How has the changing economic landscape affected capital markets and what can we expect to see next?
In nature, when too much change happens too fast, it can cause stress fractures throughout the system. The economy is no different. We’ve enjoyed an extended period of low interest rates and easy credit designed to induce growth in the markets. The Federal Reserve’s intervention both from an interest rate standpoint as well as money printing (quantitative easing) standpoint has been unprecedented. In fact, the majority of the growth experienced in the past two decades can be attributed to the Fed’s relatively relaxed monetary policy. Then, the pandemic hit. The Fed had to take action and moved at a high level of speed we’ve never seen before – and rightfully so. The shutdowns provided a much-needed hedge for the precipitous drop of interest rates, as well as the Fed’s increased buying of bonds from the market in an effort to induce extra liquidity. When productivity fell during the shutdown, these tactics successfully shored up the economy.
Fast forward to today, and the landscape has changed. Federal programs, along with the fiscal policy in the form of paycheck protection program (PPP), economic injury disaster loans (EIDL) and employee retention credit (ERC) assistance, have pumped so much aid into the economy, that the government has essentially doubled down on the recovery, swinging the pendulum the other way and inducing inflation.
Prematurely interpreting this inflation as transitory, the Fed increased rates as a correction. However, it soon realized that the inflation was structural in nature and here to stay. As a result, the Fed started doing everything in its power to reverse the effect of “easy money.” And, as expected, doing too much, too fast, has had repercussions. Here are just four of them.
1 BANKING WOES
The collapse of Silicon Valley Bank and other regional banks was an unintended casualty of the Fed increasing rates too quickly. At the same time it increased its Fed fund’s rate, which subsequently increased short-term interest rates, the Fed pulled additional money out of the system through quantitative tightening. As interest rates increased, credit spreads also rose on bonds that many of these banks owned and the bonds’ values plummeted. When banks like this fund their balance sheets using long-duration bonds without sufficient interest rate hedging mechanisms in place and this situation occurs, there’s a mismatch. As we’ve seen recently, this imbalance has dire consequences not only for the failed banks but for the market overall, creating a credit crunch.
2 THE RIPPLE EFFECT
In an effort to inspire confidence in the system and the regulatory framework, the Fed and other regulators have tightened control over new loans being originated by at-risk banks. Additionally, and arguably more importantly for the U.S. economy, is that mid-size and regional banks are some of the largest buyers of commercial real estate backed bonds. These include CMBS (bonds backed by fixed rate mortgages on commercial properties), SASB securities (bonds backed by large loans on large buildings), CRE CLOs (bonds backed by short-term bridge loans on commercial real estate), and other commercial real estate loan derivatives. This phenomenon yanked liquidity out of the overall commercial real estate lending system and spreads on commercial real-estate-backed bonds skyrocketed to a new level. Higher spreads combined with higher index rates now begets higher coupons on loans. When both short-term rates and spreads increase, the market is hit with a double whammy, as the Fed intended. Liquidity floating in the market is reduced, creating a trickle-down effect and easing the inflation pressure.
3 EFFECTS ON HOTEL FINANCING
Hotel financing has yet again found itself front and center of commercial real estate lending. For one, office trends fundamentally have changed, creating capacity for other asset classes. From a risk standpoint, the view hasn’t gone down per se, so investors are still demanding higher credit spreads for every dollar of risk that they take on financing a hotel asset.
But, even with this mindset, many hotel projects that were passed over a few years ago can now be financed. Keep in mind, however, that the economic uncertainty from the bank failures and credit crunch has pushed leverage on hotel assets down. Additionally, the current economic environment could affect job losses. A reduction in income directly impacts both leisure and business travel. Right now, all these factors are taken into account for every deal being underwritten across the country. Converting hotels to apartments remains a trend, providing needed housing for the lower to middle income workforce and culling obsolete product out of the marketplace.
4 EFFECTS ON OTHER COMMERCIAL REAL ESTATE LENDING
Apartment financing remains liquid thanks to Fannie Mae and Freddie Mac. Private debt funds and regional banks, however, no longer underwrite unlimited rent increases and 3% to 5% inflation increases that were built into last year’s projections. Self-storage continues to show resilience and, as an asset class, has weathered the storm largely unscathed. Industrial assets also are solid, but to stay in balance with the interest rate environment, industrial trade cap rates are expanding. Retail has had the biggest comeback. As we put the pandemic in the rearview mirror and consumers reconnect socially the pressure of online shopping and other ecommerce trends has lessened. This is creating healthy tailwinds for the retail sector and the capital markets are showing their support for this trend.
HOW RATING AGENCIES ARE REACTING
The agencies that rate commercial-real-estate-backed loans, namely FITCH, have recalibrated their model to deliver better risk ratings for some asset classes. This new approach should help retail, hotel and apartments, and self-storage assets get financing and hurt office. Overall, there is plenty of liquidity in the alternative lending markets and this will be the time for nonregional bank players that have proven balance sheets to shine. CMBS debt funds and life insurance companies are ready, willing, and able to open their checkbooks for the right deal.