Fed Action Aims to Boost Market Confidence as CRE Financiers Adjust to New Normal
Market spikes and uncertainty driven by the coronavirus led to a monumental Fed interest rate cut. What’s on the minds of financiers, and what’s next?
“If you’ve seen one financial crisis,” Former Federal Reserve governor, Kevin Warsh, said during a speech in 2008, “you’ve seen one financial crisis.”
In other words, no two crises are alike. And the coronavirus is like nothing we’ve seen yet.
Following a month of chaos in global exchanges over the uncertainty around COVID-19, The Federal Reserve slashed benchmark interest rates to nearly zero late Sunday. The move followed an emergency half-point rate cut on March 3, well ahead of its scheduled meeting on March 18.
The action, together with a slew of announced stimulus packages totaling over $1 trillion, was aimed at boosting the U.S. economy as the coronavirus pandemic continues its global spread.
“I don’t think the rate cuts do anything but create a confidence that there’s a willingness [from the federal government] to provide stimulus to get the train back on the tracks,” Jordan Roeschlaub, a vice chairman and co-head of Newmark Knight Frank’s debt and structured finance group said on Monday. “We are of the mindset that a government intervention should be viewed as a positive.”
Some feel the rate cut to zero was too drastic at this stage and doesn’t solve anything in the near term. Meanwhile, the real estate market has reacted to the disruption with its own period of repricing.
“This rate cut means nothing and it will do nothing,” said JCR Capital co-founder and managing principal Jay Rollins, who has worked through two different financial crises and multiple market disruptions over the last three decades. “How you cure a virus [impact] with a rate cut is unbeknownst to me. This cut leaves you with nothing left [to cut]. Real estate loans have floors and everyone’s already at their floors; the price of real estate loans aren’t going down because of the cut — the opposite is happening. Everything is being repriced. Returns have repriced up and values have repriced down. Nothing is what it was worth two weeks ago. People want to get paid more to transact, versus two weeks ago. Maybe the rate cut helps credit cards, car loans or mortgage REITs’ refinances rate, but it’s a major nonevent.”
Commercial real estate lenders are proceeding with caution, and borrowers won’t necessarily get the great deal they hoped for when seeking financing, Eric Orenstein, a member within Rosenberg & Estis’ transactional department, said. “The cost of funds to banks may now be lower, but because of the increased risk to lenders, a decent chunk of that saving in the Fed drop will be eaten up in the spread.”
One lender who spoke with CO on the condition of anonymity described the market uncertainty as having a “provocative” impact. “It’s making everyone step back and say: How do I underwrite this thing?,” he said. “And the only thing they can do to comfortably underwrite is to say, ‘Ok if I was at 70 percent [leverage] yesterday I have to be at 55 today.’”
In a report released Monday afternoon by NKF’s debt and structured finance group, the firm took to a calming approach to addressing the volatility, writing, “to be clear, we are seeing lenders continue to both quote and close loans.”
As the epidemic has worsened, the industry has responded. Firms first began halting mass meetings in January, then extended the vigilance to in-person meetings before the majority of firms began working from home last week. The coronavirus’ impact reaches wider than the health implications, also adversely affecting properties in the hardest-hit sectors — most obviously retail and hospitality — that are routinely owned, leased and financed by our industry’s best.
“I don’t think any of my clients are in panic-mode,” Orenstein said. “They’ve all just taken a step back and are re-evaluating.”
He gave the example of a client who was putting together an assemblage in New York City for a development site. “We had three plots all lined up and were ready to sign contracts but my client pulled out last Friday afternoon,” Orenstein said. “He said, ‘This is great, and I’d love to revisit in 60 days but this isn’t a good market to start this [development].’”
But, lender sentiment still “errs in favor” of continuing to fund construction, per NKF’s report. Construction budgets are being adjusted around the impacts of COVID-19 on potential labor supply and supply chain disruptions and “sponsors who are proactively preparing contingency plans around the supply chain are being rewarded by lenders with more favorable treatment.”
Orenstein said he has been in constant dialogue with his lender clients, but for the most part “they’ve pulled back on lending,” he said. “I have some clients who are going to close deals that they have [in the pipeline] but as far as evaluating new deals they’re trying to take stock of their existing loan portfolios, find out which deals are going to have problems in the next month or two and start solving those problems ahead of time. I think people learned their lessons in 2008 and are trying to be very proactive to figure out where they’re going to have issues.”
The lender who spoke with CO on the condition of anonymity concurred on the modus operandi: “We have deals that are under wraps and we’re close to closing and we’re going to honor them. I think that anyone who hopes to have a relationship with the brokerage and borrower community going forward needs to do that,” he said.
“The people who are going to transact are going to be the people who have to do so, [driven by] something that will make [them] transact,” Rollins said, adding that “equity is starting to drop out. Syndicates, country club capital and family offices are the first to go to the sidelines; that has already happened. Institutional capital, mostly on the equity side, will fall into two camps. One group will hit the pause button and say, ‘we don’t know what the world looks like,’ and the second group is saying, ‘we’ve been conservative and have money on the sidelines and we’re looking for opportunities.’”
Rollins said his firm is in that second grouping.
“We have dry powder and can see past this. We’re looking for things we can deploy into,” Rollins said. “Maybe not this week, but we’re getting a sense of what’s happening so we can deploy by maybe at the end of next week. It’ll be based upon the basis of the asset, and it’s going to be based on current cash flows. It’s way too early to be pouring into hotels; some people are throwing retail centers out into the market. It’s not driven by asset classes. People who need liquidity will be forced to raise money in an illiquid market. It’ll be ownership driven.”
NKF’s report noted that debt funds and other alternative lenders that rely on leveraging positions by borrowing via warehouse facilities or utilizing CLO executions are “suddenly uncertain of pricing and/or forced to adjust their risk tolerance as their exit becomes less predictable and, potentially, less liquid.”
“If you think about a local or regional bank doing this on its balance sheet as opposed to a debt fund who’s going to be utilizing leverage to generate returns they need—that’s a really big difference,” the lender said. “Anyone who relies on warehouse or repo facilities is kidding themselves if they don’t recognize that they don’t know exactly what they can quote today.”
For borrowers looking to acquire or refinance apartment properties now via agency financing, on the other hand, things look better. “Rates are incredibly low and if they can get a deal closed they’re well positioned to go ahead,” the lender said.
NKF’s report stated that life companies remain active but selective, “tightening the strike zone and not necessarily lowering the cost of debt…Several life companies have temporarily halted rate locks for new loan applications, further indicating a conservative approach to new business.”
NKF analysts wrote that just last week a handful of major life companies had lowered a previously established fixed-rate floor of between 3 percent to 3.35 percent, depending on property type. “That floor was occurring when the 10-year Treasury was closer to 75 to 100 [basis points],” the report said, adding that the new floor is around 2.75 percent to 2.85 percent. “This floor is worth watching as it is one of the few sources of opportunity for borrowers to take advantage.”
Orenstein is closing two deals this week; one is a loan in New York City for an office building while the other is a development site in California. “We’re moving forward; the directive is to get them done,” he said. “I do have clients who are actively putting out term sheets and still getting deals done.”
And Roeschlaub told CO that his group, which originated $17 billion in debt and equity last year, has closed on eight deals in the last two weeks.
“It’s a supply and demand shock, and I think everyone’s going to do the right thing to get from A to B. If you take a step back, there are going to be opportunities in the short term,” Roeschlaub said.
A Crisis Like No Other
With market fundamentals strong for an elongated period of time and no clear signs of the bull market ending, market participants had—until recently—wondered and guessed what the next shoe to drop would eventually be.
“This is the shoe,” the lender said. “What I have a really hard time getting my head around is that everything is shutting down. After 9/11, nobody flew or stayed in hotels but people were still going out to dinner and frequenting their local establishments. That is going away en masse. So many of these businesses struggle to make payroll on a week-by-week basis. If they shut down for three months, how do we know they’ll have the availability of cash to start back up?”
JCR’s Rollins said that the market is entering a period of new price discovery, and that it’s impossible for anyone to know where this is going to go.
“This is more akin to 9/11. In a good old fashioned financial crisis, you can see your way through and know what needs to be done. This is something where you don’t know how bad it’s going to be and there’s no socioeconomic protection,” Rollins said. “The good news is this is going to be over at some point, but the question is: how long and how much damage is going to be done before we get to the other side?”
That said, “it’s early,” said Colliers International Florida’s Ken Krasnow, who was based in New York during both 9/11 and the global financial crisis. “People are still assessing.”
Justin Kennedy, a co-founder of 3650 REIT, said a lot of people had called him on Monday, saying ‘Isn’t this just like 2008?’. “No, it’s nothing like 2008,” Kennedy said. “U.S. residential and commercial mortgages were the focal point of the global financial crisis and it was sparked by systemic leverage which doesn’t exist in the markets today, particularly in the financial institutions. I think we’re a little more like 9/11 in terms of a crisis that has financial impact, but is not a financial crisis.
“There are certain sectors of the corporate debt market that people are concerned about, but Treasury Secretary Steve Mnuchin has been clear that they’re going to attempt to help these troubled industries and that will trickle through to the real estate industry, where a lot of these industries are in our tenant base.”
Comparing the current market disruption with 9/11 and the GFC, Krasnow said the key difference is that in both of the aforementioned crises the underlying concern was ‘How will we get out of this?’”
“With Lehman, people were worried about systemic failure and the markets were not functioning,” Krasnow said. “Same with 9/11, which was very specific to New York. We were sitting there in the middle of the fray and wondering ‘Will this city recover?’ This [pandemic] is not localized and it’s not systemic. It’s medical in nature, not finance, or real estate related. So I think most people’s perspective is that we’re going to have a rough couple of months but as for the underlying fundamentals of our market — nothing dramatically changes.”
“I was talking to someone today and they described it perfectly,” Krasnow continued. “‘When you take a test at school they say ‘pens down!’ and you have to stop what they’re doing and put your pens down. But if you picked your pen up you’d still be taking the same test. But when I look at 2007 and even 9/11 you were doing algebra at first on the test then it switched to calculus.’”
Rollins said: “In the financial crisis, we lost all control; every weekend people were failing. We haven’t even seen the layoffs, which might come next week, and then there are the bankruptcies. The shock will come to people who are young and haven’t experienced this.”
With the majority of the industry working from home, a slowdown is certainly to be expected. Many industry players are also questioning whether we’ll see distress in the coming days.
“The answer is yes, but more in the longer term,” Orenstein said. “I was speaking to a client this morning about defaults and I said to him ‘You need to start thinking about what you’re going to do’ and he said ‘Maybe I’ll let these loans fall into default,’ and I said ‘From a public policy standpoint I don’t know if that’s going to work.’”
Foreclosures and Uniform Commercial Code foreclosure sales aren’t likely in the short term however, because lenders and borrowers are going to have to make a concerted effort to work loans out first, Orenstein said, adding that Rosenberg & Estis’ bankruptcy group is gearing up for an increased number of workouts.
“For sure, there will be more distress,” the lender said. “In New York’s hospitality sector specifically there were already a number of capital stacks that were upside down. This is just going to facilitate a much more rapid discovery of those prices. You’ve got the labor costs going up and revPAR is down. Everything is working in perfect tandem for the downside.”
According to NKF’s report, lending on hospitality has come to an abrupt halt, with lenders “almost universally taking pause on new debt pursuits and in some instances even unwilling — or unable — to close on loans under application. Until the depth and breadth of COVID-19’s disruption to the lodging and travel industry can be better interpreted, there will be a notable contraction of the hospitality lender universe and a widening of credit spreads — the latter of which will be most prominent in the bridge lending space. For existing loans, there will clearly be distress given the immediate impact to cash flows for the lodging sector.”
For now, most deals are still getting done, albeit with a little more vigilance and a tad bit of “overcommunication,” Roeschlaub said.
“No deal is the same. But for an acquisition financing with substantial new equity coming to the table, there’s some sensitivity around closing, so buyers and sellers are working together to effectuate a financing,” Roeschlaub said, adding that everything is dependent on forthcoming stimulus or the pandemic slowing down. “With refinances, [things are getting done via] lenders being in direct dialogue and providing real-time data and working hand-in-hand with [the counter parties].”
While political infighting and polarization has become the new norm, one source pointed to examples of collaborative supportive action that will spur confidence for active commercial real estate professionals; they are things like the government’s planned economic stimulus, municipalities calling for moratoriums on evictions and foreclosures as well as a recent proposal from the House of Representatives that the Trump administration has gotten behind that would subsidize paid sick leave for workers and help support the middle and working classes during the outbreak.
“Assets have lenders. Will there be a moratorium on lenders [defaulting on properties]? There’s a domino effect, here, if a big bank needs a moratorium. What we don’t have yet is real leadership from the president — and this isn’t political commentary on the president — but he’s behind and he has been behind,” Rollins said. “Whatever happens needs to be big and bold and encompass the lending and the landlord communities.”
“It’s an election year, so Trump is going to do anything he can to boost the economy,” said one broker source, who spoke to CO on the condition of anonymity to avoid any conflicts around making politically-driven statements.
But, the Trump administration’s attempts to prop up the economy may be all for nought.
“[We’re looking at a] two-week shutdown of the entire country,” Rollins said. “It’s happening already, state-by-state. That will be a massive economic blow, and perhaps the rate cut was a prelude to that. Anyone with floating-rate [debt], without floors, would be OK. That’s the base case we’re operating under as a company and what we’re preparing for.”
“We just got pushed over the edge into a recession,” the anonymous lender said. “Recessions are typically gradual — there’s a slow descent and a slow ascent. But this was like, ‘Hey, I’m just going to grab you and throw you into a mini depression where no stores are open.’”
A recession is guaranteed, if we’re not already in it, Rollins concurred. “The question is how bad it will be, which will depend on the virus. If the industry grinds to a halt for a month or more, it’ll be bad — recoverable, but bad.”