The signals no one in commercial real estate likes to see are present. Two banks with ties to the industry collapsed. Commercial property prices are down. Tech companies, once reliable office tenants, are downsizing their footprints. Even the industrial sector, a favorite of investors the past few years, is experiencing a mild decline. Can we officially proclaim that we are in a recession? It’s hard to say.
To get a better understanding of what’s happening in the market, we spoke with Don Pavlov, Lev’s head of capital markets. Before joining Lev, Don was the associate director for the debt and structured finance team at Newmark in New York City.
Lev: Silicon Valley Bank and Signature Bank just collapsed. What effect are you seeing so far in the capital markets?
Don Pavlov: The banking industry was thrown into a frenzy last week when regulators seized two banks within three days. This caused stocks of over two dozen banks to plummet, and customers scrambled to withdraw their funds.
However, I am confident that the unique circumstances surrounding SVB and Signature Bank, coupled with the government’s commitment to support troubled institutions, the Federal Reserve’s new Bank Term Funding Program, and the guarantee of deposits at both banks will keep systemic banking risk under control.
The closures are likely to cause the Federal Reserve to take a more cautious approach to monetary policy tightening in the near term, reducing the size of their hikes throughout 2023.
While the banking industry may face some turbulence, the general economic outlook remains broadly the same, and the positive outlook across most commercial real estate sectors is still strong. This week, base interest rates and peak SOFR rates dropped significantly as the market expects the Fed to continue to ease. In simple terms, the cost of borrowing, from interest rates to rate caps, has decreased significantly, making it an excellent time to secure short- to intermediate-term debt. A strong regional banking system is crucial for commercial real estate, and the government has expressed support for this sentiment. The banking industry is going through a period of adjustment, but I don’t believe it’s as large of an issue in commercial real estate lending. In fact, this could be an excellent opportunity to take advantage of current market conditions while they last. Banks are still lending and investing, and there is still a lot of money looking for the right investments. Investors should examine their portfolios and potential investments closely to take full advantage of current market conditions. The vast majority of the regional and community banks we work with continue to quote and actively lend on deals as we move into 2023.
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Lev: When we spoke in January, you mentioned that you and your team were seeing a lot of apprehension from lenders. Is that still the case?
Don Pavlov: Unfortunately, that is still the case for the majority of groups out there. There was a time of heightened optimism in late January and throughout February, during which many lenders and market participants, including myself, believed rates would stabilize and spreads would tighten leading to higher origination volume in H2 2023. However, I believe Federal Reserve Chairman Jerome Powell’s recent comments at the Fed meeting dampened those expectations.
The market is most certainly fractured. Since we’re constantly reaching out to lenders, we have a pulse on who’s active and not, and who is welcoming new customers or saving capital for existing customers.
However, lending is still a business, and groups need to deploy capital. Unlike some other down cycles, I believe this latest pullback in new originations is less of a result of illiquidity in the capital markets (despite a small component of unscheduled extensions limiting the ability to recycle capital) and more so to the general attitude of “risk-off” until there is a clearer light at the end of the economic tunnel. Meaning, lenders have the capital to deploy – but they can’t, or are unwilling to, push leverage or venture into new locations and/or asset classes without being accompanied by a compelling underwrite and story.
Lev: What types of deals are you and your team seeing right now?
Don Pavlov: We have seen an uptick in transitional opportunities, including heavy value add and ground-up construction deals. Some of these opportunities are from sponsors who have previous lending relationships that are either constrained on leverage, unable to price competitively, or on the sidelines altogether.
As I mentioned previously, lenders are becoming increasingly unwilling to take risks in today’s environment where underwriting assumptions are becoming less predictable. This is exacerbated by these groups seeing properties in their portfolio, which they lent on 2-3 years ago, failing to meet those initial underwriting projections.
Instead, lenders are more focused on opportunities that they can more easily understand and mitigate risk, such as permanent financing. However, permanent opportunities that offer sensible investor returns, especially new acquisitions, are becoming increasingly scarce given the drive-up in rates and the current bid/ask spread. This is driving sponsors toward higher-yielding value-add or construction opportunities.
Lev: What are you seeing in regards to the bid/ask spread?
Donald Pavlov: Obviously the bid/ask spread has gotten wider. Generally speaking, sellers aren’t being forced to exit positions, which allows them to decline offers that buyers view as “market” offers now. Sellers are holding on with the hope that things improve in the short-to-medium term.
We are seeing this play out in the fact that commercial property sales in the United States during January 2023 were at their weakest levels since the onset of the Great Recession. In addition, we have observed a significant year-over-year decrease in permanent acquisition financing requests, primarily due to rising interest rates, which have curtailed investors’ returns, without any corresponding drop in the accepted sale prices.
Lev: What deals are lenders excited about financing these days?
Donald Pavlov: More so now than ever, lenders are focused on opportunities that they can more easily underwrite and that still pencil out when those assumptions are stressed. They’re focusing on more established markets, and typically in the traditional asset types – regardless of business plan. There typically has to be a very persuasive reason for groups to venture out of that target box such as a strong sponsor with a previous relationship, compelling business plan or basis, etc. Anything speculative, even including industrial and multifamily, is getting more scrutiny with many lenders requiring some level of pre-leasing in order to push leverage or tighten spreads.
Lev: What are some asset classes that are struggling?
Donald Pavlov: I don’t think I am saying anything groundbreaking when I say Class B & C office have taken over retail as lenders’ boogeyman. Companies are downsizing with remote or hybrid work. If they choose to hold onto a physical space, they are gravitating towards Class A spaces with amenities to retain talent. Even with the recent push to return to the office, there is still an oversupply of space in the market. While still available, financing for these lower quality assets is very low leverage, “spicy” pricing, and typically require an equity injection at close.
Lev: Don, thanks so much for taking the time to speak with us.
Don: My pleasure.
Thanks for reading Digging Deeper, Lev’s analysis of the major trends in the commercial real estate marketplace. Each installment brings expert insight from Lev’s team and provides context about the major trends influencing deals and market climate.
