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Mark Reichter of Gantry on market recalibration ahead of a new government cycle.
The outcome of the 2024 election is decided, and whatever side of that contest you were on politically, commercial real estate professionals will now need to process rapidly evolving market conditions. Despite the recent rate cuts by the Federal Reserve in recent weeks, we have seen a converse spike in treasury yields, a nearly 70-basis-point increase over the past 30 days, and treasury yields are much more closely aligned with CRE lending costs. It remains to be seen as to whether or not we should expect treasuries to remain at this heightened level as the market aligns for a new government cycle.
For multifamily investors already navigating some choppy waters, this new volatility in underlying benchmarks will cause additional unease. We’ve already seen a pause in asset trades as buyers recalibrate. Sellers are still facing a challenging market where refinancing maturing low-rate debt faces the challenge of debt-service constrained loan amounts, which will impact property values. Still, multifamily fundamentals remain essentially strong, even as new underwriting tests emerge. In some markets, we have seen some softening in rents as a substantial wave of new product comes online this year, but that increased vacancy is tightening, and a dearth of development planned to deliver in 2025 and 2026 should reverse cooling rent growth and tighten occupancy moving forward.
We are still in a better place overall year-over-year in terms of current rates and the market has mostly adjusted to a higher cost of capital. The 52-week spread for treasuries ranges widely from 3.5 percent to up to 4.7 percent showing volatility is still a concern. This impacts sentiment but we are still seeing manageable debt options for the time being.
The bright spot is that as the market continues to move through a period of recalibration, liquidity in the capital markets remains strong. National, regional and community banks in this cycle that have retreated from making new originations as they process through struggling construction loans on their books has been mitigated by alternative sources.
Arguably, the potential for rising treasuries can make today’s rates more attractive than they currently feel, and that is saying something. The question is, where will your capital come from? What is the best way to approach financing in a volatile market?
Life companies: The insurance lenders have stepped up over the past two years as a ready source for permanent and bridge debt. In a volatile cycle their willingness to lock rate at application will be a huge contributor to smoother closings. If rates were anticipated to fall significantly in the near term, that could reward a borrower’s hesitation, but currently upward movement or a hold at current levels are more likely than a significant drop. Life companies are also competitive on spread depending on asset and sponsor quality. Their streamlined process once they have checked their initial boxes is appealing. Life companies have also become more willing to build in prepayment flexibility past the five-year mark. The tradeoff with life companies to other capital sources is often they provide less loan dollars requiring a higher equity contribution. They will also limit interest only periods. That being said, rate lock at application is by far the most attractive element in a volatile cycle.
For transactions that are less rate sensitive, agency and CMBS options will also be appealing.
Agencies: The Federal agencies are only available to multifamily CRE borrowers and can often provide more dollars and longer interest only periods. However, rate lock does not come on the front end of the underwriting process, a lag that can scuttle a viable transaction simply through volatility. Agencies want to meet their allocation targets, and if they are not meeting their market caps, they may lower overall spreads accordingly. What hinders the process on the agency side is once the underwriting lender is done and submits the loan to the agency, it takes pause for the approval process. Depending on agency business flow, that can slow down the approval process to a crawl without a clear rate lock. Due to concerns of fraudulent activity in the past, agency lenders are scrutinizing and doing a significant amount of due diligence in the process that you won’t encounter with the life company lender set who directly control their complete underwriting process. Will the new administration privatize the agencies in the near future and ease the burden of these stringent underwriting parameters?
CMBS: CMBS loans are very cash-flow driven and can require a far more complicated underwriting process (especially with B-piece buyers) and thus these loans are far more subject to rate volatility. While not as competitive on spreads as life company and agency options, they are able to offer more dollars and full-term interest only to support debt service. These loans have returned to favor with the investment markets as underwriting has improved their quality. While for other asset classes CMBS may be the only option for securing debt, multifamily access to agencies and life companies presents compelling options to prioritize. CMBS will also be appealing to larger ticket financings that exceed life company or agency criteria.
Bridge: Shorter-term bridge loans are appealing to a borrower looking to get past current realities to a future (and hopeful) lower rate climate. For assets seeking to improve NOI while they wait for rates to come down these loans make sense. Bridge debt can get done quickly and bring debt funds into the mix, albeit with significantly higher rates. There are also fixed and floating rate bridge loans to consider. Fed action does have a more direct correlation with SOFR than treasury benchmarks, making a variable rate loan an option worth considering in this current cycle. Ultimately, an asset that was a little over leveraged with a bank loan or construction loan may be able to bridge out to a future lease up and stabilization. Bridge loans provide an additional option to the more stabilized alternative lenders listed above and should not be ignored for a property in transition.
Every real estate cycle presents opportunities. When debt is approximately 70 percent of the capital stack, knowing and capitalizing on the cost of that debt is key to any transaction. In a tough cycle for commercial real estate, where volatility and disruption are prevalent and long-lasting, knowing what capital options are available to you is vital and timing is everything, especially in a moving rate environment.