Debt Today – Navigating the Cross-Currents of Rising Interest Rates and an Evolving Regulatory Environment

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Rising interest rates and calls for deregulation from the new Trump administration have emerged as top-of-mind issues for real estate debt and equity professionals across the US and globally.

Will last year’s slowdown in commercial real estate transaction activity continue through 2017 and dampen demand for debt and equity capital? How will the increasingly clear interest rate directives from the US Federal Reserve impact the costs of financing and asset pricing? For private real estate lenders, we see continued strength in commercial real estate fundamentals, coupled with current supply constraints across several of the traditional lending channels as drivers for the private debt market.

For private real estate lenders, we see continued strength in commercial real estate fundamentals

Structural changes in the way banks provide CRE debt have created strong financing demand from private lending sources that will likely persist throughout this period of tightening monetary policy and regulatory evolution. Furthermore, Heitman believes there are attractive opportunities for investors to add a real estate debt allocation to their portfolios and combine core and core-plus equity strategies with the diversified, income-producing benefits of a debt strategy that exchanges “equity upside” for “credit protection.” Serving as a complement to a direct equity strategy, the predictable income returns from real estate debt offer ways to reduce volatility and counterbalance the cyclical asset appreciation/depreciation experienced in private equity real estate.

Market Conditions Present Investment Opportunities

Commercial real estate markets have largely recovered but the market must now confront the reality of rising interest rates. In the past year, the first shoots of higher interest rates have emerged and the Federal Reserve has sent an increasingly clear message that there will be continued rate hikes over the course of the next several years. The magnitude of rate increases and ability of real estate owners to capture inflation and/or rent growth premiums will determine the impact of higher rates on property fundamentals and values.

In the past year, the first shoots of higher interest rates have emerged

For private real estate lenders, a market opportunity remains open to fill the voids created in certain sectors of the $3.7 trillion commercial mortgage industry which remains challenged and constrained by regulation and reduced risk tolerance. Banks and CMBS lenders are subject to a significant regulatory and compliance burden that is making lending more costly and restricting advance rates on all types of property. Recently, President Trump took the first step to rollback the 2010 Dodd-Frank act by signing an executive action requiring the US Department of Treasury to draft an outline for scaling back the financial regulations. Revoking Dodd-Frank outright requires an act of Congress, and amending the rules or granting exemptions will likely be a lengthy process. However, despite the recent movement on Dodd-Frank, the structural changes made to lending standards through the Basel Committee are expected to have long-term impacts on how banks lend and shape their cautious role in financing commercial real estate. Over $1.0 trillion of CRE loans mature over the next three years and many of the long-term loans made by insurance and securitized lenders were originated near the last market “peak” when credit standards and underwriting discipline were at their weakest point in decades. We expect a segment of these loans will require creative debt and/or equity capital solutions to meet their refinancing needs.

Changing Profile of Real Estate Debt

Despite the recent movement on Dodd-Frank, the structural changes made to lending standards through the Basel Committee are expected to have long-term impacts

Demand from borrowers for commercial real estate debt capital—for acquisitions, construction, development, and repositioning of assets—has tracked the sales transaction market and returned to levels comparable to those before the GFC, but the type of loans, their risk profile, credit requirements, and the processes of obtaining debt have taken on new forms. Life insurance companies are competitively originating first mortgage loans on stabilized long-term-hold properties, but at a measured volume and at lower loan-to-value ratios of 65% or less. Commercial banks continue to underwrite acquisition and development projects, but they are increasingly selective about asset type, leverage, and sponsorship. CMBS activity has attempted to accelerate loan origination volume, but is regularly buffeted by volatility in the underlying bond markets and the resulting lack of certainty in execution and loan pricing. Consequently, only the most conservative transactions are able to source well-priced debt capital from a variety of sources and even those transactions are facing lower advance rates reflecting the fundamental shifts in underwriting and risk tolerance.

The Private Debt Alternative

Today presents a compelling opportunity to investors looking for new core-like investments that complement their existing exposure to real estate

Against this contrasting backdrop of strong borrower demand for capital and conservative debt providers, the private lending market continues to evolve and provide debt capital solutions through tailored credit products, and today presents a compelling opportunity to investors looking for new core-like investments that complement their existing exposure to real estate. Recent declines in the appreciation component of core equity real estate (as illustrated in the ODCE returns below) are shifting some investor expectations toward investments such as debt which offer defensive qualities in periods of uncertainty. By offering higher loan proceeds and more flexible transaction structures, non-regulated lenders have increased their commercial mortgage market share by more than $120 billion in the past five years. Despite President Trump’s call for de-regulation, we believe this trend towards reduced risk within the regulated lending market will persist. Furthermore, these conditions, combined with steady demand for first mortgage debt, have created a compelling and scalable origination environment for private lenders to deliver strong risk-adjusted returns over time.

HISTORICAL ODCE ROLLING ANNUAL INCOME AND APPRECIATION
1Q 2009 – 3Q 2016

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Importance of Structure

Senior debt provides an attractive risk profile given its priority claim on collateral and cash flows

Private debt takes many forms because it is often a solution to an investment-specific need. Mezzanine debt, senior loans, and preferred equity are each structures that can be employed to solve investment-level issues and extract a balance of risk and return for debt investors. Today, in a period of asset price uncertainty, we believe senior debt provides an attractive risk profile given its priority claim on collateral and cash flows. While each private debt structure varies in legal structure, and a variety of other aspects, each carries the key feature of debt products—a priority over equity on distribution of cash flow and capital proceeds as illustrated in the chart below.

COMPARING THE CAPITAL STACK

comparing-the-capital-stack

Borrowers are turning to private lenders for surety of timing and execution and for flexible structures

This dislocation and imbalance in the debt capital markets is producing a new and scalable opportunity for private lenders to supply higher leverage debt capital to qualified owners and buyers that are no longer able to obtain the amount or type of capital from their traditional lending relationships. Borrowers that need speed and certainty in obtaining and closing a loan can find that traditional lenders may not be able to accommodate their timelines due to increasingly complex internal application and closing requirements. As a result, borrowers are turning to private lenders for surety of timing and execution and for flexible structures that traditional lenders are moving away from due to the evolving regulatory challenges. The ability to meet the unique needs of borrowers allows private lenders to originate higher yielding loans at an attractive risk premium.

Knowns and Unknowns

As we begin 2017, there are many unknowns facing the US economy and commercial lending. Will some or all of Dodd-Frank be repealed? Will the Risk Retention rules be impacted by a rollback of Dodd-Frank? With the adoption of global banking accords such as Basel III, would a repeal of Dodd-Frank have a significant impact on the lending market? These are all questions that we will be keeping a close eye on in the coming months and years.

Regardless of any domestic regulatory shifts, the global Basel Committee rules, which determine the capital banks must hold against certain types of commercial mortgages and construction loans, are one of the key factors behind the disciplined lending conditions and constrained supply of higher leverage financing. While the aggregate effect of these regulations and the uncertainty surrounding their enforcement and future is difficult to quantify, we believe they generally are expected to continue to motivate traditional debt providers to remain more conservative and likely will increase debt costs for borrowers. We further believe that commercial real estate mortgage advance rates from these traditional lending sources will remain conservative, and borrowers could be forced to accept the higher costs of either private debt (and/or additional equity) capital to recapitalize maturing loans and acquire new properties. Against this backdrop of an evolving regulatory environment, rising interest rates, and continued strength in commercial real estate, the current market conditions provide a favorable environment for investors looking for new, core-like investments through debt that complement their existing exposure to real estate.


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