U.S. real estate market update—July 27, 2020

Benchmark rates dropped precipitously, credit spreads shifted fundamentally, and LIBOR floors have taken on a new level of importance. Clearly market dynamics and sentiment have changed. However, except for a brief spike in March and April, all-in coupon rates and debt yields have remained relatively flat over the first half of 2020, despite the volatility in base rates and lending spreads. Below is a chart illustrating all-in coupon rate trends by property type followed by excerpts from lending market commentary provided to independent debt valuation clients spanning the last three quarters.

December 2019

Rates and spreads

With an increasing Treasury yield in Q4, lenders offset spreads slightly, which muted the impact to all-in lending rates. We observed fixed rates to have increased 5-10 bps over the quarter. Floating-rate spreads increased 10-15 bps as LIBOR declined.

Floors

While some lenders kept interest rate floors for fixed-rate loans in the 3.25-3.50% range, the combination of increased Treasury and market spreads resulted in all-in rates generally at or above the floors. We still see some lenders bidding aggressively for desirable assets. Some insurance companies have filled their annual allocations or are very close, which makes them more selective. Agency lenders have not moved spreads much since Q3, which is somewhat surprising given their new mandate guidelines.

March 2020

COVID-19

Mid-quarter, forecasts were optimistic that COVID-19 would have only a muted impact on the U.S. economy—perhaps limited to slower global growth and a supply chain disruption caused by a short-lived manufacturing shutdown in China. However, as the crisis grew in late-February/early March (eventually being declared a pandemic by the WHO), governments responded by closing schools, instituting stay-at-home/work-from-home orders and generally restricting interaction in a practice that is commonly known as “social distancing”. The resulting mass business closures have had a ripple effect on the economy and are expected to lead to increased unemployment, GDP contraction, and a potential recession (despite ongoing fiscal and monetary stimulus). Throughout the month of March, Chatham Financial has conducted interviews with more than 60 lenders, capital markets teams, and other market participants to understand the impact of recent economic events on commercial lending markets. Many of these conversations happened on at least two occasions—once at the beginning of March as base rates declined significantly and then again in late March as credit spreads widened. The commentary in this section summarizes the outcomes of these conversations.

Fixed-rate debt

There were two material market shifts for commercial real estate loans in March. In the first half of the month, many lenders were pricing new fixed-rate loans with all-in coupon floors between 2.50% and 3.00% depending on term and property-level risk characteristics, with only best-in-class, low risk investments receiving the lowest coupon floors. However, late into the week of March 16, floors and credit spreads began to climb significantly as lenders became more concerned about the economic impact of the COVID-19 crisis. As the month ended, more lenders generally stopped providing quotes for new deals, with some lenders reporting quotes only for best borrower credit with all-in coupon floors ranging from 3.50% to 4.25% depending on property type and location.

Floating-rate debt

Based on conversations with borrowers and lenders of senior floating-rate loans, spreads widened 30 basis points on average for all property types quarter-over-quarter. Like fixed-rate debt, floating spreads increased over the month of March. Some lenders increased LIBOR floors on floating rate loans to 0.50-1.00%. Toward the end of the month, many lenders “priced to lose” deals by quoting high spreads that were not expected to close. In some cases, these spreads were 200+ bps higher than the prior week.

Transitional loans

LIBOR floors in loans from debt funds and other non-bank bridge lenders have been a common structural feature as many of these lenders are focused on ensuring an all-in minimum yield. Over the past few years, as LIBOR fell and this space became increasingly competitive, we have seen these floor levels come in somewhat, but many debt funds still maintain LIBOR floors above 1%. Debt funds, generally, held all-in yield expectations flat over Q4 and most seemed willing to trade a lower LIBOR floor for a higher spread. In March, banks began putting LIBOR floors of 50-100 bps on repurchase agreement lines, which are an important source of capital for some debt funds. The increased cost of capital for debt funds led us to increase our market data for transitional loan spreads by 15 bps to offset the higher cost of capital.

Market rate conclusions

While in early March we expected market rate conclusions to decrease by as much as 60 to 80 basis points, the spread widening in late March reversed those declines with market rates for some property types, such as hotel and retail, increasing from Q4. As of March 24, 2020, and based on our market research, market rate conclusions remained flat quarter-over-quarter for office, industrial, and apartment loans with an applied market rate floor of 3.50%. This means that some loans that had historically received low market rate conclusions may result in an increase to the market rate floor. Others that had historically been above the floor will result in no change quarter-over-quarter. Retail properties not materially impacted by COVID-19 closures, such as many grocery anchored centers, received a 3.75% market rate floor. Retail that has been impacted by COVID-19 closures, as indicated by late March adjustments in property values, received higher market rate conclusions with a 4.00% floor. Other property types that were impacted materially by recent events also received higher market rate conclusions when compared to Q4 (e.g., hotel, student housing).

June 2020

COVID-19

This quarter has been in the heart of the COVID-19 pandemic. There was a lot of uncertainty and volatility at the beginning of the quarter which has gradually stabilized and created opportunities for those positioned with dry powder and risk tolerance. We have seen the U.S. go into lockdown and the gradual state by state reopening process. Some states have fared better than others during the reopening, and the fear of a “second wave” is on the mind of many while the general stock market, supported by the Federal Reserve, has been more optimistic about the recovery.

Fixed-rate debt

When rates are low, most borrowers opt to lock in fixed-rate debt. Now, many borrowers are utilizing floating-rate debt to retain favorable prepayment terms. Additionally, the change in the shape of the forward curve (previously inverted) has made floating-rate loans attractive again as they initially price below the alternative fixed-rate loan. As Treasury yields declined in March and April, most fixed-rate lenders increased spreads and/or floors, causing a drop in demand on longer-term fixed-rate loans. Borrowers were hesitant to lock in at higher levels compared to February and early March and instead opted to wait out the pandemic-induced shutdown and either extend loans or use floating-rate debt until they see more attractive pricing. Origination activity picked up in June as rates started to return to their pre-COVID-19 levels for some apartment and industrial assets.

Floating-rate debt

Opposite of fixed-rate loans mentioned above, floating-rate loans have come into favor given the low cost of debt relative to fixed-rate loans where all-in coupon floors are coming into play. Additionally, many borrowers are not looking to hold for the long term, so the prepayment flexibility of floating-rate debt is important as they look to opportunistically sell when the outlook improves. That said, many banks (especially national banks) have been on the sidelines, preserving capital to provide liquidity to existing corporate clients. Regional banks and some debt funds were active throughout Q2, winning bids that likely would have gone to national banks in the past. LIBOR floors have been a consistent theme in Q2 ranging from 0.50-1.00% for banks and 1.00-1.50% for debt funds.

Transitional loans

Many debt funds and other non-bank bridge lenders took a step back from the market in late Q1 and early Q2. The lenders that utilized leverage via repo lines and the CLO market have largely remained on the sidelines as these funding sources dried up. This has allowed funds that do not use leverage to step in and fill some of the liquidity void.

Market rate conclusions

Similar to March 2020, our market rate conclusions are based primarily on conversations with borrowers and lenders in the institutional commercial real estate market. Origination activity picked up late in the quarter—data from recently closed and pending transactions is also incorporated into the conclusions for debt valuations as of June 30, 2020.