CRE: A New Monetary Environment

Inflation is on the rise. Interest rates are still low. How long? Who knows?

While consensus predicts that 2022 will be another great year for commercial real property, the reality of financial realities could cause some confusion. This type of uncertainty is the baneful of CRE plans.

We are more inclined to fight the last battle,” Harold Bordwin, principal and managing partner of Keen-Summit Capital Partners, said. We see it from the back of our eyes, but the crystal ball does not always show us what is happening.

The industry is constantly in a new battle.

TRACKING INFLATION

The last time inflation was near its current rates was in the aftermath of the 2008 financial crash. That was almost 15 years ago. During that period many people entered the industry but never learned how to manage significant inflation. It is important to have a sense for the future.

It is difficult to predict the future direction of inflation. The Federal Reserve has never been capable of controlling inflation. The Fed has always wanted a rate of 2%, but it has often been lower over the past decade. While the Fed claims that higher inflation is temporary, the institution has admitted that it may take longer than expected. Oxford Economics projects that sticky supply driven inflation will continue well into 2022. Core CPI is expected to reach 4.7% again, and raw national headline inflation (including volatile food and energy prices) to be 5.3% in 2022’s first quarter.

All this seems to fuel investor inflation worries. They are already worried about the direction of inflation. According to Morningstar, Treasury Inflation Protected Securities was the most successful sector in the bond market during October. TIPS rose while other bond types saw losses or were flat. The rush for interest drove the median yield to -1.75% even though investors were paying more than par, according to U.S. Treasury. This is a real loss of value considering that coupon interest rates ranged from 0% to 1/8.

As stock prices continue to be historically high, one could expect that more money will move into other assets, such as CRE, which might have a positive real return above inflation.

According to Tim Wallen, CEO and co-founder of MLG Capital, a private equity investment firm that invests in real estate, there is a lot of equity moving to real estate as an inflation hedge. Through inflationary periods, real estate usually outperforms stock and gold.

The general observation brings up specific concerns for investors and developers, landlords, operators, and tenants. The official average numbers reflect price changes in many types of products and services, across different geographic areas. The implications of what you need may be more difficult to accept depending on your specific needs. Ask anyone who has tried to plan construction projects in 2021. Lumber and other commodities could still be at higher prices than they were in previous years, even after the recent drop to dizzying heights.

The idea of commercial real estate being an inflation hedge is based on the belief that renegotiating rents provides an escape valve. Managers and property owners can raise rents to meet higher prices.

Richard Litton, president and CEO of Harbor Group International, states that in the finance area, we act as a lender. We are principally lending on apartments in America. If we were to think about how properties perform, whether we were a lender or investing in direct to own, the inflationary part for us is quite positive because rents can rise. Renters are limited in their ability to pay higher rents. They need wage inflation. All things being equal, it’s a great place to be in real estate compared to other areas, like if your long-term lease assets have small rent bumps.

There are however, complications. There are many issues. Ayoub Rabah, president at Coldwell Banker Realty Central West, said that many landlords and tenants have not paid attention to lease escalation clauses in the past decade. Instead, they rely on CPI indexes and fixed bumps each annual. Property owners will want to ensure that the escalations of rental rates are sufficient to provide the income necessary for routine maintenance if inflation is a concern.

Bordwin states that most people believe inflation inflates the real estate market. This is a positive. Do you have a plan to build-in? Do you have a plan for a build-in? What are you putting in there to rent in 2024 and 2025? For the past ten years, nominal inflation has been present. Now, you need to think about it. It is a point that you have to negotiate. You need to contribute 4%, 5%, or another number. It could make all the difference. It’s easy to be a genius when there is a rising market.

INTEREST RATES & LOANS

Inflation could also be impacted by higher interest rates. After many years of dovish policy, the Fed indicated that it will increase rates. This is despite a long road to a more traditional normal.

Fed policy, regardless [Chairman Jerome Powell]whether they are confirmed or not, are variable, and interest rates are a function both of purposeful manipulations made by the Fed and market conditions, according to Jeff Bartel, chairman, managing director, Hamptons Group.

Wallen believes many people are worried about the prospect. He says that interest rates are something I consider when I look at them. This pattern is actually about economic recovery. Of course, macroeconomic events such supply chain disruptions, as well as businesses trying regain lost profits from the pandemic, also play into this pattern. While interest rates may not be the only thing that matters, we believe that you need to see a 7.6% increase in revenue growth to offset the drop in value. To offset this valuation differential, you will need higher earnings.

Hunt Holsomback is a managing director at Alvarez & Marsal Private Equity Performance Improvement and leads the corporate real-estate services. “I see rates going up over 12 months,” he says. I don’t think it will be significant. The trend will be in the upward direction, but at a moderate rate.

That is due to the amount of money that is available. According to Jeff Pori, CEO of Kingsbarn and founder, there will be less money sitting on the sidelines, and more money available to jump in. We expect that there will be more money competing to finance the project. If there were no competition in the market, and more money, I would expect interest rates to go up. It is likely that more money will keep it under control.

CRE can also be affected by changes in interest rates, as they are tied to contractual agreements. Many of them were based on LIBOR (or the London Interbank Offered rate). However, due to concerns about rate-fixing and scandals surrounding accuracy, the use will be discontinued by 2021. Firms that refinance within a few years are now facing questions.

What does this mean to your interest rates? Marni Ahram is a principal attorney at Shapiro Lifschitz & Schram. What will be the benchmark placement and which triggers will it have? It is important to have this discussion before you go to the documentation phase. This is when you will be creating your term sheets, which outline the basic terms of the loan. Make sure everyone is on the same page about the LIBOR sunset, benchmark replacement, and how it will work before you start to spend money on lawyers and fees. Although there are many ways to avoid it, it is easier to come to an agreement with everyone upfront.

Ahram has advised clients to negotiate a replacement. What is the benchmark rate for replacement and what would the total cost of the loan to the borrower once the benchmark replacement has been in? She said.

One candidate is the secured overnight lending rate, or SOFR. It is published regularly by the Federal Reserve and is based on Treasury transactions.

Litton states that SOFAR is receiving a lot attention right now. Freddie Mac is an example of a prominent lender in the apartment sector that uses a SOFAR foundation.

Ahram notes that the consensus of my clients on financial side is that term SOFAR is going be the best. They are pushing their lenders to agree to that, but lenders don’t like to commit.

A realistic completion time for construction and development loans is an important aspect of negotiation. Supply chains can cause problems.

Ahram says that most construction lenders require completion within a set time frame. Principal payments start once completion has occurred. You can’t complete if you don’t have the materials. You don’t want the lender to get nuclear on you because it is impossible to get steel beams or furniture. Your lender needs to be educated about the realities and pitfalls of construction. Even if they have a long history of lending, a person with no finance background may not be able to understand the building process.

This is another area where a rise in interest rates can help to contain costs. Greenspoon Marder partner Mark Fawer says that rising interest rates can help to reduce inflation and could also lower demand. This would result in lower prices for materials and labor. There is a possibility of an offset feature in construction depending on the time between the increase and decrease in cost.

Lenders are more open to loan approvals, depending on the property type. The good news is that lending conditions have improved. Ahram says that lenders are more willing to provide supplemental loans for improvements. They don’t give them any problems with underwriting. On the other hand, office owners in Washington and New York are having a bit more trouble than usual. There are no guarantees of lease extensions or companies taking up the space they need with changing work patterns. It is increasing costs for building owners and tenants aren’t looking to modify their leases or extend their leases. It all flows up to their lenders. Some cases allow for extensions of principal payments. In some cases, curtailment requirements are required. It’s like having workout loans on the side. These are the issues that nobody is talking about, but they’re not in exercise yet.

Bartel states that this will increase pressure on developers, builders, and investors. Mezzanine lenders have greater opportunities to secure deals to pay for construction and development costs. Developers and builders will have to raise the price of their products to the end-user. We will not know if that happens in 2022 during a federal election or if it is something we will see in 2023.

AUTHENTIC LOOMING 2008

Rajul Sood from Acuity Knowledge Partners, head of commercial loans solutions, said that one sign of activity was the resurgence of CRE securitization. It has reached the volume it was prior to the 2008 global financial crisis. Even Freddie Mac is the most prolific issuer in many years. This is mainly due to favorable Fed policies and the push in multifamily and industrial subsectors.

Why is the CMBS market so successful? GlobeSt.com hears from Gerard Sansofti (executive managing director, as well as a leader in the debt and loan sales platform at JLL). If a money market manager can see that I can get more on a AAA-rated mortgage bond than on a AAA corporate bond then I will invest in the mortgage bond.

If this raises concerns, take a deep breathe because the fundamentals of the situation are different. Sood says that mortgage delinquency has not increased much and that mortgage delinquencies still average 3.3%. They were at 24% before the crisis. Sood spoke to bankers who claimed they have sufficient liquidity and are currently comfortable.

Sansofti believes that the structures for CMBS issuances today are more stable than they were in the past. There was floating-rate CMBS back then, but the structure of these deals today is very different. A CMBS today is more than a single asset and a single borrower. It involves multiple loans. You should be fine if you have had one or two deals go wrong in your portfolio. Also, before 2008, we projected rents out for 2 to 3 years. Our leverage was much higher at 80%. Underwriters today look at market data and not projections.

He believes that risk is being correctly priced. Sansofti states that people who take on more risk than the 65% threshold, such as mezzanine lender lenders, typically get paid an additional 200-300 basis points for the risk. It is all dependent on the yield expectations for other investments.

There are many sources of capital. Sansofti says there is a debt fund world that originates bridge loans. CMBS once accounted for more than 50% of the market. Today, it is 10% to 15%. Banks have more capacity. Insurance companies also have much more money in. I don’t see the liquidity problem we ran into last time.

Institutions consider the spread as a function of how much they are borrowing against. Hameer Vaid, a senior manager with Alvarez & Marsals Private Equity Performance Improvement Group, said that if the capitalization rate is higher then their weighted capital cost, they will generally agree to the deal. We see that multifamily bets are still being placed. The cap rate was significantly less accretive than those weighted average capital cost.

2022 could see a continuation of higher inflation. There may also be an increase in interest rates and macroeconomic stress like supply chain shortages, as well as changes to Federal Reserve monetary policy. There is plenty of cash available for investors and borrowers, and there is a significant need on multiple CRE fronts, including multifamily, high-end office, medical, and industrial. Even with some challenges, 2022 looks like a great year.