Putting financing predictions under the microscope
When economic conditions change too quickly, other factors are affected and unintended consequences can be left in the wake. We’re seeing the effects of this rule right now. As interest rates have skyrocketed at historic velocity, other elements have started to break. The Fed’s history-making policy action of raising short-term interest rates at unprecedented levels and quantitative tightening has led to a pullback in liquidity. This situation affects the bond markets and long-term bond yields, while directly impacting activity within the capital, lending, and equity markets and the valuation of hotels and other commercial real estate assets.
HOW BANKS ARE RESPONDING
Capital sources haven’t reacted to the rise in rates in lockstep. Because each type of capital provider faces different regulatory pressures, reactions are more nuanced. Our banking system largely is driven by regulators and their capital requirements calculations for financial institutions. For example, a community or regional bank must focus on its total tangible book value compared to regulatory capital requirements. With the recent interest rate runup, most banks are facing the possibility of mark-to-market value losses against their book value. If these losses are realized, there will be massive shortfalls in regulatory capital. To remain in compliance and stay afloat, banks would need to raise additional capital. This is a double whammy for banks, because the additional capital would have to be raised at lower valuations. Hence, it’s more convenient for banks to pause lending on new transactions, remove risk from their balance sheets, and concentrate on working out existing real estate loans. As a result, we’ll continue to see banks retrench and slow lending activities.
FOLLOW THE LEADER
Credit unions are in slightly better shape than community and regional banks but are following the banks’ lead for lending and slowing new credit issuances. Life insurance companies are actively lending but find it more lucrative to buy market rate bonds backed by real estate loans instead of originating their own paper. They recognize they’ll be better able to generate outsized yields and improve risk-return by purchasing newly issued CMBS and CRE CLO bonds to build their portfolio.
BACK TO CMBS
With capital sources facing these nuanced challenges, CMBS and private debt funds have emerged as largely the only games in town continuing to lend to hotels, hotels, multifamily, industrial, retail, and self-storage properties. Throughout 2024 we’ll continue to see a constant wrestle between interest rates and cap rates. Asset valuations likely will remain flat or even decrease further as cap rates expand trying to catch up with the renewed interest rate environment.
WHAT TO EXPECT IN 2024
The silver lining in 2024 will be higher cash flows on hotels, due to continued strong travel demand and hotel room rate price elasticity. The continued expansion and demand for hotel rooms and ongoing lack of new supply should also bode well for hotel owners looking to sell or refinance.
Consumer spending will slow in the new year, along with rent growth for multifamily properties. Both slowdowns will have a negative impact on retail and apartment valuations. Office will remain in its rut, but well-located, good quality, and well-tenanted spaces will be able to find financing within the CMBS markets. B-piece buyers, which are the hedge funds that buy the first loss positions for a CMBS issuance, have raised a record amount of capital that can be put to work buying b-pieces of newly issued bonds.
The innovative five-year CMBS loan will emerge as a winner for 2024, because it features an interest-only option, along with shorter-term pre-payment lock out. There also has been a large amount of capital raised for preferred equity or mezzanine positions behind senior loans. This capital will be instrumental in preventing massive maturity foreclosures and combating the inability to refinance existing transactions with upcoming maturities due to higher rates and lower valuations, essentially closing the gap.
We should continue to see higher interest rates in 2024, along with friction in the transaction market. Buying and selling volume will remain slower than normal, but we’ll likely avoid a complete doomsday scenario because of supply and demand of capital and the equilibrium provided by the market forces. The strength of the CRE CLO markets should motivate debt funds looking to originate bridge loans to stretch for value-added assets, providing a lifeline to many loans that would otherwise be foreclosed. Overall, securitized loans and capital markets-based products – with their unique ability to provide risk transfer by originators of these loans to the owners of the bonds – will establish a market balance. Now, more than ever before, it’s important for hotel and commercial real estate owners to work with knowledgeable advisors and stakeholders who are plugged into the capital markets and have the right relationships to get your deals done.