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How Healthy Are the Capital Markets?

Despite the uncertainty and volatility brought on by the pandemic, the capital markets have remained healthier than anticipated.

The COVID-19 pandemic has certainly had an impact on the capital markets. As we enter the six-month mark, many are wondering what this means for the current state of the capital markets, and ultimately, what’s next?

With more than 30 years of industry experience, MetroGroup has weathered several economic downturns and understands how to navigate in times of uncertainty. Particularly, how the markets may react, what investors need to know, and the impact on financing commercial properties.

Below is an outlook on the current state of the capital markets and what investors can expect over the next several months as the pandemic continues.

Availability of capital

Despite uncertainty and volatility earlier this year, the capital markets are relatively stable and healthier than originally anticipated at the beginning of the pandemic.

There are ample capital sources available and sectors such as the CMBS market that were most impacted earlier in the pandemic have returned. Below is a breakdown of volume from all five lending groups:

  • Banks and thrifts: 40 percent
  • Agency: 20 percent
  • Life company: 15 percent
  • CMBS: 14 percent
  • Other: 11 percent

This is demonstrative of the fact that lending groups have healthy and ambitious allocations for commercial mortgages. While lenders have certainly become more conservative in their underwriting, they are still actively lending.

In fact, we recently provided financing on a retail center in Redlands where we were able to secure very competitive terms on behalf of the sponsor during the pandemic. Retail and hospitality industries were two of the sectors that were hit hardest by COVID-19 and there is a misconception that no lending is happening in these sectors. There are lenders who see opportunity and are willing to work with sponsors to get transactions done.

Because of our long-lasting lender relationships, we understand where they are looking to place capital. In this particular case, we were able to demonstrate the value of the asset to lenders through its quality location and essential tenants.

Lenders are also looking to lend across product types, including office, multifamily and industrial. In regard to multifamily product, we have worked with agencies who are lending all the way down in the 2.50 percent range. We also work with life companies and some banks in the high 2.00-percent range. That said, most of the lenders are in the 3.25 percent to 4.00 percent range, with many of them in the 3.50 percent range, which is still attractive to investors.

As it pertains to industrial, lenders continue to see a great deal of strength in the single-tenant net leased investment market. With capitalization rates in the 5.25 percent to 6.25 percent and financing available in the 3.00 to 4.00 percent range, this creates reasonable cash-on-cash returns. We see industrial buildings in strong markets as a very desirable asset class as prices represent investor preferences. We have also seen an increase in sale-leaseback investments, where regional and national tenants are selling their real estate to create liquidity. Office assets with stable long-term credit tenants are also attractive to lenders. City center office and suburban office buildings are selling selectively; city center office buildings are only selling with strong long-term weighted average rent rolls. However, we have yet to see any office buildings trade at opportunistic prices.

What is important to note is that all the different lender classes and capital sources are still active and attempting to be competitive. We see some institutions being very competitive and competing on rate to win the business where other lenders have floors and won’t compete with rate. However, some lenders with higher rates attempt to compete with flexible prepayment terms, additional advances during the term, or other structures not offered by the lower rate lenders.

Rates are still historically low

The current interest rate environment bodes well for investors as rates remain at historic lows. Many investors are opting to refinance maturing loans at lower rates than initially originated.

For example, building owners with well-conceived, healthy projects seeking reasonable conservative leverage are taking advantage of interest rates that are at an all-time low. For example, for an owner who placed a $10 million mortgage on a building 10 years ago at an interest rate of approximately 4.25 percent, the payment was $590,000 per year. The principal balance of that loan today would be $7,490,000. If replacing that exact loan with an interest-only payment at 2.7 percent, the payment would go from $590,000 to $215,000 per year. Similarly, we are providing mortgages on properties with a cash-out component increasing the loan amount by 50 percent and the annual debt service remains near its previous annual payment.

Historically and traditionally, commercial real estate interest rates have been priced using the 10-year Treasury as the index. In the last five years, the 10-year Treasury has, for the most part, hovered around 2.00 percent. It did hit 3.25 percent at the end of 2018, but overall stayed averaging around 2.00 percent. In March of this year, it dropped to its present level of approximately 0.65 percent. The Mortgage Bankers Association is predicting that the 10-year Treasury will increase to slightly below 1.00 percent by year-end and average 1.20 percent for 2021. That said, with interest rates and the index so low, most of the capital sources have installed interest rate floors. In the event that the 10-year Treasury rises slightly in the next year and a half, we do not anticipate all-in interest rates increasing much.

What’s next?

There will certainly be a recovery period and we may see a slight dip in loan volumes compared to previous years. That said, in times of uncertainty, often a significant amount of innovation emerges.

We are seeing many industries change their business models to adjust for consumer behaviors. As asset classes, industries and consumer behaviors adjust, capital for real estate will adjust with it.

Overall, over the next several months and into 2021, we anticipate that there will be ample capital sources available to meet investor demand, interest rates will remain at historic lows providing refinancing opportunities for investors, and ultimately, despite continued changes throughout industries, capital will continue to adjust alongside it.

Ivan Kustic serves as vice president MetroGroup Realty Finance, a private mortgage banking company based in Newport Beach, Calif. You can contact him at [email protected].

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