August 2023 Capital Markets Recap

Tim Milazzo
September 8, 2023

CEO Tim Milazzo and Director of Capital Markets Huber Bongolan recently went live to share a comprehensive update on the current state of commercial real estate capital markets. Follow us on LinkedIn to be notified about upcoming live events.

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Not able to listen? Read the full transcript from the discussion here:

Hello and welcome to StackSource's commercial real estate capital market update. We are in September of 2023, recapping August of 2023. News, events, rates, we're going to get into all of it. I'm Tim Milazzo, I'm CEO of StackSource. I'm joined by my colleague, Huber Bongolan in Sunny, California, who is our director of capital markets. Huber, good to see you.

Good to see you, Tim. Excited to be here today.

All right, so we're going to start with news, What was the biggest financial and capital markets news from August? We have three stories that are wider than commercial real estate and have a lot of impact on the real estate capital markets. The first one, in early August, the credit rating agency Fitch downgraded US Treasury bonds from their traditional AAA rating down to AA Plus. Now, AAA Plus is still well within the range of credit rated. It is a high confidence interval, but not for US Treasury bonds. The US is used to be treated like royalty in the capital markets whenever they issued debt, and that has been moved down one notch. Now this is a long-term shift. There's been a lot of political discussion around this, of course, as it pertains to the country, but we can no longer consider US Treasury bonds at this moment in time in history as the risk-free rate, which they have been treated as in Economics 101 classes up. And this has long-term implications for the capital markets. In the short term, we've seen some uptick in treasury yields, which we'll see on the next slide.

But before we get there, also in the downgrade category, there have been some key regional banks that also received downgraded credit ratings or have been placed on watch lists by rating agencies. So some of these key recognizable names in commercial real estate markets will be KeyBank, Valley National Bank, and Comerica. All these institutions have done a lot of commercial real estate lending over the last ten years. They are not mom-and-pop or community banks. These are while they're considered regional banks, they're quite large players in the commercial real estate lending and capital market space. And this is going to be of interest in the months ahead to see how the market adjusts. There are still several banks that are facing balance sheet issues, so they're mixed between lending and deposits, and that's where their challenges lie. The third piece is back up to the United States level. BRICS is a series of countries that are not in North America and Western Europe that are closely allied with the US. But Russia and China, and they're expanding their trading block in this BRICS alliance. The biggest news here is that these countries are intending to settle cross-border payments within their network now of eleven countries without the US dollar.

So this goes hand in hand with the Fitch downgrade with the Skyrocketing National debt. Once again, this is a long-term decision, it is a long-term implication for what's going to happen in the commercial real estate capital markets is what is going to come out of this. These are important notes that are broader than real estate but are going to filter down into yields, they're going to filter down into spreads, and the strength of the economy and the strength of the dollar versus other currencies. So now we're going to shift and look at what's happening as far as bond yields. And Huber, what do you see in this chart? What are we looking at in this chart?

Absolutely. So there are a couple of different rate lines here. You'll see that they're denoted by the different color schemes here and these go back to January 2021. So kind of the most obvious here that everyone sees is inflation. That is the discussion that's always top of mind for everyone in capital markets, commercial real estate and for the past couple of months here, starting in maybe July before July 2022, it was a welcome sign seeing inflation starting to come down. Now you'll see most recently the small blip up where it's gone up a little bit and we'll be watching that to make sure that all of the Fed policies that are in place, what is in store for the future, we want to see that inflation number continue to go down. And Jerome Powell, as everyone knows, chairman of the Fed, has made it very clear that he is steadfast in getting inflation to the 2% mark. Other rates that we're tracking here, of course, are the ten-year US Treasury as well as the two-year US Treasury and term SOFR with rate increases that are used to battle inflation.

You're starting to see these rates continue to trickle up and what's interesting to us is the difference between the ten years and the two years on how those curves are still inverted, whereas in a normal cycle usually the ten-year rate is higher than two years. You'll notice that for the past couple of months now actually been almost happy, For more than half a year, the two-year treasury has been higher than the ten-year treasury, usually a harbinger of recession. Whether we're in one now that's a topic for debate. But these are rates that we're constantly tracking and will continue to track to advise our clients. So speaking of rates, moving on to our next slide here, different rates are associated, maybe minimum bounds and maximum bounds that you see on the right side, these interest rates that are associated with different types of lenders. So you see the loan program type on the left-hand side. We've updated these rate ranges. Again, minimum bounds for maybe the most conservative of deals. We're talking low loan-to-value ratios and limited risk. In the top ten MSAs, you'll usually see rates on that lower side of the spectrum depending on which type of capital provider you go to Fannie, HUD, CNBS, regional banks, and then of course, you have on the other side of the spectrum.

If a lender were to do a deal, and it was a very risky deal, then what would be that upper bound that a lender would typically charge? So these are typically what we're seeing in the market here at StackSource We have about 1000 unique different capital providers, and around 2000 different programs that we're tracking to get this data here. So these are constantly updated in real time. If you were ever curious in terms of which rates are appropriate, what is the minimum maximum, the norm for each of these lenders? You can easily go to our website and we have the commercial mortgage rates posted there. So moving on, to underwriting and deal structure, I'll kick it off on the first bullet point and then pass it over to Tim. What are we seeing in terms of August updates to deal structure and underwriting structure one of those has to do with cap rate expectations. So with spiking bond yields it's putting pressure on cap rate expectations. You'll probably be seeing this or reading about this, but the difference between buyers of commercial real estate, sellers of commercial real estate, and the bid-ask spread.

What we're starting to see is with interest rates for bonds going up, buyers are starting to demand higher cap rates, a higher yield, and a higher return on their commercial real estate assets. So you're starting to see that with bonds that are indeed safer in some, sometimes not, but bonds with those interest rates increasing, cap rates are starting to have that upward pressure and expectations for cap rates, higher cap rates, higher yields for commercial real estate, those are also starting to increase, right?

And at the same time cap rates have upward pressure and these bond yields are spiking. Speaking of bonds, life insurance companies in particular, their originations have been down sharply this year and part of the reason for that is that we see there's competition for commercial mortgage dollars not only with newly originated loans but as acquisition activity has been low and refinancing activity has been low. With interest rates up, those same dollars may be chasing bond purchases. So there have been bond purchases in recent months from banks that are struggling or have outright failed. There's a signature bank block of bonds that's still on the market from the FDIC. So life insurance companies and other long-term commercial mortgage players, are looking at their balance sheet as an origination avenue and also a bond-buying avenue and those are both demands on their capital. And so what that does for borrowers is it means you're going to see moderated leverage that can be offered from these players that could use the same money to buy these bonds. So it means there's more restrictive underwriting for borrowers because Lifecos and others are considering these bond purchases.

Excellent. And then that last bullet point that you see their equity capital seeking a preferred tranche. So I mentioned earlier how at StackSource we have around 1000 unique capital providers. Now we use the term capital provider specifically because it spans the spectrum of debt players as well as equity players. And one of the trends that we're seeing in the equity space, those are JV investors. Whether they are limited partners, co-gp we're starting to see that for their risk tolerance, they're seeing an opportunity to play in a safer part of the capital stack. So not necessarily debt, but that preferred gap financing, trunk mezzanine debt, or preferred equity. To put it clearer, when previously in a safer, more normalized market an equity provider would have been comfortable providing JV equity in the form of co-gp or an LP equity check. Now we're starting to see they're much more comfortable in a preferred tranche mezzanine or preferred equity space. The reason for that, one of the reasons for that is in that space, what we're seeing now with lenders is that they're pulling back with higher interest rates and more conservative underwriting standards.

Senior lenders are starting to pull back on the amount of proceeds that they're willing to give. So where can a sponsor make up for that missing part of the capital side? Those proceeds that they need to make up now that the senior lender won't provide as many dollars? Well, they can find that in the form of gap financing, preferred equity, or mezzanine debt and having that part of the capital stack being in that position yielding rates in 1112 upwards of 15%, maybe being able to negotiate a piece of the equity slice. We're starting to see a lot more players move into that gap financing space and seeing that opportunity there.

Absolutely. Speaking of preferred equity and equity providers, seeing that the market is moderating leverage and many lenders are more restrictive in their underwriting than in times past. While StackAource had already been closing structured capital transactions with mezzanine and preferred equity as advisors, we've built that into our platform. As announced last month, in recent weeks we now have filtering and matching equity partners set up in our portal so that everything from senior to mezzanine debt and now to preferred equity and equity partnerships has a set of filters to find the right capital provider based on scenarios. This takes into account location, asset type, business plan, and then user-selected filtering options. So are you looking for preferred equity, Your cogp, what is the investment horizon, the total capital stack, and what that looks like between third-party equity and the sponsor's equity will come up with matching capital providers instantly. As you can see there's no upfront cost to this. Our portal is free to enter a loan request and see who you're matched with, with no obligation before deciding if you want to move forward to solicit quotes and work with a stack source capital provider to go out to market.

So in the months ahead, we're expecting some news and some events in the capital markets huber. What can we expect in the next couple of months?

Awesome. So going into these three bullet points here with a little more detail, the next FOMC meeting is September 19 and 20th. I think most of us, no one's expecting that they'll cut rates, but I think there's a bigger expectation that they'll hold an offer now. Wait and see as data comes in, the most recent responses from the Fed kind of signaled a higher-for-longer type mentality. It's still yet to be seen all the ramifications of the increases previously. So I think the market is betting that with this specific meeting here it would be a hold rather than an increase in rates. But no one knows. There is still data that's coming out between today and the 19th. So we will see. We'll be watching intently as Jerome Powell speaks and announces their next move at that meeting. The second bullet point here is a large volume of loan maturity and interest rate cap expiration. So those are two kinds of different topics that we'll be watching in the month ahead. When it comes to the volume of loan maturity, the big question is what happens to these deals? What happens when these original loans that were when they were taking out had a much lower interest rate?

We were in a much more favorable capital markets environment, there were many more players in there. What happens to those now when the rates previously hypothetically were maybe at the threes and now they're trying to refinance and rates are now in the seven-eight for this deal and they don't have those proceeds? Is that the opportunity, like we talked about, for that gap financing to come in? Is there something else that's going to be something that they figure out as these large volumes of loans mature? And then lastly, the interest rate cap expirations. So for those that may not be aware, when it comes to floating rate debt, sponsors usually purchase a rate cap which works in the form of an insurance policy It caps the amount that your debt service can increase because rates are floating, and rates are going up. Well, number one, today those cap rates are incredibly expensive because of the path of interest rates. And two, what happens when those rate caps expire, when those insurance policies expire and now rates can go up again, and now properties that used to be protected and their debt service being able to be met, now interest rates are too high, their NOI stays stagnant, what do they do?

Is there a way to increase NOI? Is there a way to purchase another cap rate? Those are questions that we'll be watching in the months ahead. And then that bullet point leads to our third one, distressed Sale and Note Opportunities. So if a solution can't be had, of course, sponsors are out there looking for different types of solutions, looking for lenders calling on us to help them find that financing. But what happens when they can't? Or what happens when you look at all of your options and a sale is the only one that makes sense, right? So we'll be watching that in the months ahead. Distressed sales opportunities, What does that do to cap rates? Usually, you have that upward pressure that we talked about before. Or I just got off the phone with a lender discussing this when other lenders are selling their notes. So lenders selling notes to other lenders, these distressed notes where they may see trouble grooving ahead and they're trying to get them off their books, or they need additional liquidity to escape being downgraded. So they need to sell these notes.

What do they do? So these will be hot topics that we'll be covering in the months ahead.

Excellent. And before we move over to the Question and Answer segment of the live stream here, once again we're Stacksource Huber on the West Coast, Tim on the East Coast here. Our company is a team of capital market experts across the country. They are capital advisors who help real estate investors find the best debt and equity for their ideal capital stack. We do that with transparency so you can see not only the providers you're matched to, but all the quotes coming in on the platform, which lenders are quoting and declining, and which capital providers are offering equity into the deal. We find competitive terms. We have a nationwide reach. We've closed now more than $1.5 billion of transactions across 46 states. As we transition to the Question and answer, if you're watching live on LinkedIn or YouTube, go ahead and drop a question into the comment section and we will see it. And as questions come in, we'll address them live. If you have questions that do not get answered on the live stream or you're watching later, please do email us at Okay, Huber, I have a question coming in about the commercial real estate market having distressed sales and note expirations.

What opportunities does that afford real estate investors?

Absolutely. So number one, there are market deals and off-market deals. If you're in a position where you have a vast network of brokers or you're able to find these off-market deals, when it comes to distressed sales, you might be in an opportunity to find sellers that need liquidity. There's something about the property that you know how to turn around. If you have access to capital or you maybe have a great war chest and you have the liquidity to do so, you could be able to negotiate for a much lower purchase price to turn these deals around. If you're patient, it's tough to foresee what's going to happen in the next year, two years to commercial real estate. But if you have a patient timeline, you have patient capital behind you, you're able to find these deals, these sellers that are in distressed situations, you're able to negotiate and get a much lower purchase price. Typically commercial real estate investors make their money on the buy. So once the market normalizes, then you should be able to see an incredible return on your investment because now is the time for people to start buying if they're able to.

Yeah, absolutely. Excellent. We've got a couple more questions coming in from the various channels. Here's another one I'd like to ask you, Huber. Can you provide examples of preferred tranche investments in the context of the market right now?

Sure, yeah. So I'm working on a construction loan right now, This one's in downtown LA where historically we used to be able to get just one provider to get to 80% of the capital stack. And my sponsor is fortunate that he and his partners can come up with the additional 20%. So that would typically be the easy match. Maybe a year ago, two years ago, you found a construction lender that was comfortable getting to 80%. My sponsor ethnic group comes in with the additional 20%. Boom, there you go. The 20 comes in first, then followed by the debt. But nowadays you're starting to see lenders constrained to around 50%, in some cases up to 60% to 70%, depending on the deal, of course. So in this specific case, the senior lenders are topping out at around 60% of construction cost and we're coming in to find a preferred equity tranche to come in for the remaining 20%. Now it gets a little bit more complicated because these two players also have to agree to work with each other. In some ICA inter-creditor agreements, the senior and the mes piece or the prep equity piece need to get along and understand what each other's terms are, making sure that still works for the deal.

But we are continuing to see that these preferred equity mezzanine debt tranches for being that gap, equity being that additional 20% sliver, they're usually charging between twelve to 16% in that range to solve for that piece of the capital stack and allow our sponsors to maintain only 20% equity in the deal. Because if that wasn't true, then they would need to go out and raise more funds to come up with a 40% gap now.

Yeah, which also changes the economics for those investors. Of course. We have one question coming in about StackSource and whether the capital services we provide have a unit Min and Max. So StackSource, commercial financing as well as multifamily five units minimum gets us into commercial mortgage lending territory. And so no maximum, but five units minimum if it's a multifamily residential alone.

Excellent. And Tim, this next one, this one's for you in regards to the debt rating downgrade. So what are the potential long-term effects of the United States debt rating downgrade on commercial real estate financing?

Yeah, well, I think we've seen one of them already, which is the dollar gets weaker and then countries choose not to use US dollars as a reserve currency or to settle their trades in US dollars. What that does is it can weaken the dollar against other currencies and that can have a couple of second-order impacts on real estate. Specifically. One of those is with a weaker dollar and if it is no longer functioning as the reserve currency in the future, you may see less foreign investment into US properties. So we've traditionally seen the US and real estate and land in the US being used as a piggy bank for the world. They are banking in US dollars and with US properties and investing as a haven. If the dollar continues to be threatened as that reserve currency, we may see less foreign investment. A second piece is that US investors may be investing further overseas as well. So another second-order impact, is cross-border capital flows. Not only may there be less capital flowing into the country, but there could be more capital flowing out of the country. And third and final is there is the same pool of investment overall at a global scale seeking investment opportunities.

And if US sovereign debt is less attractive because it's downgraded and it's seen as more risky, that's going to mean more expensive treasury yields. And most long-term commercial mortgages are one way or another influenced by U.S. Treasury bond yields, which can mean more expensive commercial mortgage rates. We can just simply see commercial mortgage rates go up. So as you covered before in the earlier slide huber, many banks, credit unions, and even government agencies like Fannie Mae and Freddie Mac, their rates are starting in the mid-sixes today. But if the US dollar and treasury bonds are weakened further, we can see a higher spread on that money and we can see more expensive money for real estate investors. So there's a multi-order impact and none of it is good for the prices and the borrowing power for real estate investors in this country. I think we are at the end of the livestream. Questions? Hubert, it's been good talking with you about the capital markets. None of this changes entirely in a month and so that's why we do this every month. Come back to LinkedIn live on YouTube or watch the replay.

You can always catch the replays from prior months at Huber it's been good talking capital markets and we're going to keep looking at this stuff.

Absolutely. Thank you everyone. Thank you for the time Tim, and always feel free to reach out anytime. Everyone. Thanks.

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