In today’s world of commercial real estate finance, there is a vast ocean of cash available to fill a capital stack. The financing world has evolved in the post-recession years with alternative lenders emerging to fill the void left by bank consolidation, a decline in worldwide commercial mortgage backed securities (CMBS) issuance and a general decrease in risk appetite.
Traditional lending sources
Developers still, and always will, rely on the traditional lending sources like banks, life insurance companies and CMBS lenders. During my 17-year career in commercial real estate finance, I have had the opportunity to work in each of these specialties. Each of these debt sources fills a niche that in years past was clearly defined. During the current cycle, lenders are offering a broad array of capital products and the distinction between these lenders are often blurred.
Those developers with a long-term hold strategy interested in building a new warehouse facility would approach a bank for construction financing. Once the building was complete and stabilized, the owner would refinance the floating rate bank debt with longer-term fixed-rate CMBS or life insurance company debt, with the latter traditionally being lower leverage.
Unfortunately, the cyclical nature of commercial real estate cannot sustain this utopian world for extended periods of time. Now that we are a decade plus removed from the Great Recession, headwinds are being felt across the financing landscape that are disrupting real estate finance.
Banks are subject to significant federal regulation that is intended to avoid financial disasters. Depending on the size and complexity of the bank in question, they may be regulated by upwards of a dozen federal, state and local bodies. Regulation is a tedious and expensive exercise that has an opportunity cost and takes a lender’s attention away from originating new business.
The current cycle can be characterized by the lending community (primarily banks and life insurance companies) exercising much more disciplined underwriting in the hope of avoiding a market meltdown similar to 2006 and 2007; however, there are a number of factors that are stressing current underwriting standards. Despite decreased underwritten leverage, both cap rates and rental rates are at record levels—resulting in property values (on a per-square-foot basis) also being at record values. As a result, lenders are imposing stringent sizing constraints—with debt yield or debt service coverage ratios serving as the primary underwriting metrics.
CMBS lending has also felt the sting of headwinds. Capital market volatility at the end of 2018 and uncertainty in 2019 make CMBS debt less attractive for borrowers in terms of certainty of execution. According to Commercial Mortgage Alert, as of September 2018 annualized, total CMBS issuance of $77.6 billion was 19 percent below the $95.3 billion posted at year-end 2017. The decline was even greater for the warehouse/industrial asset class having declined 25 percent from $7.1 billion in 2017 to $5.3 billion in 2018. The $5.3 billion mark in 2018 for warehouse/industrial asset issuance was off by 56 percent since hitting a peak of $12.1 billion in 2015.
Emerging debt sources
Stepping up to be a new source of capital for developers has been the proliferation of alternative lenders. Over the last decade, private equity funds, pension funds and other institutional debt funds have been significant players in commercial real estate finance. For transitional assets, with a value-added component, debt funds offer non-recourse, aggressive deal structures and flexible underwriting. But with these attractive attributes comes wider spreads, higher fees and guaranteed outstandings increasing costs.
Alternative lenders are not completely immune to negative pressures in the current real estate cycle as they are also concerned by current asset valuations and uncertainty in the market. According to the data firm Preqin, “The number of private equity real estate funds closed and amount of aggregate capital secured has decreased for three successive quarters to Q3 2018.” Despite this fact, the $97 billion raised through Q3 2018 is greater than the amount raised in each of the past two years over that same time period.
Answering the bell
In order to remain competitive, traditional banks and life insurance companies have become more aggressive and/or emerged from a long-held and cherished comfort zone to entice business back to their balance sheets. The recourse is what was once standard policy from banks has now transitioned into a point of negotiation.
Banks are now offering non-recourse loan options, and to entice industrial developers (more so than any other asset class) banks need to match the market and offer speculative, non-recourse construction loans. The notion of spec, non-recourse construction loans would have been laughed out of credit committee only 5 to 7 years ago, but now is very much a part of many bank loan books. Banks are extremely selective when underwriting speculative developments on a non-recourse basis, and availability is based upon relationship lending (as opposed to transactional lending).
To combat competition, life insurance companies have increased leverage, albeit slightly and for the right sponsor, and a limited number of life companies are expanding their product line to provide construction loans with the ultimate goal of converting the construction loan into a permanent loan at stabilization.
Many factors are contributing to an exciting future in industrial real estate, including the stable performance of industrial as an asset class, the deep pockets of debt funds, more aggressive banks and life companies which are allowing developers to pursue a myriad of industrial opportunities.
In mid-January, Bridge Development Partners and JV partner DH Property Holdings announced they are developing a four-story, 1.3 million-square-foot, last-mile distribution center in Brooklyn, New York, which will be the largest multi-story warehouse in the country, allowing truck access to all four floors.
In mid-June 2018, a joint venture between MAT Limited Partnership and institutional investors advised by J.P. Morgan Asset Management announced the development of a 633,000-square-foot building, which will be the largest speculative industrial project in the city of Chicago in over a century. The property recently leased its first tenant, as a local 3PL firm will relocate from the suburbs.
As we have seen in the decade since the Great Recession, competition drives change, including the evolution of traditional lenders. If we in the debt world don’t grow and evolve, we will die—or from a finance perspective, we will lose market share and get acquired. Fortunately, during the current cycle, underwriting within the debt markets has been disciplined—with lenders tending to chase market pricing down—as opposed to chasing risk up (with increased leverage). With this disciplined underwriting, the hope is that during the next market downturn, equity, as opposed to debt, will bear the brunt of the fall in values.
About the author
Daniel Barrins is a vice president, relationship manager for the commercial real estate group at Associated Bank, where he is responsible for originating middle market commercial real estate loans within the bank’s footprint. Barrins has more than 15 years of finance experience consisting of commercial real estate loan originations and managing a portfolio of commercial real estate debt. He is a member of the International Council of Shopping Centers (ICSC)