An Abundance Of Liquidity Article originally posted on Globe St. on June 8, 2021 Just two years ago, Starwood Property Trust told its shareholders about its first foreclosure on a loan that was net leased to a single grocery tenant that filed for bankruptcy. The 440,000-square-foot distribution center had a loan balance of $17 million, CFO Rina Paniry reminded shareholders on a more recent call for the first quarter of 2021. “Over the past two years, we leveraged the Starwood platform to release and market the property, Paniry said. The property was sold this quarter for $31 million, “a very successful outcome for our shareholders.” A pandemic intervened in the middle of that process, of course, and grocery stores in general have proven to be resilient to the worst of economic trends. Nevertheless, Paniry’s news speaks volumes about lending in general for commercial real estate these days: times are good even as we battle the (hopefully) last vestiges of Covid-19. And by extension, funding is abundant, coming from both established players and new entrants alike. Starwood Property Trust, for example, originated $2.2 billion across 12 loans for an average loan size of $184 million for the quarter. These were offset by $1.1 billion in loan repayments, bringing its commercial lending portfolio to a record $11.2 billion at quarter end, according to Paniry. Even distressed and special situation borrowers can often find the necessary capital to complete deals, thanks to a plethora of funds lined up for this very purpose. To name one example: Earlier this year Machine Investment Group, which focuses on opportunistic, distressed and special situations investments across the US, provided a $208 million recapitalization of a hospitality portfolio located in Hollywood, CA. With the package, sponsor Relevant Group is now completing the construction of the two hotels by this summer. A Bountiful Picture A year ago, it was a vastly different picture. The pandemic, it had become obvious, would not be clearing up by summer or fall. Furthermore, its effect on the commercial real estate industry was unclear, especially with the office asset class. In response, many of the traditional commercial real estate debt providers, including life insurance companies, slowed down their lending pace. Underwriting got significantly tighter. The situation could not be more different today. “They are hitting it full force this year,” says Brian Stoffers, global president of debt and structured finance for capital markets at CBRE. “The banks, especially the big money center banks, pulled back for three or four months. Now, they’re hitting it big.” Even the office sector, whose future is admittedly still unclear, is attracting funding. Boston Properties, for example, recently announced a $2-billion joint venture with two unnamed sovereign wealth funds to target this asset class. The investment venture will help Boston Properties better compete for opportunities in its core markets, which remain competitive, according to comments CEO Owen Thomas made during the REIT’s first quarter earnings call. The REIT and its partners will commit up to $1 billion each and have the opportunity to invest one-third of the equity in each identified deal at their discretion. “We believe this venture, with approximately $2 billion of investment capacity, provides us the financial resources and return enhancement to be an even more nimble and competitive participant in the acquisitions market,” Thomas said. In addition to the traditional players, newcomers are also entering the space. “The big new entries are really these different debt funds,” Stoffers says. “I think investors are looking at risk-adjusted returns. And they’re saying, ‘You know, in this low-rate environment, these debt funds are offering pretty decent yields. And in most of their lending, there’s an equity slug on top of what they’re giving them in the way of debt.’” Given the environment, Stoffers says these funds are viewed as a good, risk-adjusted bet by investors. “They’re out there, and they’re out there in big numbers,” he says. This is an issue that Berkadia has been following through its debt fund tracker. As of early May 2021, Berkadia recorded close to 130 different debt funds, according to Hilary Provinse, executive vice president and head of mortgage banking at the company. “Those are either private equity, debt fund vehicles or some operators who have raised funds where they’re investing either preferred equity or debt into different parts of the stack,” Provinse says. “So there’s just a ton of liquidity on the debt funds.” For office assets with tenancy issues, debt funds will typically provide the reserves and work with the borrowers. “It’s not across the board, but the money is coming back to the office,” Stoffers says. Even if they’re working at home one or two days a week, Stoffers says people are coming back to the office. “Therefore, lenders are doing more and more in the way of office financing,” Stoffers says. Stoffers says the situation is similar in retail. While essential retail has done well throughout the pandemic, strip centers and restaurants are coming back. “We’re finding money for nearly all forms of retail right now,” Stoffers says. “It might be a little more expensive money [for retail], but there is money out there.” In the hotel space, there is also plenty of money available. “We’re very active in the hotel space right now from an equity and a debt perspective,” Stoffers says. “There is no shortage of capital for hotels. We do think that the convention hotels are going to take the longest to return. But some of the drive-to destinations are doing incredibly well.” With all of this competition in the debt market, buyers are benefitting. Stoffers says loan-to-values are higher at the margins and spreads are lower. Treasury’s underlying index for longer-term fixed-rate deals has gone up. “The floating rates indexes haven’t really moved much,” Stoffers says. “That’s where they’re getting aggressive on the cost of the money. It is not so much with the underwriting because there is so much equity out there. Borrowers aren’t having trouble raising equity. Lower loan-to-values is not an issue.” Chasing Fewer Deals, Certain Assets The picture is not completely rosy, of course. Perhaps most worrisome for borrowers is that a good bit of this capital is only looking for certain types of deals. “As we get adjusted to a new world and from what we see in the Fed space, in particular, there is a lot of capital chasing essentially fewer product types of asset classes,” says John Hofmann, commercial production team leader for KeyBank. “What you have is a slight supply-demand imbalance.” US sales volumes fell 32% versus 2019, according to Real Capital Analytics. And, in January, RCA showed a 58% decrease in year-over-year transaction volume. “All of us in the debt capital markets rely on assets trading hands,” Hofmann says. “And the transaction activity is more muted. But we expect that to pick up here very shortly.” Hofmann says sponsors in the asset classes that were more resilient to COVID are “getting incredible terms—better terms than they were getting pre-COVID.” “We see a lot of demand for multifamily, industrial and self-storage.” “Multifamily, industrial and self-storage continue to be our favorite asset class in terms of where they are now versus pre-COVID.” Hofmann also notes that debt providers prefer acquisitions. “If it’s a new transaction at a new basis, we see a lot of demand for that,” he says. “Where you see less demand is on refinance and those other asset classes [retail and hospitality], but they are starting to come back,” Hofmann says. Despite the recovery, Hofmann says lender investment committees are tightly scrutinizing harder-hit asset classes. “I think everyone’s investment committees now are tougher,” Hofmann says. “I think they’re harder.” As part of this process, Hofmann says people are focused on tenant health. “People are asking different questions,” Hofmann says. “It’s focused on the collections, the tenant financials and I think most importantly, the resiliency of the cash flow coming out of COVID.” Another area where lenders are trying to be cautious is new construction. This, of course, has always been the case—since there are any number of risks that could delay or even halt development, including securing entitlements, labor or materials, lenders understandably require more from borrowers on ground-up development. But in this market, where multiple players are offering debt for apartment projects, lenders are finding they have to get a little more competitive. “Typically banks’ construction lending is usually at 60%, 65% or maybe 70% [loan to value], says Steve Rosenberg, CEO of Greystone. “However, a borrower just came to us looking for 90% construction financing. They got it. It wasn’t from us, but they got it. We’ve almost never seen that before.” Looking at that one anecdote, it might appear that developers need to put less skin in the game to build new apartment projects. But that doesn’t mean lenders are necessarily making irrational decisions. Despite an increase in new groups coming in and providing debt, Rosenberg doesn’t see any flashing red lights, at least not in multifamily construction. “I am not seeing anyone doing anything where I shake my head and say, ‘Well, this is really idiotic,” Rosenberg says. “I’m not seeing that, but you can see where lenders are pushing the envelope. Do I see a yellow light there? I don’t know. It doesn’t feel like it. I’m not seeing unsafe lending. I’m not seeing anything like we saw in the subprime market.” Still, there are some concerns about development costs that could threaten projects. “They are putting some of the properties that were going to be constructed on the sidelines,” Rosenberg says. “So no question about it. Costs are going up and the equity may not be able to achieve the yields that it needs to in order to move ahead.” The issue may be even more critical on affordable housing projects where margins are already tight. “We even see it on the affordable side,” Rosenberg says. “Those deals are pretty tight, and with the increase in construction costs, we definitely see some projects that don’t work now.” Rosenberg is excited about some construction financing products out there, particularly loans from the Commercial Property Assessed Clean Energy program. These loans help commercial real estate owners make energy efficient, water conservation and renewable energy improvements to their buildings. Greystone is launching a C-PACE division for these loans. “I’m very excited about [C-PACE loans] because obviously, we want to promote energy efficiency and green investments,” Rosenberg says. “I like the idea of the C-PACE where a property owner can assess themselves a tax and essentially finance it because it has a priority lien in front of the first mortgage. You can raise capital at a relatively low cost of funds. And C-PACE can be used for potentially 20% to 30% of the capital stack on new construction.” Debt Sources Abound for Multifamily But if lenders have doubts about certain types of new construction and the office asset class, there is no hesitation on their part for multifamily. Fundamentals in the multifamily asset class have largely recovered from the pandemic in terms of leasing and rent growth. Lenders have taken note, not that they ever completely abandoned this favored asset class. “We’re definitely seeing the economy opening up and the asset classes that we’ve participated in, particularly on the multifamily side, valued as high as ever,” Rosenberg says. “Multifamily pricing has not come down at all. It has become even more of a global asset class than it was before.” That popularity is attracting capital from all corners. “We’re seeing even more sources of capital coming in, and we’re having to compete harder and get even more aggressive and creative,” Rosenberg says. “The asset class itself is a hot asset class. We’re seeing a lot of capital chasing it.” The terms on loans are also getting better for borrowers. “If anything, we’re going up the capital stack to compete better,” Rosenberg says. Rosenberg says there was an expectation that Fannie Mae and Freddie Mac would focus on affordable housing and become less aggressive in the market-rate business. And, in the process, their credit box would become even tighter. But that hasn’t materialized. “They started out that way [backing off], but the reality is they haven’t been able to achieve the volumes that they anticipated achieving,” Rosenberg says. “So we’re seeing even those boxes opening up a little bit.” While it is mainly the same players competing on the permanent side, a host of new entrants have entered the bridge space. And, existing asset managers are allocating more capital to the multifamily asset class. “On the bridge and repositioning financing, the competition is coming from individuals or entities that are asset managers,” Rosenberg says. “So whether it’s a Blackstone or an Apollo, everyone has got a transitional loan program these days.” REITs are even jumping into the bridge lending space. “We’re even seeing large, publicly traded real estate ownership companies coming to market with a debt product,” Rosenberg says. “It’s not a long-term debt product. Everyone wants to get some additional yield. So we’re seeing traditional owners utilizing their cash to make loans.” REITs can take advantage of the arbitrage between what they’re paying in their dividend and what they’re earning on bridge loans. “If their average cost of funds is 2.5% or 3% and they can lend money out at 6% or 7%, that’s huge,” Rosenberg says. “It makes a lot of sense. They know the asset class because they’ve been on the equity side of it. So they understand the assets and they’ve got easy access to cheap capital. Why shouldn’t they participate? It makes a lot of sense.” The net effect of all of this competition is better terms for borrowers. “Sometimes it’s good to be a lender,” Rosenberg says. “Other times, it’s good to be a borrower. This is one of those times where it’s pretty good to be a borrower.” A New Type of Private Equity One interesting development in the midst of all this liquidity is the fairly new trend of developers turning into private equity providers as well. One recent example is Al. Neyer, a 125-year-old commercial real estate development and design-build firm, which just closed its first real estate investment fund. The company has raised $110 million from 105 investors and expects to fund $300 million in class-A industrial projects. “Until now, Al. Neyer would raise equity on a project-by-project basis,” according to a spokesperson. “Over the past several years, the company has experienced explosive growth, becoming 100% employee-owned in 2014 and expanding to Nashville in 2015 and Raleigh in 2019.” The firm has a pipeline of 20 projects that could mean as much as 12 million square feet of industrial space, given the demand from e-commerce and manufacturing. Neyer expects to “deploy all the equity within 12 to 18 months, and plan to launch additional funds once all equity is deployed.” Neyer isn’t the only real estate with a burgeoning private equity arm. Boundary Cos., a Bethesda, MD-based firm founded in 2014, recently revealed having closed its first investment fund. Although Boundary didn’t disclose the amount of the fund, it did say it expected to undertake $300 million in investments. Although firms raising their own money isn’t “uncommon,” Peter C. Lewis, chairman of Wharton Equity Partners, says, “You are seeing a little more traction.” One reason is financial self-interest for both the real estate firms and investors. Without private equity middlemen, the business gets more of the profit and limited partners have less investment dilution. Projects like those of Neyer and Boundary are likely to be attractive because of their targeted nature. “Investments must also be very focused on sectors that are likely to outperform,” Paul Getty, CEO of First Guardian Group, says. “Both of these funds are targeting very hot sectors—last mile distribution centers and storage, which can also be a type of distribution center for smaller retailers and mom and pop entrepreneurs.” “Real estate operators are getting smarter,” Lewis says. “They’re coming to the conclusion that it’s better to do this in house.” But if they can’t, there is a world of capital waiting to accommodate them.