Transaction activity has been subdued for almost 12 months now as investors have had to navigate their way through an increasingly challenging economic environment.
What was initially expected to be a short-term, inflationary spike has turned into a year-long battle, with a tightening monetary policy that looks set to continue. We’re no longer hearing the mantra ‘lower for longer’. With long-term rates settling in at over 3.50 percent, the market is having to adjust to a higher for longer environment.
Many clients are asking us: what does this mean for commercial real estate lending?
Debt must be accretive in order to make sense for investors to borrow, and until this happens, it is likely that transaction volumes will remain low. To make the numbers work again, there are two crucial things that need to happen – either in tandem or individually – in order for transaction volumes to pick up to levels seen before short-lived UK prime minister Lizz Truss’s ‘mini budget’.
First, pricing needs to adjust downwards. We have started to see this materialise to varying degrees in a number of sectors. The extent of the price adjustment ranges significantly from one deal to the next, but as more evidence comes through of asset prices softening, we expect this to trigger increased transaction activity.
Second, the all-in cost of debt must come down – a seemingly contradictory statement given we are expecting rates to stay higher for longer.
Supply and demand
All-in financing rates are made up of two components: SONIA and the lender’s margin. We know that the SONIA forward curve shows rates coming down from May 2024, which is not helpful in the short-term. However, lender margins can be adjusted downwards.
It might seem counterintuitive for lenders to reduce margins during periods of heightened risk, but as the banking shocks experienced earlier this year have ebbed away, we have seen margins beginning to tighten.
Due to the influx of new entrants into the debt market, and the dearth of transaction activity, basic supply and demand would suggest that as the supply of debt increases, the demand for debt decreases. Due to a lack of deals in the market, lenders are willing to reduce margins to win the most attractive deals.
Where we are seeing this most acutely is with those lenders with funding that is not linked to SONIA. These lenders can offer all-in rates that support their return requirements – typically high, single-digit returns – while simultaneously under-cutting those funders who price debt over SONIA.
We have seen evidence of this already, with debt funds offering all-in rates of 7.50 percent for value-add deals at leverage above 70 percent loan-to-cost, ensuring debt is accretive for borrowers, and commercially acceptable for lenders. Looking ahead, we expect there to be further pricing adjustment in the second half of 2023, with 2024 beginning to show some light at the end of the tunnel.