The Forces Shaping the 2019 Capital Markets

Shlomi Ronen

Looking back to examine some of the issues that helped shape the real estate landscape last year provides us the opportunity to look ahead at how those trends might affect the industry in 2019.

Most evident in 2018 was the added liquidity brought about by the phenomenal growth of debt funds.

The record amount of capital raised by these funds continues to increase at a seemingly historic pace as institutional investors see debt as an opportunity to achieve attractive net returns with far less risk than equity investment, especially as we get into the late innings of the recovery. In addition, the re-emergence of collateralized loan obligations allows managers to sell loans typically kept on balance sheet in the secondary market

This increased competition, not just among debt funds, but traditional lenders as well, has resulted in significant spread compression and higher leverage, as much as 85 percent LTV for well-located projects with strong sponsorship. This phenomenon, where the gap between long- and short-term rates narrows and leverage creeps up, occurs toward cycle peaks and is a definite sign that we are in the very late innings of the recovery.

Trade Uncertainties

The other significant trend that has shaped the real estate markets this year is the climate of uncertainty that has impacted the industry both positively and negatively as a result of the current administration’s policies.

The trade war with China, for example, and the institution of tariffs have increased costs for developers, making investment in projects more difficult.  This is especially true for developers of single- and multifamily projects. Estimates from the National Association of Home Builders claim that homebuilders, and those in the home remodeling industry, almost exclusively used products from China, the primary target of the new tariff policy. 

Rising costs on items like steel, aluminum and granite slowed or even stalled development in markets around the country as developers had to rethink, in some cases redesign, their projects as a result of uncontrollable increases in materials costs. Such volatility makes it very difficult to underwrite much needed housing, making it a point of focus of many lenders and investors today. The temporary truce between the United States and China suggests that hope springs eternal, but the recent volatility in the stock markets indicates that there is still much work to be done before a workable trade pact is finalized between the two countries.

Another Potential Capital Infusion

While the new policy on tariffs impacted the industry somewhat negatively, the administration’s efforts to increase investment activity in economically distressed communities led to the development of Opportunity Zones, under the Tax Cut and Jobs Act. Opportunity Zones, which encourage investors to reinvest their capital gains in economically distressed communities in exchange for significant tax benefits is now attracting a lot of private capital—with estimates of as much as $100 billion being raised by newly formed Opportunity Zone Funds. According to research from Yardi, there are more than 8,700 areas in all 50 states of the U.S. that were designated Opportunity Zones by the Treasury Department. While offering tremendous opportunities for both residential and commercial development, the deployment of that capital will take some time.  

And on the regulatory side, the current administration has been a little steadier. Having chipped away at Dodd-Frank, life has become a bit easier for the small banks, although two months into the year, that has not yet happened in a wholesale way as of yet.  It was also in 2018  that the White House and GOP members of Congress favored removing Freddie Mac and Fannie Mae from U.S. conservatorship, where they has been since 2008. While it is unlikely that Congress will act in 2019 to privatize the GSEs, the discussion signals that significant changes are on the horizon.

As we continue into 2019, the focus on debt funds and the geopolitical roller coaster should continue. Lender diligence should continue in a demonstrable way for some time, although we may see some further spread compression as competition continues to increase with an abundance of capital seeking to finance a finite number of deals, to the benefit of borrowers. 

It is worth noting that while retail continued to struggle in 2018, investors and lenders are getting to understand the asset class a lot better, giving cause for some optimism this year. We are beginning to see more categorization, a much more precise definition and stratification of both the retailers and the types of retail. That’s helping everyone, including investors, to start to understand what seems to work and what absolutely does not.

Shlomi Ronen is managing principal & founder of Dekel Capital, a Los Angeles- based real estate merchant bank.