Debt markets have mainly avoided a liquidity crisis since the onset of the pandemic, with debt volume less impacted in 2020 than investment sales, Newmark President of Capital Markets Strategies Anthony Orso told CPE.
And when it comes to New York City, Orso is “cautiously optimistic about the near future” of debt markets for all asset classes, as overall financing activity is expected to maintain momentum. He also shared his insight on the forces behind the shift toward the single-asset/single-borrower market, as well as why the boom in commercial real estate collateralized loan obligations is one of the bigger surprises of the year.
Additionally, Orso explains why tech companies have been a prime indicator in tracking the economic recovery in commercial real estate.
What can you tell us about commercial real estate workout conversations in New York City right now?
Orso: Generally, in a real estate workout, asset-level performance is a result of property metrics. With the pandemic, however, negative asset-level performance is the direct result of a global public health crisis. As such, workouts today are about borrowers and lenders working together until these macro-level impacts are resolved.
Long-term asset value is a greater focus than short-term default interest rates and penalties. Largely, our team has seen lenders cooperating with borrowers in terms of deferring interest, using existing property reserves to pay debt service and recapitalization. We recently led the workout of a prominent Fifth Avenue luxury retail asset, and the conversation revolved around when—not if—the asset would recover. The next question becomes: What do we need to do to make it to that point?
In what property sectors is the most financing activity currently occurring in New York City?
Orso: Multifamily has remained the largest segment of New York City’s commercial real estate financing market, both pre-pandemic and post-pandemic. The percentage of office financing activity declined slightly in 2021 to just under 33 percent, from 34 percent, of commercial real estate financing total pre-COVID-19.
According to Newmark’s 2Q21 U.S. Capital Markets Report, financing activity has remained robust in the past 12 months, and New York City has been at the forefront in 12-month loan originations. Can you tell us what’s behind this performance?
Orso: That “financing activity has remained robust” refers to the fact that the debt markets have largely managed to avoid a liquidity crisis like that following the Great Financial Crisis, and that debt volume in 2020 was less negatively impacted by COVID-19 than investment sales volume (-35 percent vs. -43 percent year-over-year, respectively) in New York City. While sales volume declined across all markets, borrowers were largely able to refinance and/or recapitalize, and the lending community was still active, albeit more so in certain property types.
As far as New York City being at the “forefront” of 12-month loan originations, while the market did see a greater dollar value of loan originations compared to other U.S. markets, it is historically one of the lowest yielding markets as a whole. So that figure is relatively unsurprising (higher rents x lower cap rates equals greater volume).
How do you anticipate New York City’s debt market to perform for the remainder of the year?
Orso: I’m cautiously optimistic about the near future in New York City’s debt markets for all assets. The city has regained more than 94 percent of its pre-pandemic office-using employment, and delinquencies are declining substantially (CMBS delinquencies were down 40 percent within 10 months of the peak).
Manhattan registered positive office absorption in back-to-back months for the first time since the pandemic began. As the market continues to recover, we do expect an uptick in overall financing activity through the fourth quarter of 2021 and into the first quarter of 2022.
Refinancing as a percentage of total financing activity remains above pre-pandemic levels and peaked in 2020. Going forward, do you expect the trend to persist?
Orso: Refinancing activity comprises a greater proportion of total financing activity for several reasons—the low interest rate environment, and the fact that—for a good portion of the pandemic—acquisitions were entirely stalled, decreasing the equation’s denominator.
Now the question is: Do we see those variables changing any time soon? Despite the ever-so-slightly-hawkish tilt from the Federal Reserve in the last few weeks, the market has largely priced the expectation that interest rates will remain—relatively—low for a prolonged period, so the first variable driving the trend is likely to remain.
The second variable, however, seems much less convincing: Refinancing as a percentage of total financing activity actually declined from 66 percent in 2020 to 62 percent in 2021. As funds seek to deploy record-levels of dry powder sitting on the sideline, the market continues to recover and the gap in pricing expectations between buyers and sellers continues to narrow. Acquisition financing will almost certainly regain its pre-pandemic share of overall financing activity.
Conduit loans have historically dominated the majority of CMBS issuance, but the single-asset/single-borrower market is increasingly popular. What’s behind this shift?
Orso: There are a few forces behind the shift towards SASB, but one of the most significant drivers has been the institutional-quality sponsorship and assets backing loans. Beyond the high credit requirements for the underlying assets, it seems that CMBS lenders and investors value the comfort and convenience of really knowing the borrower.
Not unrelated is the fact that SASB deals have largely outperformed conduit deals. Data from August showed SASB delinquency at 2.8 percent compared to 6.9 percent for conduit. Similarly, special servicing rates—delinquent and current—were 5.4 percent for SASB and 9.0 percent for conduit. It makes sense that this segment of the CMBS market “thawed” first—not to mention that they’re easier to underwrite.
Commercial real estate CLOs have also been gaining market share in recent years. Why do you think that is?
Orso: One of the bigger surprises of the year has been the boom in CRE CLOs, which have already eclipsed 2019’s total issuance volume just in the first half of 2021. There are a few forces behind the resurgence in CRE CLOs.
First, it’s important to consider that of the roughly $50 billion of CRE CLOs outstanding, over 47 percent consists of loans secured by multifamily properties. Multifamily as an asset class has proved to be a superbly resilient investment throughout the pandemic, resulting in greater investor appetite for multifamily exposure throughout the capital stack.
Secondly, in the current low-yield environment, investors are flocking to deploy capital in any instruments with even modest returns, pushing prices higher across the board. These two factors combined have resulted in record-low yields for the senior-most tranches of CRE CLO deals (2021 has occasionally seen AAA SR notes price below +100 basis points), in turn lowering the issuer’s cost of capital and allowing them to compete more aggressively for deals, especially in multifamily.
In our deal pipeline, we’ve seen debt funds take an unprecedented level of market share in the past few months—not surprising considering they can offer a sub-3 coupon for 75 percent LTV.
What are your expectations for the overall debt market, and the commercial mortgage-backed securities arena in particular?
Orso: Perhaps unsurprisingly, I have a bullish outlook on the overall debt market, partially due to my positive outlook for commercial real estate in general.
Throughout the pandemic, tech companies have been the proverbial canary in the coal mine. Their actions have been a key indicator in tracking the economic recovery in commercial real estate.
This year, those actions have painted a positive picture of the future, especially in New York City: Google’s $2.1 billion purchase of St. John’s Terminal; Amazon, Apple, Facebook and Google adding more than 22,000 NYC employees; and Amazon, Apple and Facebook adding more than 1.6 million square feet since the start of 2021, and so on.
For every story I see about a firm delaying the return to the office, I see two stories surrounding tech companies leasing more space, taking subleases off the market or buying real estate.
This macro-level optimism applies to CMBS as well. My view is that as the market—and the world—moves back to normalcy, increased sales volume for stabilized assets and elevated investor demand will likely continue to drive CMBS financing volumes higher, especially in 2022-2023, as interest rates remain low.