Traditional lenders’ willingness to write riskier loans to compete with the growing pack of non-bank players was a key theme at Real Estate Capital’s first NewYork Forum, reports Al Barbarino
Amid fierce competition, with abundant equity and debt capital flowing into commercial real estate, lenders are feeling as much pressure as ever to find the best risk-adjusted returns, delegates heard at the inaugural Real Estate Capital NewYork Forum 2015.
“Everybody is desperate for yield,” Richard Flohr, managing director with Prudential Mortgage Capital Company, noted on more than one occasion.
Delegates were left to decide for themselves if desperate times have called for desperate measures. But based on panel-lists’ remarks it was clear that competition is stretching traditional commercial lenders into riskier assets, markets and loan types as they seek higher returns.
Much of the pressure to move into new, often higher-risk areas comes from the growth of private lenders, from mortgage REITs and private debt funds, to a range of other private equity lenders that have recently turned to debt, to a consistent wave of foreign lenders.
“Much of the capital is coming from that alternative bucket and they want a much higher yield, and we are also catering to the demand out there by moving into that high-yield space,” Flohr said.
Niraj Shah, managing director with Rockwood Capital, added: “We’ve seen a lot of transient money come into the space from a lot of private equity funds raising debt funds… and we’ve seen pricing come in in a big way.”
Shah spoke of a $110m loan his firm placed on a property in Mountain View, California with “initial guidance” that stretched up to 650bps over, but ultimately priced in the low 400s.
“We really have to pick our spots to get yields,” he said, pointing to another recent example, a NewYork City hotel deal his firm did. “Given fear in the market [due to] supply issues, we were able to get into the high teens, so we found good value there.”
The competition has pushed traditional commercial real estate lenders into asset types they might not have previously dealt with: secondary and tertiary markets, and into Europe. They are originating riskier parts of the capital stack and writing more construction and development loans.
Both domestic and foreign lenders – the latter partly motivated by tax incentives – once happy to lend senior loans on stabilised assets are dipping into mezzanine lending and preferred equity. Traditionally conservative state pension funds are even becoming a consistent debt capital source.
“The riskier construction side is where we have had to do a lot of our work of late,” said Brian Sedrish, a managing director with Related Fund Management. “We have to be willing to take that risk to get deals done.”
The firm is also making significant preferred equity and mezzanine investments in search of better yields and pushing into Europe, where the market is “much more fragmented with a lot more opportunities.”
Advised by Highbridge, Related recently took a participation in an £80m mezzanine loan as part of the finance package for Rocket Investments’ Atlas apartment building on the edge of the City of London.
Sedrish added: “There’s an abundance of competition coming into the space. It’s a series of funds that raised capital under the view that they would take advantage of the large spreads they could achieve relative to benchmark treasuries etcetera.
“That will continue for a while until ultimately there’s some distress along the way and some of the groups that shouldn’t have raised capital in the high-yield space – because they might not have been equipped – will go away.”
A funding void to be filled
Gary Dinka, a director with MetLife’s debt strategies group, and other panellists noted that heavier regulation on banks – and the inability of CMBS to fully bounce back – has created a void that has not yet been filled. “There’s plenty of deals and business out there for everybody,” he said.
The gap left by banks has in part been filled by mortgage REITs, private debt funds and a seemingly self-imposed sense of discipline, absent during the past crash and now allegedly at play.
“The regulatory impact has had a huge impact on banks and their ability to make loans, so deal flow has never been better,” said Robert Hellman, managing director with Pembrook Capital Management. “But that makes it much more difficult because we have to sift through a lot more deals – and a lot out there that just doesn’t qualify.”
Having previously held several banking roles, Mike Nash, senior managing director and global head of Blackstone Real Estate Debt Strategies (BREDS), said he was well aware that banks were experiencing “pretty dramatic mood swings” due to more punitive regulation, which was having an impact on their ability to maintain a consistent strategic approach.
Speaking confidently of prospects for firms such as his, he said: “Our birthday in this business was post-crisis and it’s hard to raise capital, and scale that capital, in the way we’ve been able to do. We’re here, we’re scaled up and we’ve got a strong brand supporting us.”
Nash also drew attention to the growth of private debt providers due to a flight of professionals away from banks, citing his departure from Merrill Lynch as one example. Blackstone also hired Jonathan Pollack – who Nash called a “bright light” in the industry – from Deutsche Bank in June as BREDS’ chief investment officer.
“Lots of people are moving to private capital,” Nash added. “Everyone wants the path of least resistance when they are doing transactions. It’s exhausting to focus on all the other stuff [such as regulation] – it’s a burden and it’s not value-adding.”
However, despite the opportunities created by banks’ travails, the effect on liquidity of traditional lenders pulling back is seen as a downside. “We want banks to be strong, liquid and credible – that’s in our interest,” said Nash. “Liquidity, transparency and a willingness to lend in tough markets are good things. It’s a bad thing when people are unwilling to commit capital and liquidity dries up.”
Sharing the platform with Nash, Jeffrey DiModica, president of Starwood Property Trust, the largest US commercial mortgage REIT, also saw the waning influence of banks and other traditional lenders as in some ways a negative factor.
GE Capital, for example, exited commercial real estate lending this year partly because regulators in 2013 had deemed it a systemically important financial institution, exposing it to the same regulations as large banks.
“It was a shame to lose GE from the market,” DiModica said. “They were a good competitor and their withdrawal was an unintended consequence [of regulation]. It’s also an unintended consequence for the banks to be lending less.”
DiModica rejected the idea that banking regulations should also apply to private debt providers. “The government never has to come in and bail us out,” he asserted. “Bad decisions are reflected in our share price.”
Are we nearing a peak?
Leverage is creeping up, there are more requests for interest-only loans and lenders are feeling more pressure on pricing. But, at the same time, panellists indicated that there is nothing occurring in the CRE lending world that is cause for any grave concern.
Keynote speaker Peter Sotoloff, co-founder of Mack Real Estate Credit Strategies (MRECS), said fundamentals remain solid compared to the past cycle’s peak “and there is nothing on the horizon that looks like it could facilitate the next downturn”.
MetLife’s Dinka noted that “we are seeing more interest-only loan requests and also seeing a push on most of the underwriting parameters”. But, he added: “It’s nothing that is not manageable on senior positions.”
It will be “interesting to see what happens” as private sources of capital come in and scoop up that business, Pembrook’s Hellman noted.Will this bring the end of the current cycle? One panellist noted that we are in year six of what could be a seven- year cycle.
However, with rental income still rising and the fundamentals of the US real estate market looking solid, Jerry Gisclair, executive managing director at Colliers, expressed a common view when he said he would “hesitate to say we’re at a peak”.
Reflecting on pricing, Thomas Harney, head of merchant banking and capital markets at Ladder Capital Finance, said: “Some people are stretching a bit, but it’s not like 2007. Since the crisis, investors have flocked to real assets like real estate because there are good fundamentals.”
“I don’t think there are red flags,” agreed Michael Riccio, senior managing director at CBRE. “I’m a bit sceptical about Houston andWashington has cooled.We’re seeing people going to the secondary markets for relative value and secondary investors going to the tertiary market in the hunt for yield. In gateway cities it’s tough to get yield and people are trying to find it.”
Underwriting discipline is being maintained, added Michael Squires, a CMBS originator at Rialto Capital Management. “Since 2010, underwriting has become more technical and you have to appease the rating agencies,” he said.
“They are referees who rate loans and pools and give you pricing. They have a much more integral role. We are very sensitive to rating movements and they have done a good job of holding the market to a certain standard and making sure it doesn’t get ahead of itself.”
Widening spreads also present a growing opportunity for borrowers. “There is volatility, so the market becomes inefficient,” said Riccio. “It creates an opportunity for someone and that is usually the borrower in this environment, because the chances are they will get offered one spread that’s way different from the rest of the market.”
Blackstone’s Nash called for a small rise in interest rates, “as it would express confidence in the market. I would have moved them up in September, but they will probably move in December. But global growth is slow, so rates won’t be sky-rocketing any time soon.”
Sotoloff talked about the “wild card” that could occur with a renormalisation of interest rates, asking: “What stresses does that put on borrowers looking to hit return targets when, maybe, the economy isn’t quite so rosy?”
Ted Norman, head of mortgage originations with TIAA-CREF, had other worries: “Interest rates moving up against the backdrop of an improving economy is not a bad thing… history shows that.
“What keeps us up is the unknown geopolitical event; there are a lot of planes flying around Syria, for instance, and that is unrelated to our business… something like that is probably what will cause the [end] of this market.”
The European Viewpoint: Banks’ retreat transforms the landscape across the pond
Three key issues brought up by US lenders — the influx of non-bank lenders, the retreat by banks and lenders’ difficulty in finding the right yield — were echoed by European delegates, including panellist Christian Janssen, head of debt with TH Real Estate.
“The big change we’ve seen in the past five years is the non-banks coming in — and also the banks are focusing on shiny, stable assets,” he said.
“Regulation since the crisis has dramatically changed the lending market in Europe. Before the crisis, 90-95% of debt was provided by banks… [before] regulators decided that the market was over- concentrated.”
Janssen noted that increased capital requirements led to a “massive retreat” from the banks, opening the door for non-bank lenders, including his company.
New groups of lenders, including US pension and insurance companies, have aggressively entered European markets, offering traditional 10-year products, while CMBS has failed to come back as it has in the US and “basically doesn’t exist anymore.
“The US has had a much more balanced competition of capital providers in CRE debt and Europeans look to it with envy from that point of view,” Janssen added.
Europe is not a “cohesive entity”, so lending in different regions is dramatically different. As a result of the competition, the firm’s uni-tranche mezzanine loan fund is focused not on “the biggest cities in the centre of town”, where a previous funding gap has been filled and “returns are being reduced to virtually nothing”, he said.
“If you move out to value- added, up to 75% [leverage], you can get decent returns — a 6-7% target in our fund.”