Developers and investors seeking capital to finance commercial real estate (CRE) are facing a new reality in which capital is both more expensive and less available.

The cost of capital has increased significantly along with higher interest rates and wider spreads from lenders. In addition, higher financing costs are putting pressure on loan-to-value ratios (LTVs) and the amount of capital that lenders are willing to provide. Piling on top of that is a pullback from the large national banks that are concerned about balance sheet capacity, capital reserve requirements, and stress tests if there is a recession ahead in 2023.

“There are fewer lenders in the market than there were six months ago,” says Gerard Sansosti, executive managing director, debt platform leader at JLL. Borrowers still have options, but those options depend on the credit quality and type of deal, as well as what that borrower is looking for in that loan.

Twelve months ago, a creditworthy borrower seeking permanent financing on a high-quality apartment property could secure fixed-rate financing at sub-3 percent. Today, that same deal is likely to find rates that range from 5.5 percent to 6 percent–plus with leverage that is often topping out at 55 to 60 percent. Short-term floating-rate debt has seen a similar shift. An 80 percent LTV bridge loan at 3.5 percent simply does not exist today. Lender spreads are 350 to 400 basis points over a roughly 3 percent Secured Overnight Financing Rate (SOFR) benchmark rate with a sharp drop in leverage. Costs are likely to push higher with more Fed rate hikes teed up for November and December.

Lenders across the board are being more cautious on the levels at which they are financing due to limits from debt-service-coverage ratios (DSCRs). “We haven’t talked about debt-service-coverage ratios for a decade because interest rates were so incredibly low, but now they’re coming into play,” says Jeff Altenau, an executive managing director at Cushman & Wakefield in Chicago. Lenders want to see a 1.20-times cover on stressed underwriting, which is a constraining factor when calculating maximum loan proceeds.

“Banks have underwritten that way for some time, but we’re seeing interest rates creep up to the point where that is starting to constrain things and banks are starting to modify their stressed metrics in terms of their interest rate constants,” he says.

Capital constraints pose a big problem for a commercial industry that is highly dependent on debt financing to fuel investment sales, development, and refinance maturing debt. Yet there also is room for optimism. The Mortgage Bankers Association is predicting that commercial/multifamily mortgage and lending activity will total an estimated $766 billion this year. Although that is a 14 percent drop compared with robust lending that occurred in 2021, the association also is forecasting a rebound to $848 billion in 2023.

“Liquidity is still there. There are still numerous loan options on any given loan opportunity that goes out to the market both on the commercial and the multifamily side,” says Jeff Erxleben, president of the debt and equity business at Northmarq. “The big question for borrowers is where can I access capital, and where is it priced at a level that is workable?” 

Shrinking Pool of Lenders

The large national banks have moved to the sidelines. “The big money center banks are focused on keeping balance sheet capacity for their very best clients,” says Sansosti. That pullback also is creating ripple effects that reach into the nonbank market. Most nonbank lenders are funded by warehouse lines that they get from the money center banks, and the pricing on those lines has increase increased from 150 to 175 basis points over SOFR to 275 to 300. In addition, with less capacity and the inability to create capacity through a collateralized loan obligation (CLO) execution, nonbank lenders have less debt capital to deploy, adds Sansosti. Wider spreads have significantly slowed activity in what had been an active and liquid CRE-CLO market.

On a positive note, while spreads have widened, other capital sources remain active. “We have done a lot of business with local community and regional banks over the last three to six months,” says Sansosti. “My concern is that there will be a trickle-down effect.” There is already some evidence of that occurring with some mid-tier regional banks that have said that they have been told to reduce their balance sheet exposure, while others have said they are not lending for the rest of the year. “Some of that is concern due to all the volatility in the market, but we’ve still seen the smaller bank market remain very active, and for now, that’s a good thing,” he says.

Fannie Mae and Freddie Mac continue to represent a bright spot in the apartment sector. Each had $78 billion in capital allocated for 2022, and even late in the year the two agencies still have plenty of money to lend. “Fannie and Freddie have always had the mantra of providing liquidity throughout every cycle and that remains true today,” says Erxleben. “So, that liquidity is there, and they are actively quoting deals.” Going forward in 2023, they will continue to be active and support the market with financing, he adds.

“Nonbank lenders have capital to deploy. The question is whether they can do it in a compelling manner for borrowers in providing attractive cost of capital without bank A-note support and bank line leverage support,” adds Altenau. In addition, there is more capital positioning to provide gap financing solutions and fill the hole in the capital stack between the first mortgage and equity financing. For example, there are several commercial mortgage–backed securities (CMBS) lenders and originators that are looking at aggregating a five-year-only fixed-rate pool, which will allow them to provide a better cost of capital to investors, notes Altenau.

Goldman Sachs also announced a “Digital CMBS” web site where U.S. borrowers can receive offers in the $5 million to $35 million range.

Financing Challenges Slow Deal Flow 

Higher financing costs have certainly blown up some deals that were in the pipeline and caused others to push pause on new investment activity. The drop in leverage also is a significant issue. “Leverage has been a major factor in why we haven’t seen as many transactions,” says Altenau. The reality of buyers being able to achieve 50 to 55 percent leverage translates into unacceptable sale pricing. At times, it is not accretive to fill that gap with mezzanine or preferred equity, he adds.

Although investment sales volume year-to-date through September is outpacing 2021, the latest data from MSCI Real Assets shows a marked slowdown in third-quarter activity. The $172.2 billion in closed deals is down 21 percent compared with the same period a year ago.

However, some borrowers are finding an easier path to financing than others. Lenders remain very selective on weaker sectors and deals, notably office, hotels, and retail, although properties with strong locations and fundamentals can still get financing. Lenders appear to be shifting more in favor of doing senior loans with a preferred equity piece that provides higher leverage. “That’s where the accretive loans are getting done, and I think that’s where they will get done in the foreseeable future,” notes Erxleben.

Looking forward into 2023, some industry participants do expect financing activity to pick up once there is more stability in benchmark rates and clarity on whether the Fed is likely to be dovish or hawkish on rates. On the positive side, the fundamentals within most property types remain very strong. “Big picture, this is a capital markets–driven event where lack of clarity as to what’s going to happen to rates has driven some folks to the sidelines right now,” he adds.