CRE is due for a fix, and COVID-19 wasn’t it
The word “recovery” comes up a lot these days, describing everything from recent job gains to the resurgence of lending and the volume of transactions in commercial real estate. But before investors get too blown away by the good news, they should stop and ask, “What are we recovering from?” “
It may be safe to say that the nation is on the verge of recovering from the pandemic. Just over half or 51.4% of U.S. residents had completed a series of COVID-19 vaccines as of August 26, according to tracktherecovery.org. Consumers are returning to sit-down restaurants and traditional retailers, and businesses are navigating back to the office. Employment has rebounded across many industries, although jobs in the bottom quartile have fallen 20% or more since January 2020 and have changed little in the past 12 months.
What we are not recovering from is a correction in commercial real estate or the economy in general. To the surprise of many experienced commercial real estate finance professionals, including myself, the real estate markets have not had much to recover from. For now, at least, it looks like the federal government’s measures to support the economy during the pandemic have averted a default catastrophe that threatened to swallow occupants, landlords and lenders.
This feat is all the more remarkable given that commercial real estate tends to undergo a correction roughly every 10 years, which would suggest that it was scheduled for a correction before the arrival of the coronavirus. The pandemic seemed destined to trigger this market reset, but instead the pandemic has become a break in the business cycle. More than a year later, market participants are combing mixed economic indicators for signs of a correction that never happened.
On the one hand, the approximately 3,000 US assets in Trimont’s portfolio show a solid return to performance as measured by on-time principal and interest payments. On the other hand, COVID-19 infection rates are increasing and low-paying jobs have contracted. Amid the general risks to the economy, it would take little to plunge us back into a recession.
And there are developing conditions that are worth watching. These include the influx of capital into the real estate sector and a proliferation of investment funds reminiscent of the whirlwind of activity that preceded the 2008 global financial crisis (GFC).
Competition for capital placement increases the temptation to relax underwriting, which can lead to riskier investments and encourage inflated pricing of funded properties. The pressure to minimize risk is particularly strong for some closed-end funds, whose managers only have a certain amount of time to invest committed capital, but lost most of a year that offered few investment opportunities. that can meet their internal risk / return thresholds.
Uncomfortable with growing risk, lenders and investors wrap themselves in layers of financial structures designed to mitigate risk exposure. In fact, the unprecedented degree of structured lending today is itself a warning indicator of unsustainable market conditions that must eventually realign.
Alignment for warehouse lines
The recent multi-year drop in interest rates has intensified the pressure on fund managers to deliver the returns promised to investors. To increase marginal returns, many lenders now take out mortgages by supplementing their equity with low-interest capital borrowed through a warehouse line of credit. In just two to three weeks, the originator will sell a newly created mortgage to a permanent investor or through securitization, pay off the warehouse lender, and use their restored warehouse credit to create more loans.
Using a warehouse line can help a principal offer more competitive prices by reducing their cost of capital. One downside, however, is that leverage means that the originator places less of their own capital in each financing, so they have to speed up their number of loans and / or increase the average loan size to maintain their placement rate. of capital.
Likewise, the number of warehouse lines, note-for-note investments, guaranteed loan bonds and other debt structures is also increasing as funds scramble to deliver the returns promised in the rate environment. low interest today. While the aforementioned structured debt transactions and the like can help lenders generate the necessary returns for their investors, these strategies require high volumes to meet investment goals.
Consider the writing on the wall
Recognizing that a correction in commercial real estate is not just a possibility but increasingly likely over the medium term, market participants need to prepare for all possible scenarios. Asset managers need to understand where their assets stack up against expectations. Maintain good relationships with investment partners and understand the demands they may have in a crisis. Initiators should stick to their underwriting standards and avoid complacency becoming excessive, as many did before GFC.
There are still stages left in this cycle and many exciting opportunities remain in the market. But commercial real estate veterans know their industry tends to overheat and then correct itself every 10 years or so. That’s why many were on the lookout for a correction in the last few years before the pandemic, a decade after the GFC. This remedial event may well still be ahead of us, however, as COVID-19 was not this one.
Beau Jones is Managing Director, Client Services – Americas, of Trimont Real Estate Advisors, a globally integrated loan and credit manager for the commercial real estate finance industry.