The capital markets have experienced a rapid transformation over the course of 2022, bringing attention to new themes and trends that continue to unfold. Rising rates, economic uncertainty and record-setting inflation continue to impact the marketplace, including lender appetite. While we don’t want to present a pessimistic outlook, as there is still plenty of demand for mortgages, it is important to be transparent and note the shifts that are taking place. Here are some of the themes and trends we have noticed in this quickly changing environment.
What does the lending landscape look like right now?
Life companies, banks, conduit lenders and debt funds are asking themselves the same questions: How should we be pricing mortgages and where should we be placing our capital? All these lenders were equally active and competitive over the course of the last few years and focused primarily on winning outright business. Allocations were at an all-time high, and rates were at historical lows. The competition among lenders for good quality lending opportunities was fierce.
Today, the picture looks a little different.
• Life companies remain active, primarily in multifamily, industrial and retail, but they look to corporate bond yields as a benchmark for pricing. Bond yields are out ~85 bps since the beginning of the year, causing spreads to widen. Upward pressure in the Treasury markets have doubly impacted rates, yielding an all-in increase of 250-300 basis points.
• Banks have been extremely competitive throughout the year with substantial deposits on hand, but now face higher regulatory scrutiny. This means higher deposit requirements for first mortgages, making pricing far more expensive for the borrower. Additionally, banks are less motivated to lend on new relationships in this environment, focusing primarily on their existing client base.
• Debt funds today have raised record amounts of capital, but the collateralized loan obligation market and warehouse lines have been put on pause or are too expensive, making pricing very inefficient today.
• Lastly, commercial mortgage-backed security spreads have spiked due to the lack of securitization demand, and the “floating till close” nature of the rate has made it extremely difficult to execute confidently. While there have certainly been some hurdles to overcome, the greater lending universe remains active, albeit in a different way, shape and form.
Office deals are receiving the most scrutiny.
The elephant in the room right now is office. As we all know, the landscape has shifted, with variations of hybrid work schedules and flexible work-from-home policies that are still in place, even almost three years after the onset of the pandemic. While the tide may be slowly changing with more pressure to have individuals back in the office, it is still an employee market, and workers are dictating companies’ office policies. This has given lenders pause, resulting in limited appetite for first mortgages secured by office properties.
So, what office deals are being financed right now? The answer is very few, but not exactly zero. There are common themes among the office deals getting financed now; highly diversified rent rolls, minimal near-term lease rollover, strong physical utilization, attractive basis and low leverage. While this may seem obvious, it is difficult to find the right combination to generate lender interest. Stabilized properties with the above attributes provide the best chance to garner interest from the lending community. Essex has had recent success and is currently working on several office financings with life companies and regional banks with the above qualities. On the other hand, transitional, commoditized office properties with vacancy or large near term roll in a softer market have become much more difficult to finance due to the nature of capital that lends in this space. Historically, debt funds have dominated this arena, but have seen a pullback on warehouse lines from their line lenders and inefficient pricing that makes deals much harder to pencil and has slowed activity down. Just like the rest of the market, the attitude toward office is changing daily and will be important to track moving into 2023.
Key underwriting constraints have shifted from the first half of the year.
Over the last 24 months, lenders had eased some of their underwriting constraints to compete in a marketplace that had a high demand for mortgages. As the risk spectrum changed in the second half of 2022 as a result of the themes discussed, lenders have tightened their underwriting parameters to become more conservative. One of the key metrics that lenders focused on recently, in-place debt yield, has shifted. Now, the focus is debt-service coverage, given the rising rate environment. As rates have risen since the start of the year, debt service coverage has come into play much more often and has been a limiting factor in the ability to push leverage. Even if the debt yield or loan-to-value metrics are strong, lenders still want to see north of a 1.25x debt-service coverage ratio, which can constrain proceeds, particularly as rates keep rising. This is a trend that will likely continue until we are in a more stable, lower rate environment.
So, with all of that said, what does lender appetite look like for the rest of 2022?
In years past, the week after Labor Day has always marked the final year-end push for deals to close before the New Year. With such a strong first half of the year, many lenders were a majority of the way through their allocation at the midyear point heading into summer. That, coupled with an extremely volatile market and potential for negative economic conditions, caused some lenders, while still active, to start to be more selective.
There is still an abundance of dry powder to be placed in real estate mortgages, but just at a little bit of a slower pace. With that said, we are in that in-between period where some lenders are focusing on rounding out their year-end allocation and others are focusing more on first-quarter 2023 production. The window to slide in a year-end financing is closing, with about one month left until lenders fully focus on 2023 production.
Despite some of the headwinds we are facing in today’s world, we continue to remain active finding creative financing solutions for clients in a rapidly changing and unpredictable market.