Call it a borrowing headache. When Bridge Investment Group signed a contract to buy an office building last year, the firm sent out a request for proposals to all 66 lenders it had done business with over the past 12 months. The Salt Lake City-based real estate firm received just one proposal, executive chairman Bob Morse told delegates at the PERE America Summit 2022 in November.

Although few borrowers are as candid as Morse about financing challenges, Bridge is far from the only borrower feeling the pain from a capital-constrained lending market.

The cost of capital has risen sharply across multiple geographies over the past year. In the US, the world’s largest property market, nominal bond yields reached a 13-year high of 6.48 percent in October 2022 and remained elevated at 5.82 percent in early January, up from 3.51 percent a year earlier, according to Chicago-based manager LaSalle Investment Management’s ISA Outlook 2023 report.

Total US commercial and multifamily mortgage lending is expected to fall to $700 billion this year, down 5 percent from a projected 2022 total of $740 billion, according to a January 2023 forecast from the Mortgage Bankers Association. The $740 billion figure was revised from $1 trillion, as projected in February 2022.

In Europe, meanwhile, 29 percent of banks were tightening their credit standards as of October, the highest level in the past 10 years, according to the European Central Bank’s October 2022 bank lending survey.

“The degree of dislocation or pullback in the debt markets was underestimated going into year-end,” said Lauren Hochfelder, co-chief executive at Morgan Stanley Real Estate Investing, the private real estate investment management arm of investment bank Morgan Stanley. “Many market participants remained optimistic that banks would be ‘back’ come January 1. It sounded a lot like the 2021 refrain that everyone would be back in the office after Labor Day.

“Many commercial banks meaningfully increased their commercial real estate exposure in the first half of 2022 and now have backlogs to sell loans in a higher rate and more uncertain environment. To boot, they’re experiencing more limited loan repayments.”

These reasons, together with regulatory capital requirements, mean that many commercial banks are now more capital-constrained. Insurance companies are also more restricted as a financing source, having seen more limited loan repayments. This in turn can impact their new capital allocations, Hochfelder added.

The pullback in lending from banks has had an indirect impact on alternative lenders, such as debt funds, many of which utilize back leverage from the banks. “That back leverage is now disproportionately available to the stronger players in the debt fund space, and it is more expensive,” she observed. Meanwhile, activity in the securitization market, including commercial mortgage-backed securities and collateralized loan obligations, has also shrunk dramatically.

“Beyond much higher cost of financing, [the fact] that myriad types of lenders are all pulling back at the same time has a more material impact than many were acknowledging,” Hochfelder said.

PERE spoke with a dozen borrowers, lenders and advisers on private real estate’s biggest borrowing challenges, the workarounds being adopted and how some of those workarounds have their own limitations.

Going all in

“The degree of dislocation or pullback in the debt markets was underestimated going into year-end”
Lauren Hochfelder
Morgan Stanley Real Estate Investing

One workaround for better capitalized players has been to close deals entirely with equity. MSREI, for example, has closed on several investments over the past six months on an all-cash basis. “Where there are opportunities to acquire the right quality real estate at attractive pricing, with other buyers who are dependent on financing sidelined, we are comfortable over-equitizing – closing all-cash today and likely financing when the debt markets find a new equilibrium,” Hochfelder said.

Over the past month, MSREI acquired on an all-cash basis approximately $250 million of high-quality industrial assets in top US markets such as Northern New Jersey, South Florida and Boston. The owner of most of the properties sought to close on the sale prior to year-end. “We understand that others tried to cherry pick individual assets and string out diligence or closing periods to secure financing,” recounted Hochfelder. “Our willingness to close all equity on the whole portfolio, together with our deep presence and insights into these markets, enabled us to meet a very abbreviated timeframe.”

LaSalle, meanwhile, has done most of its acquisitions over the past six months on an all-cash basis. With the cost of financing exceeding cap rates, “it made us question whether the use of leverage was optimal at that time,” explained Brad Gries, co-head of the Americas.

“The debt is available but it’s at a cost that is sometimes dilutive to the overall return”
Joe Gorin

Negative leverage has similarly driven Barings to focus on doing smaller deals on an unlevered basis. Although the manager can find financing for most of its new investments, “we don’t necessarily like the debt pricing terms,” said Joe Gorin, head of US acquisitions and portfolio management at the firm. In the US, spreads on core loans are starting at 300 basis points over SOFR while spreads on value-add loans are in the range of SOFR plus 450 to 650 bps. “The debt is available but it’s at a cost that is sometimes dilutive to the overall return.”

As a borrower, Dutch pension investor APG still sees appetite from lenders to provide debt overall, but the ability to finance deals can vary significantly. “It probably depends on what kind of debt you’re looking for and what projects you’re looking for,” said Robert-Jan Foortse, head of European real estate. “In some cases, it is actually pretty dire, and in other cases it’s actually not so bad yet. When it comes to construction finance, or development finance, that part of the market I would say is dire, and there we do see a lot of issues emerging.”

Development financing terms typically suggest an internal rate of return “well into the double digits” for lenders at a 50-60 percent loan-to-value ratio, he notes. It was after receiving such terms on a construction loan that APG decided recently to fund a development project with full equity. The pension fund manager plans to refinance the development project with a loan for a stabilized asset, rather than a more expensive development loan, after the project is completed in a year’s time.

Double-digit returns, moreover, provide an additional incentive for borrowers to invest all cash. “For some of us in the market, we will probably try to do a bit more with equity, because with our equity, we then implicitly make the same double-digit return that the lender would have made,” Foortse noted.

However, “even for us, it’s probably difficult to do everything all equity,” he says. “Our pockets may be deep but they’re not endless.”

Boosting lender relationships

Other borrowers have sought to expand their lender relationships to increase their financing options. The vast majority of Dallas-based manager Crow Holdings’ lenders have been traditional commercial banks and insurance companies. But over the past year, the firm has expanded its number of lending relationships by approximately 30 percent, according to chief executive Michael Levy.

“We have had to branch out,” he said. “And we have spent more time pursuing dialogue with a broader swath of commercial banks across the US.”

As the large money center banks pulled back from lending significantly, “you saw local and regional commercial banks across the country be able and willing to step into that void,” Levy explains. “As a result, we’ve put a lot more energy and effort into developing that relationship set. And therefore we have a wider number of lending relationships.”

Chicago-based manager Harrison Street similarly has worked on building its relationships with regional lenders over the past two years as money center banks have moved to the sidelines. “One of the things that we spent a tremendous amount of time on is better understanding the nuances and sensitivities of the regional and local banks that we started to align with over the course of the past 12-24 months,” said Mike Gordon, partner and global chief investment officer.

Although the process was “time-consuming,” the relationship-building effort has paid off, he remarked. “They’ve become great repeat lenders for us.”

However, “one of the issues that did cause some consternation over the course of the past six months was changing policies in the context of the regional banks,” Gordon said. For example, the firm was working toward a closing with one regional bank when it received a call that the bank’s investment committee had reconvened and decided to syndicate a large part of its exposure to other banks and lenders prior to closing. This led Harrison Street to have to extend contracts with its counterparties, Gordon recalled.

There are other potential issues involved when working with local and regional banks. While these banks have been much more active than other real estate lenders, they are volume capped given their size, Hochfelder pointed out. Additionally, “regional banks are presumably seeing a decline in customer deposits, which in turn impacts their balance sheet capacity to lend.”

Low hit ratios are a pain point

Even active lenders have been financing only a small fraction of real estate transactions

Related Fund Management’s credit platform has seen a lot more dealflow as former competitors have exited the market, Related’s Brian Sedrish says. Along with debt funds facing capital constraints, these competitors also include corporate lenders that in recent years had expanded into real estate because of the attractiveness of real estate credit spreads but have now pivoted back to focusing on corporate debt, as the opportunity set in that market became more compelling.

For Related, the hit ratio – the percentage of transactions the firm looked at and ultimately closed on – has historically ranged between approximately 4 and 5 percent, but Sedrish estimates that now “we’re probably a couple of points less than that.”

A big change is that while in the past a portion of that hit ratio was driven by the firm losing out on transactions to a more competitive lender, now, “we turn down a lot of deals we could probably do,” he says. “It’s less of an issue of us losing them to competitors. Those deals that we look at and decide not to do, the reasons are more skewed now to our decision to not want to pursue it.

“The view right now is that we want to be extremely discerning.” As such, Related has changed its underwriting process as a lender by increasing its focus on two areas. “From a high-level perspective, there’s a big unknown as to what the right valuation at stabilization, what the right cap rates are,” Sedrish notes.

“You need to be much more thoughtful about what the knock-on impacts of valuation are in a rising interest rate market. There are certainly correlations between valuations and capital costs.” The firm has reduced its leverage levels from 80 percent historically to 65-70 percent to provide more of a cushion to absorb where valuations may potentially end up, he says.

Related is also scrutinizing growth rate assumptions in the face of a potential recession. “It’s understanding what growth rates are the right ones to use, which goes into determining ultimately valuation,” he explains.

Meanwhile, PGIM Real Estate, the real estate investment management arm of New Jersey-based insurer Prudential Financial, has executed on average on 10 percent of the debt deals it has seen over the past several years. According to global head of debt solutions Jackie Brady, very few transactions make the cut.

“I was talking to one of our guys about three assets this week,” Brady says. “We didn’t propose on any and they all would qualify as low loan-to-value, relatively high debt service coverage, but not the sector exposure that we wanted.”

One of those assets was a US office property that was 95 percent leased, for which the borrower requested roughly 45 percent loan-to-value financing. “And we still declined that, just given our view on the vintage of the asset and location, etc,” she explains.

With other deals, PGIM passed on the opportunity even when the firm did not have a high level of exposure to that particular property type in its portfolio. “We still didn’t want it, because of our belief in the growth of the market, whether the tenants were high credit quality or not. There’s a whole host of things that go into it,” she says.

Turning to alternative lenders

Along with regional banks, some alternative lenders have stepped in to help plug the financing gap. “We are seeing increasing involvement of non-bank lenders in financing requests for proposals as the traditional bank market starts to cap out and become less competitive,” said Alek Misev, senior portfolio manager of property for Australian superannuation fund Aware Super. “This deep, non-bank lender market is providing longer-term debt at fixed rates at margins not much higher.”

“When it comes to construction finance, or development finance, that part of the market I would say is dire”
Robert-Jan Foortse

These alternative lenders have different funding lines and financial objectives and benchmarks, such as future payment obligations rather than Australia’s bank bill swap rate plus a margin, Misev noted. They also often provide flexible covenants and have differing requirements on interest cover ratios and leverage compared with banks, he added.

On a relative basis, debt funds have become a more attractive form of financing for borrowers as debt from traditional lenders has become more costly, said Alex Knapp, chief investment officer for Europe at Hines, which has “a spectrum of financing” that includes traditional, country-specific lenders as well as debt funds. “Historically, debt funds were materially more expensive than traditional senior lenders,” Knapp said. “That margin has closed now, but I don’t know if it’s going to stay tight forever.”

But while debt funds will always play a role in the real estate financing market, “I don’t see a situation where suddenly they take over a huge swath of market share, unless assets reprice so much that 6, 7, 8 percent coupon debt money is suddenly really accretive to us,” Knapp noted.

With alternative lenders still accounting for less than 20 percent of commercial mortgage debt in the US, Hochfelder agrees. She believes that capital is likely to remain constrained until the banks, life insurance companies and securitization markets resume higher levels of lending. Additionally, some debt funds – the majority of which are structured with some type of back leverage – are experiencing their own balance sheet constraints.

These debt funds include those that utilized warehouse lines or repurchase facilities to generate high rates of return in exchange for borrowing significant capital to finance their positions. Such lenders have now had to redirect balance sheet capital to meet margin calls and have found the availability of fund-level leverage has been reduced materially or is significantly more expensive, observes Brian Sedrish, managing director and portfolio manager for New York-based Related Fund Management’s credit platform. Meanwhile, even some unlevered debt funds today are dealing with stressed or distressed assets because of specific problems within their portfolio, and similarly have pulled back.

Sub lines as a financing tool

With property-level debt less available, borrowers have also been turning to other sources of financing, including subscription facilities.

“There’s an interest in having more flexibility on the sub line because long-term debt may be harder and take more time to arrange, or less of it may be available,” said Roger Singer, partner at law firm Gibson Dunn.

In such situations, the subscription debt may be used to buy an asset before long-term debt is in place.

Many fund documents provide limits on how long a sponsor can borrow on a subscription line, he explains. Some borrowers, however, are asking their investors for the flexibility to borrow on the sub line for longer periods of time.

The risk, though, is “if you loosen the restrictions, managers can use that flexibility in ways that are not specifically what LPs are agreeing to,” Singer pointed out. If an investor grants permission for a sub line to be used for a longer period of time, it is often difficult to narrowly tailor the circumstances in which that permission will be used.

For example, “if the idea of the permission is to allow it to be used when debt can’t be arranged, it’s always a little hard to say what ‘can’t be arranged’ means,” he explained. “Many times, it’s just a matter of what terms you’re willing to accept. It’s not that investors want bad debt terms, but that’s where you could have a disagreement about whether this was properly used.”

Knapp acknowledged that “some people in the market may have used sub lines as a way of bridging through a period where the financing was unattractive in hopes of getting more attractive financing in the future.”

However, Hines would not advocate such an approach, given the typical intent of sub lines as a shorter-term liquidity tool.

Moreover, “I think the issue with using sub lines as a true financing tool is that you don’t know what replaces the sub line in due course,” he added. “It’s short-term financing ultimately. And if you have a five-year business plan with two-year financing, you’re building in risk by putting it on the sub line.”

Mixed outlook

Borrowers have mixed views on the lending market for 2023. Knapp predicts it will become easier to finance deals going forward. “I would expect conditions to ease and an orderly transition from old math to new math,” he said, referring to the changed underwriting for deals in a rising rate environment.

“We’ll see how much of a step down in valuations and loan terms that ends up being. But we’re seeing signs of peaks in inflation in America and in Europe, and that should provide a pathway to inflation falling and interest rates eventually falling back some amount.”

Foortse, however, believes that lending conditions will continue to worsen before they improve. “We haven’t seen a lot of stress yet, and I think it will come,” he predicts. “We are now getting all the valuations for year-end in our books. You will see the valuations drop, and suddenly people will realize that actually they are close to their covenants, and when they refinance they realize that the interest rates will probably have doubled. So my sense is there will be a bit more stress coming in the system in the next six months.”

Under such a stressed environment, it will become more difficult to borrow for the foreseeable future, Foortse says, with the cost of debt continuing to go up until interest rates peak, which many are anticipating will happen in three to six months. “Then the world may get better, because one could borrow a bit cheaper,” he speculated. “But for now, I think that we are too early for that.