Taking the Temperature in the CRE Debt and Equity Markets

Originally published by GlobeSt

Earlier this year Stan Johnson Co., announced the launch of a new affiliate debt services company called Four Pillars Capital Markets, which is providing debt and equity financing packages for commercial real estate investment properties. GlobeSt.com caught up with Farhan Kabani, partner at Four Pillars Capital Markets to get his take on what is happening in the CRE capital markets at the moment. Following are excerpts from that conversation.

It is well known that in many asset classes there is a huge amount of capital chasing limited assets, with the net lease category being one example. What are some of the effects of this – and in particular, is all this capital driving up prices beyond reasonable valuations?

Investors and firms are willing to step outside their historical comfort zones in search of yield. For example, single-tenant net lease owners are more willing to pursue multi-tenant retail assets. Although there’s added perceived risk, there’s also reward with high cap rates and upside lease-up potential. In past years, these STNL owners may not have had the ability to secure competitive financing for the switch in asset classes, but with the significantly increased availability of capital, throughout the entire capital stack, the lack of experience can be mitigated with higher rates, debt yield and debt coverage ratio. Similarly, the debt fund space has raised significant capital over the past five years, and now it’s thriving since the dollars can be deployed. We’ve never experienced such a dynamic marketplace with so much liquidity flowing across sectors. Low interest rates are the primary driver, and as long as rates remain low, there’s likely room for further growth. The levels of reasonable valuations today will be determined in the future, after rates have move upward. Then we will be able to decipher the winners and losers of the basis game.

Given the above question, how is underwriting holding up?

With low rates, an improving economy, and a desire to deploy capital, underwriting is holding up well.

What effect has inflation had on investment trends in CRE now and also in terms of future plans? That is, are investors and capital providers planning for a run of long-term inflation and if so, how will that affect CRE?

Capital providers will generally hedge for inflation as it relates to interest rate risk, and investors may hedge by securing longer term low fixed rates and forecasted rental increases. However, we haven’t experienced significant deviation from typical decision making caused by inflation concerns. Mainly, investors appear focused on today – especially coming out of a pandemic and evaluating possible changes to the tax code. Real estate has long been viewed as an inflationary hedge, so the overall increase in allocations to the asset class appear to be, at least in part, motivated by inflation hedge concerns on the broad market level.

Right now, capital is plentiful for most CRE assets and looks to remain the same in the medium term. What would be the economic or industry-specific reason for this capital to stop lending to CRE? In other words, what would turn off the current capital spigot?

What’s going on in the market right now is that lenders are broadly increasing allocations to the asset class, so I think of it more as a tightening of the spigot than a shut off, with one key distinction looming as a lesson from COVID-19. An unforeseen economic shock can scare lenders out of the market for a period of time, as they did for roughly a quarter in 2020, pulling lending on all but Class A and investment grade assets. We’re watching inflation closely to see whether it runs farther and faster than the Fed seems to be predicting, and policy changes by both domestic and foreign governments could have a material influence on the marketplace.

Are you seeing any dumb money enter the CRE space – that is, investors new to the space that are mainly interested in yields and not very aware of the nuances of CRE?

There are always new entrants to a booming marketplace, and without knowledgeable advisors, a lot of the new investors stand to learn those nuances the hard way. It works the other way too, however, where capital that’s been parked by fundraisers is placing increased pressure on managers to get the money out the door or return their capital. This will put pressure on riskier bets that have to be absorbed in the fund sector, which may compress total projected returns, regardless of the experience level of the investors.

Has the rising COVID cases spurred by the Delta variant had an effect on capital lending, specifically for the office asset class?

No, there doesn’t appear to have been a noticeable or widespread impact. At least not anywhere near the extent we saw in early 2020 when lenders pulled back tightly for several months.