwilling to commit to deals unless there is enough volume, which is unlikely because of the increased competition referenced above and a general reluctance for borrowers to accept the high cost anyhow.
Investors riding this wave of dequity doublespeak should consider the Surfer Mentality: when a surfer gets up on a wave, they enjoy the present moment, even though they know with certainty that the wave will eventually end. The surfer knows that they don't have to ride every single wave that comes their way, they have the freedom and the power to choose which waves to take, and which waves to let pass by. The majority of the time, the surfer is biding their time, but patience and proper positioning is all that matters for when the next wave inevitably comes. The metaphor is analogous to the current market; whilst preferred equity and mezzanine debt currently hold exceptional allure due to a retreat by senior lenders, the true narrative lies in the scarcity of senior debt and the plethora of opportunities that exist for non-bank lenders. Aviva Investors' recent analysis demonstrate that in the UK and Europe real estate equity investments are beginning to align in terms of absolute returns with debt strategies. Might the blurring of equity and debt returns imply that investors should continue to ride the wave of favourable debt transactions, whilst monitoring for accretive equity deals which appear just beyond the horizon?