Making capital stack up in a tough financing environment

Low interest rates made it easy to boost returns from real estate. Now life is much harder, especially for those with loan maturity looming.

The financing environment for real estate changed completely in less than 12 months as central banks began raising interest rates to fight rising inflation. The US Federal Reserve raised rates from just over zero to a range of 4.75-5 percent in the year to March and was followed by the European Central Bank and others worldwide.

Finance costs in most markets around the world are now several percentage points higher and are also higher than real estate yields, which means that juicing returns through debt is far more difficult, especially as asset sellers are reluctant to meet the pricing requirements of buyers. 

The Mortgage Bankers Association predicts total US commercial and multifamily lending to drop 15 percent this year to $684 billion, following a similar fall in 2022. In Europe, meanwhile, the European Central Bank’s January 2023 bank lending survey found “substantial tightening in credit standards for all loan categories.”

Steven Gower, head of treasury, debt at London-based real estate services firm Savills, says: “We have seen senior margins continue to edge higher as credit markets have become more strained. Banks now struggle to lend over 50 percent loan-to-value on an interest only basis given greater pressure on values and interest coverage.”

A few savvy investors saw the new environment coming and acted early to secure long-term debt at lower rates. Blackstone Group’s private real estate investment trust BREIT fixed 87 percent of the trust’s balance sheet for more than six years. This gives the trust a weighted average interest rate of only 4.1 percent.

The New York-headquartered manager says: “We took a non-consensus view over the last few years that interest rates were going to substantially increase. Locking our interest rates has generated $4.2 billion of value increase for BREIT investors in 2022.”

Navigating a tough environment 

However, asset owners or purchasers are not in the position of being able to lock in long-term financing at such favorable rates. They also face an environment where banks, in particular, are less keen to lend to real estate. 

The simplest solution – and one that allows buyers to move quickly and secure assets – is to use 100 percent equity. Chicago-based LaSalle Investment Management has carried out most of its US acquisitions in the past six months on an all-cash basis, Brad Gries, co-head of the Americas, tells PERE. All-equity deals mean buyers can add debt at a later date, potentially in a better borrowing environment. 

However, very few investors have deep enough pockets to acquire everything with cash, and those who are borrowing need to have an eye on where interest rates will move in the short and longer term. Inverted yield curves in some markets mean that longer-term financing is cheaper, but borrowers need to protect themselves from short-term rises. 

Apwinder Foster, head of product strategy at DRC Savills Investment Management, says: “Where possible, borrowers will seek to procure interest rate caps to protect them from further interest rate rises in floating loans. Where caps are too expensive, lenders may provide fixed-rate loans.” 

Development finance is a further challenge, due to bank reluctance to lend, she says. “Banks have reduced their appetite for lending in this space, which means that non-banks are more likely contenders, providing whole loans. Whole-loan lenders will look for tighter covenants with milestones aligned to the progress of the construction, cost overrun guarantees and large cash reserves to ensure the interest income is paid during the term of the loan.”

While the borrowing environment means it is hard for purchasers of real estate to add value via the capital stack, falling values and rising interest rates are even more challenging for those who need to refinance assets. Their first option is to inject more equity, the need for which has sparked a new wave of fund recapitalizations and extensions. If there is not enough equity available, they may need to consider more expensive options.

Gower says: “Values have fallen and senior lenders have reduced LTVs, creating a potentially significant funding shortfall if equity is not available to plug the gap. Borrowers who have typically borrowed on a reasonably conservative senior basis are being forced to consider mezzanine debt or preferred equity as they try to refinance. However, given interest rates are now much higher, the issue is often that there is not enough operating cashflow to service the cost of a senior/mezz structure.”

The market is already seeing what happens when asset owners cannot sell or refinance assets. Asset managers Blackstone and Brookfield hit the headlines this year when defaulting on commercial mortgage-backed securities loans secured on office properties. Further defaults are expected in 2023. However, banks will be wary of getting saddled with assets from defaulted real estate loans, so may be willing to extend loan life. 

There may be a chink of light for real estate investors, though. The International Monetary Fund said in April it expected recent increases in global real interest rates to be temporary and that “when inflation is brought back under control, advanced economies’ central banks are likely to ease monetary policy and bring real interest rates back towards pre-pandemic levels.”

If correct, then real estate investors who can hold on, either by extending the life of existing loans, recapitalizing or refinancing, will be in a good position to refinance in a couple of years’ time.