For many a sponsor and lender, 2023 was a year of disappointments. The sudden and sustained spikes in interest rates led by the Fed quickly brought a halt to the historic deal flow that followed the Covid pandemic, leaving many market participants scratching their heads on property values, stressed cash flows, and the limited availability of high leverage. Despite the slow start to year, lenders held out hope that sellers would come to terms with the new reality, the bid ask spread would tighten, and precipitate a substantial spike transaction volume in the third and fourth quarters. But this failed to materialize, with flows dropping substantially across all property types, with even the darling of the industry, multifamily, falling more than 70% YOY. In that context, a packed room of sponsors, service providers, and investment managers listened closely to a panel of lenders and brokers at the IMN’s 2024 Winter Forum on Real Estate Opportunity & Private Investing Conference, to glean insights on what the debt capital markets have in store for 2024.

When asked to frame the current landscape, Warren Min, Managing Director at Oaktree Capital Management, laid the groundwork. “If you were to summarize 2023 and look at flows and transaction volumes and why it was down 60-70%…You’ve got sellers that want to sell at $100. And you have buyers that want to buy at $60. And let’s say they come to a deal. Then the buyer is saying they want to finance it a 4% and their lender is saying it’s closer to 8-9%. It’s funny because when we were prepping for this panel, I was talking about how the financing markets are frozen and Josh (Westerberg) corrected me and said it’s actually not frozen. They just don’t like our pricing. And that is the core issue. It’s tough when an entire industry is levered to low cap rates, low interest rates, and high borrowing availability and you take all three away, it becomes a tough recipe for us.  

Mesa West’s Executive Director, Josh Westerberg, elaborated, making the point that there were subtle, but important, widespread misconceptions about the nature of the slowdown. “I would characterize it as more of a valuation problem than a liquidity problem. There is plenty of liquidity in private credit and debt fund space. If you just take a view at transaction volume itself, I think there are some misperceptions out there. Every time we come to the table with a term sheet for a new acquisition it’s not just us and Oaktree. It’s half a dozen to a down different competitors. So, there is debt. It’s more of a valuation and equity issue. And then you look at refinances. One the refinance side of the business ,you often hear a deal went to market and could not get refinanced. You have to do the nuance there, which is you couldn’t get refinanced at par or on a re-margin? You can get refinanced on a re-margin in this market. But when you can’t get refinanced at par, we go back to a valuation problem. 

While Westerberg’s comments offer some comfort around the financial health of the overall capital markest, Bryan Shaffer, Principal and Managing Director of mortgage banking firm Slatt Capital explained why that won’t make sponsors feel any better. “No one wants to refinance their loan, after they’ve already set up a partnership and have to come in with more money. In the beginning, last year it seemed like all my sponsors in January, February, March, and April were afraid to go back to their investors and wanted to pretend nothing was changing. Then by the end of the year, they were all back to their investors trying to do capital calls and the investors said we don’t want to put in any more money. The issue is you can re-margin, but you need the money to re-margin.” Unfortunately, he did not see any near-term catalyst to change that dynamic. A lot of money was raised waiting to jump into the distressed market. But it’s all afraid. It doesn’t know where that value is, and it keeps thinking tomorrow is going to be a better day. I’m working on a hotel deal now in Portland that was like a $300 million dollar asset. There’s a family office willing to put $75 million dollars. We’re still having a tough time structuring the cap table. 

Given how much stress higher interest rates have put on floating rate bridge debt, the topic of loan workouts and whether successful resolutions are helping stabilize the market, Mr. Min offered an amusing but clarifying anecdote. “I’ve got four kids. I was dividing up ice cream and I gave them all equal scoops. One of my kids was like that’s not fair. And I said, what do you mean? You can’t get fairer than this. And he said, well I’m the oldest so I should get more. And my daughter was like, I came to the table first and the rule is if you get more if you get there first. One of the things we are grappling with right now is no one knows what fair is. The way workouts are working now depends on who your senior lender is, do you have mezzanine lenders in the capital stack, has your senior lender syndicated out the stack to foreign entities, is your senior lender a stressed lender that had repo financing on it. It’s just getting really complicated and people’s definition of fair depends on where they think value is, which is hard to figure out, and the motivations of the equity, the mezz lender, and senior lender. What I’m seeing mostly across the board is you’re trying to give the sponsor as much time as possible. Because the senior lender doesn’t want it, (the real estate) the mezzanine lender does not want to invest new capital to assume a defaulted mortgage,  and so things have gotten so bad across the entire stack that people are like well let’s try and give them more time. It’s this game where as long as everyone is on the same page that value used to be $1 billion and now is $250 million, that’s a workout that can be constructive. 

But like in any period of volatility, bright spots in the lending markets do exist. Shaffer explained that CMBS, for instance, was still a reliable form of funding, if not the most ideal. “Every borrower and sponsor hates CMBS because you don’t have that control to call your lender and get something done. But on the other hand, when markets are tough, they’re always there and their capital is reasonably priced compared to the bridge options. On a multifamily deal today, they are offering 5-year pools you can get to a 1.25-130x DSCR on the interest only loan, which is like a 1.10 DSCR on a normal loan. So, it’s making up that gap in leverage, there really is a way for CMBS to save a lot of these bad deals that are out there.” Walker & Dunlop’s Rob Quarton concurred, explaining it’s particularly useful when financing property types that receive more pushback from banks, like Class B hotels and retail.  

Similarly, Quarton explained that life insurance companies have been a refreshing source of liquidity, picking up some of the pullback of the banking sector. “Life companies have been an excellent source of that capital. Historically, in any given year they may have been 10-15% of the market. Now they’re over 25%. And they’re starting to come out with construction debt products as well for more a merchant developer build plan.” Shaffer echoed the sentiment. “Some have doubled their allocations. Standard is at $3.2 billion. If you are going to use life money, you’re usually not going to get the leverage. Symetra and Standard are getting fairly close to a normal lender but in most cases, you can get great rates, 150 bps over treasuries but the issue is you can’t get to the leverage ,so you need more cash for purchase or refinance.  

Unsurprisingly, the mood was universally dour on the topic of office. “It’s really hard to value, underwrite, and make an investment in office”, explained Westerberg. “As a lender, we hit singles. We can’t hit doubles, triples, home runs. We are preservation of capital focused. It just seems like a bad bet right now. I’ve been saying for years the best bet you can make in office today is that vacancy will continue to be higher tomorrow.” Min shared a similar view. “The math just doesn’t quite pencil because for us if you’re going to take contrarian office risk you are going to need to get paid for it on a first lien basis. Which means it’s like low doubles and that’s going to be a par originated loan. Which means who is paying for that?” Despite the bearish sentiment, California Bank & Trust’s Jake Lehmkuhl offered one silver lining. Because most regional banks had not taken on substantial office exposure, he believed they may be better positioned to fill the gap created by large money center banks, noting California Bank & Trust funded $1billion dollars of CRE loans in 2023. 

When pressed about whether he anticipated the Fed rate cuts to save the day and make for a much more active year than 2024, Min was skeptical. I am short this whole concept of six rate cuts this year. I just don’t see it happening. Frankly, I don’t even see it happening in March unless something nasty happens. You have to be in a safer position this time in the cycle. Maybe it’s just me being at Oaktree and always thinking about the next recession. We predicted ten of the last two recessions. But this just feels flimsy.