Exploring uncharted territory

How can owners successfully navigate the capital markets when liquidity is shrinking?

by RUSHI SHAH

During the past 30 to 40 years of monetary history, the United States has been in an expansionary cycle. The Federal Reserve lowered interest rates and increased liquidity through quantitative easing – basically “printing money.”

By buying up bonds and other fixed-income securities, the Fed was able to flood the market with U.S. dollars. When the pandemic hit, the Fed ramped up this practice to prevent massive economic deterioration. Unfortunately, we all are now experiencing the inevitable aftereffects of the Fed’s strategy, coupled with supply chain issues stemming from pandemic shutdowns in the form of increased inflation. To counter this, the Fed has announced it will try to reverse its quantitative-easing measures by selling the bonds they bought. This will reverse the U.S. dollar flow out of the markets back to the Fed’s balance sheet and drain liquidity from the markets. Known as quantitative tightening, this counter measure is important to business owners, especially commercial real estate owners, because it directly impacts access to liquidity.

PRESSURE FROM BOTH SIDES
The loss of liquidity combined with higher interest rates causes a double whammy in the markets. On one hand, the Fed’s economic tactics are necessary to control inflation, but they spark unintended consequences. For example, they can limit the availability of cheap capital. Now, construction projects that would have been greenlit for financing in the past, as well as maturing loans that were previously refinanceable, aren’t penciling out. As a result, today more than ever, owners and developers seeking debt and equity will need to rely on professionals in the capital markets who have access to the limited liquidity that remains.

THE HIGH COST OF LEVERAGE
Attractive capital is on its way to becoming a priced commodity because, unlike in the past, leverage today is expensive. Debt funds that historically drew on warehouse lines of credit from banks have stopped using them as the price of that money has grown too expensive. This is a good example of shrinking liquidity in the market. Soon there will be an overall repricing of risk visà-vis returns available for investors. Lesser-known players – such as credit unions, some local and regional banks, private equity funds, life insurance companies, and large wire houses – also are likely to step up to provide capital to hotels and other asset classes more than in the past.

HOTELS MAY HAVE AN ADVANTAGE
Looking ahead, hotel financing may be more active than financing for other asset classes, as few other property types can support a higher interest rate loan within the required debt-service coverage-ratio constraints. There simply aren’t very many asset types that can withstand a 7% to 10% interest rate and still maintain a debt service coverage ratio of 1.25x.

Also, one of the biggest tailwinds propelling the hospitality industry forward is a lack of new supply. Due to COVID-19, many projects have been delayed or shelved, helping the supply equation for hotel rooms in multiple markets. In addition, owners are pulling older and obsolete hotels out of the system and converting them to multifamily to meet a housing shortage. As a result, one of the better plays in a developer’s current playbook is to start planning new hotel builds now, so they’re online and stabilizing when the economy becomes healthier. Unlike hotels, the office sector is going through a fundamental shift in demand dynamics and remains a pain point for commercial real estate. Multifamily will face difficulty, especially for the assets whose cheaper priced debt is maturing in this environment.

THE DIFFERENCE-MAKER
With less liquidity in the market and the high cost of leverage, bringing in an experienced capital-markets intermediary now is even more critical for securing financing. Owners who want certainty of execution must wisely choose who they use and be willing to give the intermediary the necessary control to ensure an efficient transaction and successful result. By signing an exclusive agreement with a real estate debt advisory intermediary, owners can start the process already ahead, because an empowered intermediary can cover a wider market, garner real lender attention, and optimize results.

Within current economic conditions, lenders with balance sheets to fill and equity providers with checks to write, increasingly trust their long-term relationships for deal flow. They are being bombarded with capital requests and start with those opportunities that familiar real estate intermediaries with extensive knowledge and experience and proven track record of closing deals bring to the table. Giving a debt advisor true control is critical. Nothing raises a red flag more for a lender than receiving a loan package from multiple competing sources. When competing intermediaries are working the same transaction, it’s always the borrowers who lose. Capital sources will immediately think, “what’s wrong with this project, property, or borrower?” They’ll perceive the sponsor as amateurish and probably desperate. Lenders don’t want to waste their limited time and resources on transactions they feel are less likely to make it to the closing table. In this industry, when no none has true control of the transaction, good deals that could have gotten done, don’t. In this backdrop, relationships will become more important than ever before.