Debt Capital Markets Rebound

While deals are less complex, liquidity flows from varied sources.

The financial crisis that escalated in 2007 with the residential subprime collapse and later the bankruptcy of Lehman Brothers in 2008 changed our financial markets forever, particularly real estate capital markets. When you layer on the impact of technology and changes in preferences and tastes for space use, the combined effect is even more profound. The debt capital markets industry hit bottom before a recovery began, and many casualties would never recover. The public outcry was loud, and regulation was implemented to help mitigate the perceived greed and the losses in the future.


While the recession ended in June 2009, it took longer for the markets to come back. Unemployment levels now match lows that haven't been seen in 18 years and, before that, since that late 1960s. The challenge for many companies is finding and keeping the right people - how much space they occupy per person; where people live, work, and play; where and how they shop; and what they spend their money on - and that now presents challenges to capital markets participants. So how did the industry fare in 2018?

Today's Debt Markets

On the debt side, liquidity continues to flow. Options for a debt bid are broad, varying from local banks, debt funds, commercial real estate collateralized loan obligations, commercial mortgage-backed securities shops, mortgage real estate investment trusts, private lenders, insurance companies, and even developers who have started lending businesses.

Overall, the deals are less complex since CMBS 2.0 began in 2010, although many large loans are being cut into several pieces to be spread out across many CMBS deals. The amount of leverage in the system has declined significantly since the peak of the financial crisis, and while competition is growing to invest capital, several alternatives are muting any undue aggressiveness, at least for now.

Single-asset, single-borrower deals have seen significant growth. For example, consider the 2016 loan on a single office property like 9 West 57th Street, a 1.6 million-square foot property in New York City; CMBS debt was combined with private debt in the form of privately placed B-note. Another example is a single loan to a single borrower on a cross-collateralized portfolio of assets, like a pool of hotels. During the first half of 2018, 50 percent of the new issuance CMBS were single-asset, single-borrower deals, matching the total conduit issuance.

Floating rate bridge financing has come back to the securitization market, with a strong resurgence in the commercial real estate CLO sector. Originations more than tripled from 2016 to 2017 ($1.8 billion to $7 billion), according to Morgan Stanley's commercial real estate CLO tracker, and are on track to more than double again this year. In addition to the securitized floating rate product, bridge lenders have liquidity to provide anywhere from $3 million loans to $500 million loans. Sponsors who raised capital range from smaller debt funds to multibillion-dollar private equity funds and global asset money managers. Even traditional developers who aren't finding the yield they seek on the equity side of the balance sheet are entering the lending market.

Public REITs also have been active in the lending space. Blackstone, Starwood, KKR, ARES, and TPG all created publicly traded mortgage REITs to tap the demand for liquid high-quality mortgage investing. Some of these individual REIT loan investments exceed $500 million, illustrating the scope of the current mREIT market.

When including traditional money center banks, regional and community banks, insurance companies, and foreign banks and institutional investors - all of whom continue to lend actively - it's clear that the debt markets are not suffering from a liquidity shortage. But too much liquidity in the system isn't necessarily a good thing.

What's in Store for 2019?

As the market moves into eight years of a strengthening real estate cycle, remember that recoveries are not consistent. While both major and non-major market property categories have surpassed the prior peak, a significant spread exists between the major and non-major categories. Drilling down further, multifamily markets have shown the greatest recovery, while suburban office and retail have shown the least. On a national basis, retail is the only major category that has not returned to its pre-financial crisis level.

While the fundamentals still appear strong, at some point the band will have to take a break. The recent tax reform bill injected some energy into the system, but the effects will wear off. Transaction volume year-over-year has declined, according to Real Capital Analytics, and much of the 2018 volume has been portfolio- and entity-level deals.

Interest rates. Rates continue to move up slowly, potentially impacting the ability for assets to be financed. However, in the two and a half years leading up to the end of 2007, the 10-year Treasury averaged 4.65 percent, ranging between 4.1 percent and 5.1 percent; in 2018, the 10-year hit 3 percent, according to Real Capital Analytics. That's still a 150-basis point difference. As for the spread between cap rates over Treasuries for commercial properties (excluding multifamily), the average for that same 2007 period was 2.1 percent, while the average for the first seven months of 2018 was 4.7 percent. Looking at average cap rates for these respective periods, the prior peak is only about 30 basis points higher on average. When looking at Treasuries and real estate spreads, there is room for movement.

Another indicator of room for further rate increase is the spread of historic mortgage rates and the 10-year Treasury. During the same two-and-a-half-year period, the spread ranged from 80 basis points over the 10-year up to 230 basis points, spiking over the last five months of the year, when the capital markets started to face significant challenges in the subprime residential and collateralized debt obligation space. The average, excluding those last five months, was a little over 100 basis points. In comparison, the mortgage rate spread to Treasuries is just shy of 200 basis points during the first seven months of 2018.

In short, interest rates need to be on the radar going forward, especially when looking at refinance risk for shorter term bridge loans that assume some repositioning of an asset.

Current expected credit loss standards. Beginning in mid-December 2019, the new Financial Accounting Standards Board reporting for the accounting of credit losses for certain instruments takes effect. The new measurement is based on expected losses, commonly referred to as the CECL model. It applies to financial assets measured at amortized cost, including loans, held-to-maturity debt securities, net investment in leases, and certain off-balance sheet credit exposures, such as loan commitments. While not a regulatory change, it is a financial reporting change, and it could have significant implications to lenders - banks, funds, or anyone who has financial assets like commercial real estate loans. Firms need to reserve from the date the asset is originated using a repeatable, defendable, and supportable process, so that in the event that losses do occur in the future, a reserve has been captured based on a consistent model over time. The implications are tough to measure in terms of implementation costs, requirements, and timing. The challenge for external auditors will be to look for documentation and evidence used by management in preparing their estimates.

When a correction in the market will come is uncertain. When it does occur, it will look different than the last one. It will not be a highly levered capital markets across-the-board implosion like last time. Some major private equity funds are out raising capital, some of the largest amounts that they have ever raised - perhaps either to buy, to bet on further improvement, or in anticipation of distress. The capital will be available, along with the technology to analyze deals quickly, and the experience and wisdom gained from the last implosion.

Where Is the Supply and Demand?

by William G. Leffew, CCIM

Supply and demand for real estate capital follows two basic avenues. First, who is borrowing and what are their goals for a real estate asset? Second, who is lending and what are their observations and perceptions of both the market and a specific asset?

According to the June 2018 Federal Reserve Release of Mortgage Debt Outstanding, commercial banks account for $2.16 trillion of the $4.1 trillion of multifamily and commercial mortgages outstanding in the U.S. The remaining half is split between government-sponsored enterprises ($703 billion), commercial mortgage-backed securities ($375 billion), life companies ($394 billion), and other lenders ($474 billion).

Borrowers with short-term goals desiring prepayment flexibility typically want to stay on the short end of the yield curve. Unfortunately, with Federal Open Market Committee increases to Fed funds, prime and Libor have soared to levels not seen since April 2008 and November of 2008, respectively. In other words, it’s expensive to stay short term. Borrowers with long-term goals, however, have benefited from a rather stable U.S. Treasury and reduction in loan spreads from the GSEs, life companies, and CMBS lenders. Furthermore, the desire for loan yield and liability matching (whole life and long-term care policy issuance) produced the need for longer loan durations among life company lenders. The result is non-recourse 10-year loan terms still in the mid-4 percent range compared to short-term, recourse bank debt in the 5 percent range.

Despite the rollback of some Dodd-Frank provisions, commercial banks remain stingy, with construction dollars preferring to stay at the 75 percent or less loan-to-cost level across most property types. Performance of construction loans and their underlying collateral in terms of lease-up at pro forma rents continues to be a focus of commercial bank lenders. Solid projects achieving pro forma levels are quick candidates for sale or the permanent market. Retaining these assets on the bank’s balance sheet requires lenders to deviate from their short-term, recourse nature in favor of traditionally permanent market deal terms. The result often can yield loan exposure issues not just in terms of commercial real estate, but also specific property types, tenant exposures, and borrower concentration.

What’s in Demand?

Favored property types continue to be multifamily (market rate and affordable), industrial, and grocery-anchored retail. Box-style retail, unanchored retail, suburban office, and hospitality are challenging asset types unless financed at a lower leverage level or with some personal recourse.

From a demographic and debt perspective, affordable multifamily projects are in demand. New class A multifamily construction at higher rent levels may be the only option to offset higher construction costs. However, it’s important to note the rate discounts offered by Fannie Mae and Freddie Mac on affordable (defined as those with rents at 60 percent of area median income or lower) multifamily projects. GSEs don’t have to count these financings against their annual production allocation from their regulator, the Federal Housing Finance Agency. These projects fulfill their affordable-housing mission and also are defined as uncapped business, resulting in the prevalence of interest spread discounts of 10 to 25 basis points.

On the institutional side, trophy-quality assets in top 25 momentum markets continue to be the focus. Many of these assets are at lower leverage levels and garner superior pricing and structure focused on cash flow yield to investors. At lower leverage points (less than 50 percent loan-to-value), buyers are employing interest-only structures designed to boost yield as an offset to paying aggressive cap rates at acquisition.

William G. Leffew, CCIM, is senior vice president at Bellwether Enterprise Real Estate Capital in Louisville, Ky. Contact him at

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Constantine Korologos, CRE, MAI, MRICS

Constantine Korologos, CRE, MAI, MRICS, is an independent real estate advisor and an adjunct professor with New York University's Schack Real Estate Institute. Contact him at


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