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Bridge loans are in favor while the extent of commercial distress today is likely to depend on how long interest rates are high, and the impact on pricing. By Paul Bergeron | | February 07, 2023

While there is plenty of debt capital available waiting to deploy, fewer borrowers are willing to transact unless they must and there is an increase in activity from private capital, and regional and local banks from those who do, according to a new report from CBRE.

Rachel Vinson, President of Debt & Structured Finance, U.S. for Capital Markets at CBRE, said in prepared remarks that she expects demand for shorter-term, fixed-rate debt with shortened call protection to endure well into the second half of 2023.

“The Federal Reserve’s commitment to reduce inflation with aggressive rate hikes continues to heighten market uncertainty, as borrowing costs increase and a lack of price discovery persists,” Vinson added. CBRE’s Lending Momentum Index declined 27% year-over-year in January.

Who’s Lending, And How Much

Banks had the largest share of CBRE’s non-agency loan closings for the third consecutive quarter at 58.3%—up from 46.4% in Q3 2022. More than 80% of bank loans were floating rates. Construction loans accounted for 37% of total bank lending volume, followed by 36% for refinancing and 27% for acquisitions. Life companies were the second-most active lending group in Q4 2022 with 21% of closed non-agency loans—up from 16.7% in Q3 2022. More than half of life company volume in Q4 2022 was for industrial deals. Multifamily accounted for 22%.

Alternative lenders, such as debt funds and mortgage REITs, accounted for 18.7% of loan closings in Q4 2022, down significantly from their 32.3% share in Q3 2022.

Higher spreads and interest rate cap costs created a challenging environment for financing floating-rate bridge loans. Collateralized Loan Obligations (CLOs) issuance was limited to $2.95 billion in Q4 2022, bringing the 2022 total to $30.3 billion—down 33.3% from 2021. CBRE’s Agency Pricing Index, which reflects the average agency fixed mortgage rates for closed permanent loans with a seven- to 10-year term, increased by 60 basis points (bps) in Q4 2022 and 193 bps from a year ago to an average of 5.21%.

Higher mortgage rates and loan constants were the key feature of loan underwriting criteria in Q4 2022. Underwritten debt yields and cap rates on closed loans inched up in Q4 2022. Meanwhile, the average loan-to-value (LTV) ratio increased by 0.3 percentage points from the previous quarter. The percentage of loans carrying interest-only terms remained high, increasing to 72.6% in Q4 2022.

Government agency lending of multifamily assets totaled $47.1 billion in Q4 2022—up from $30.6 billion in Q3 2022. For the entire year, volume totaled $142 billion—up slightly from $139.6 in 2021.

Property Owners Being Squeezed by Rates

Yardi Matrix’s director of research Paul Fiorilla tells that debt availability has diminished, and property owners are being squeezed by an increase in commercial mortgage rates, which have increased by 200 to 400 basis points since reaching historically low levels in the spring of 2022.

“The extent of the commercial distress today is likely to depend on how long interest rates remain high and the impact on pricing, Yardi Matrix said. “If interest rates settle in at 200 basis points higher, cap rates will settle in (approximately) 200 basis points higher. With values falling and much uncertainty about pricing, the only sales taking place “need to transact rather than want to transact.”

The circumstance has created an opportunity for high-yield capital to fill the gap between the balance of maturing mortgages and take-out loans.

Deals Not as Robust as a Year Ago

Peter Margolin, commercial loan originator at Alliant Credit Union, tells, “Similar to other capital providers and traditional lenders, opportunities are surfacing, and we are seeing deal flow in all our markets albeit not as robust as it was 6 to 12 months ago.

“Deal requests in this market are for shorter terms of five years or less. Sponsors and investors are expecting that the recent spike in interest rates will come down in the near term, so requesting shorter tenure loans will allow them to take advantage of future rate decreases.

CMBS and Larger Lenders Leave a Void

Andrew Spindler, senior vice president of Green Street’s Advisory Group, tells that it’s positive to see an increase from private capital and smaller banks as the decreased activity from the CMBS market and larger lenders leaves a void to be filled with impending maturities.

“These sources can sometimes provide more customizable solutions that may be more difficult to address with larger lenders,” Spindler said.

“Even though private capital and smaller banks are increasing activity; the cost of debt is still comparatively very high,” he said.

“Those looking to tap into debt markets are likely only there out of necessity and will be doing what they can do extend current financing with lenders or special servicers. The sectors that are already hard hit from a fundamentals perspective (malls and offices for example) will also be negatively affected by the changes in lending. These sectors can have longer term, larger balance debt that is typically sourced through large banks or public markets.”

Keeping Interest Risk, Credit Risk Under Control

Xiaojing Li, managing director of CoStar Risk Analytics, tells that CRE loan lenders to need to carefully strategize to achieve multiple goals of benefiting from a long-waited profit margin without draining the demand pipeline and keeping interest risk and credit risk under control.

“The shorter-term, fixed rate and shortened call protections are financing options that contain favorable features for both lenders and borrowers under the current conditions when macroeconomic indicators, rates, and valuations are yet to stabilize,” Li said.

“In an upside scenario of the economic outlook, the shorter term and shortened call protections prepare borrowers for better rates and higher loan proceeds when rates start to fall, and valuations resume the rising momentum.

“Loans with fixed-rate will also help cap the debt service obligations from rising, a probable situation throughout 2023 with the variable-rate counterparties.

“The combination of shorter term and fixed rate could mitigate the credit default risk potentially caused by insufficient debt service coverage and shortens the credit exposures for lenders.”

Li said the cost of being agile and flexible with borrowers, from lenders’ perspective, is giving way to the opportunity of locking a higher rate for longer, and a higher prepay risk.

“However, these types of losses are more likely to be realized in a recovery or expansionary scenario where credit risk is overall lower, and the profit of higher lending activities can offset the loss,” Li said.

Transaction Volume Not Showing Significant Traction

Lauren Gerdes, real estate senior analyst with RSM US LLP, tells that there continues to be a gap in valuations between buyers and sellers.

“We are seeing an increase in short-term financing solutions on upcoming maturities until the lending environment stabilizes rather than exiting,” Gerdes said. “This trend is likely to be in play throughout 2023 with interest rates expected to stay elevated through the end of the year.”

She said for the private capital debt market to take off, deals need to close.

“Transaction volume has not yet shown significant traction and most analysts are not predicting a recovery in deal count through the second half of 2023,” Gerdes said.