Capital Markets Change, But Relationships Don’t

Peter Welsh

The homestretch of a disrupted year is here. The headwinds of 2022 are a reminder that volatility and disruption are as much a part of our industry as stability and predictability. While 2022 was supposed to be the year we breathed a sigh of post COVID relief, war in Ukraine, rampant inflation and continued supply chain disruptions created new storms to weather. When cycles shift and headwinds develop, new opportunity will exist, however, and deals will still get done. Take heart and be smart. That’s what we have been telling our borrower clients.

Now is a time to be talking. One of the bright spots of 2022 has been a return to in-person professional gatherings and meetings. Getting reestablished with peers, associates and clients is especially critical for those of us specializing in the capital markets. It seems like everyone wants and needs to ask critical questions: How do we assess risk and price debt in today’s shifting economic landscape? These are good questions. Here’s what we are discussing.

The capital markets are changing quickly, and loan programs that existed two or three months ago don’t exist today, and most all lenders have met their new business targets for 2022. Thoughts have turned almost exclusively to 2023 and new origination, with the lenders we are talking to becoming much more receptive to new business. There is no desperation to get money out, but capital ready for deployment remains abundant. The landscape has changed.

The current series of Federal Reserve interest rate hikes aimed at curbing inflation is impacting bank lenders and floating-rate debt more than life company and fixed-rate lenders tied to other indexes like treasuries and corporate bonds when setting rates. For life companies, production targets for 2023 are comparable to 2022, and in the expected higher interest rate environment, we expect that this means borrowers will see more competition from these lenders for loans on higher quality assets. We are focusing clients on these fixed-rate debt options in the five- to 10-year range, often with favorable early exit clauses included. Some borrowers see shorter term bridge loans as appealing, thinking that we will see better rate conditions near term as markets process out the current waves of disruption. But with long-term rates holding well below short term rates, we are recommending the long game.

Lender Appetites in 2023

Maturities and price equilibrium will be telling factors in 2023. For those refinancing next year, we are still seeing relatively attractive fixed rates in historical comparison for performing assets. Proceeds, however, may not be as abundant as in years past. As the cost of debt has gone up, it has put pressure on buyers and sellers to revisit valuation and find equilibrium. We saw a lot of deals shake out in 2022 as the rising rate climate affected debt service coverage ratios, and we expect that sellers will begin adjusting their pricing to meet the new cost of debt capital. Once that happens, we expect to see the pace of transactions increase as sponsors decide to sell or refinance to secure their best return.

Each asset class will have its own set of considerations. The office sector is perhaps the most vexing asset classes to underwrite post Pandemic. While office assets are performing from a leasing standpoint, actual occupancy is a challenge to determine—a phenomenon that raises greater questions. The extent of subleasing space, which isn’t always reported, means real inventory is hard to determine. Also, re-tenanting costs are hard to pin down right now. We will begin to see this become a major factor for underwriting in 2023. Lenders are looking at the durability of a tenancy, how that tenant is pursuing its return to office policies, and what new demand is out there for current or potential vacancy. In many cases, new capital will be required to balance out these potential impacts to cash flows and performance.

Industrial has been a top performer in the recent cycle and will continue to enjoy a favored status among most lenders. Post-pandemic inventory onshoring, a continued growth in internet commerce, and lack of development sites in key markets mean that fundamentals for the asset class are holding strong. Our lenders favor industrial serving gateway markets and those near large population clusters in a multi-tenant format, where demand will preserve fundamentals, barriers to entry exist for new product development, and diversification of cash flow from tenancy and low buildout costs can mitigate re-tenanting costs when necessary.

Other commercial asset classes we expect to resonate with our correspondent lenders include grocery and national tenant-anchored suburban power centers. These assets have performed above expectations post COVID and are still attractive moving into the new year. Financing is readily available for historical performance. Value add, however, is not as attractive as it was a year ago. Self storage has evolved into a very attractive asset class. While some lenders who have been active in funding the asset class are getting full, comfort with the asset class has grown, with more and more lenders comfortable adding these assets to their loan portfolios and expanding financing options for sponsors in the asset class.

Peter Welsh is principal, Gantry.