Commercial Real Estate Debt: The Song Remains the Same
Borrowers continue to benefit from low interest rates and an abundance of capital, but values may be coming down.
Borrowers have enjoyed a potent combination of low interest rates, an abundance of capital, and fewer deals for lenders to quote, dynamics that should hold for the rest of the year. Lenders have been aggressive throughout the capital stack, especially in the bridge and value-add space. Private funds continue to dominate, and properties with a reasonable chance of succeeding as bridge loans receive numerous quotes on a Libor float basis. Underwriting and pricing are working in the borrowers’ favor as lenders fight for yield in a crowded market. Construction lending has seen less competition due to regulations imposed by the Dodd-Frank Act in 2010, but with the recent partial rollback of this legislation, regional and smaller banks can now compete more aggressively for construction and bridge loans, benefiting borrowers and significantly increasing year-over-year bank originations. CMBS lending was up by 13 percent in the first half of 2018, and Agencies are on pace for another strong year, albeit less than 2017’s record.
Capital markets are providing increased leverage at better pricing than at any point since the last recession, but there are clouds on the horizon for borrowers. Sales have continued to drop since 2015’s peak, and are down around 2 percent year to date from this time last year. Single asset sales dropped 20 percent in May and 12 percent in June on a year over year basis, and investors are concerned about the slowing growth in net operating income. This has led to slightly higher cap rates for the first half of 2018, and other than the industrial sector, valuations have hit their peak for this cycle.
With strong domestic economic growth, our Macroeconomic and Investment Research Group believes the Fed will raise the fed funds rate two more times in 2018. This continued tightening has increased Libor rates to above 2 percent, benefitting lenders providing floating-rate products with rates tied to Libor. Treasurys have struggled to break through the 3 percent yield mark for the 10-year note, and with fixed-rate spreads on stabilized properties in the 140–170 basis point range, coupons are still well below 5 percent. With five-year Treasury yields just 12 basis points below 10-year yields, we view five- and seven-year term loans and three- to five-year fixed-rate bridge products as a way to differentiate from the large universe of Libor float bridge lenders.
Sales Are on a Downward Trend from 2015’s Peak
Monthly Sales Transaction Volume
Capital markets are providing increased leverage at better pricing than at any point since the last recession, but there are clouds on the horizon for borrowers by year end. Sales have continued to drop since 2015’s peak, and are down around 2 percent year to date from this time last year.
Source: Real Capital Analytics, Guggenheim Investments. Data as of 5.31.2018.
Concern Grows as NOI Growth Slows
Fourth Quarter Rolling Net Operating Income Growth by Property Type
Investors are concerned about the slowing growth in net operating income. This has led to slightly higher cap rates for the first half of 2018, and values have hit their peak for this cycle.
Source: NCREIF, Morgan Stanley Research. Data as of 1Q2018.
—William Bennett, Managing Director; Ted Jung, Director
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