Meridian Capital Group Senior Managing Director Morris Betesh discusses how investors are coping.
The Federal Reserve has made history with three interest rate hikes in nine months and one more expected by year-end. The federal funds rate went from near-zero in March to a range of 3-3.25 percent in September, the highest since 2008. It’s been four decades since Fed officials have resorted to such resolutions to curb inflation.
Effects on the capital markets were slow but are now emerging more clearly. The cost of financing real estate transactions increased as lenders require borrowers to purchase interest rate caps. On the fixed-rate side, the biggest impact has been on construction lending, according to Morris Betesh, senior managing director at Meridian Capital Group. Commercial Property Executive spoke to Betesh about capital markets trends and predictions on what is to come.
We’ve seen a tightening of lending conditions recently. What effects has that had investment so far?
Betesh: I think it’s twofold. I think we’ve seen a lot of people pivot from doing bridge loans on light value-add investments to just taking lower leveraged fixed-rate loans. Borrowers who would otherwise borrow 80 percent financing on a deal are now considering borrowing 60 percent. Obviously, there are fewer borrowers out there that can write checks of that size. So, it also limits the pool of investors who are active in the market. But that is a big trend—lower leverage financing, either with agencies or banks. Same is true on the construction side.
What can you tell us about capital availability, considering the current rising interest rate environment?
Betesh: There is a ton of capital available. I thought that we would see some spread compression in the market. Obviously, when indexes go up, spreads come in a bit, just because it gets really expensive for people to borrow at higher rates, and there is less demand for capital at those rates. I do think we will see significant spread compression in the first quarter of 2023.
In the first half of this year, while things were still good, every lender out there beat their budget. We are talking to a lot of lenders. We’ve spoken with a large insurance company recently. They budgeted $6 billion dollars for the year and they invested $10 billion through September. So, they are being opportunistic for the rest of the year.
It’s really not a challenge finding money. It’s just finding money at the right cost. I think that will change significantly in the first quarter of next year when all of these capital providers will need to meet their budget for 2023. I think they’ll all start competing and you’ll see some spread compression, which will, hopefully, help offset some of the rate increases.
Are you seeing more all-cash deals as a result of the pricing pressure?
Betesh: I’ve seen it. I wouldn’t say it’s a trend. You’re talking about a handful of deals that are getting done, so I guess more are happening now than before, but it is not an amount that is actually impacting the market.
There is a consensus that the current market for debt is not great, and a lot of people are not interested in locking in long-term financing, so they’re being creative in various ways to take advantage of opportunities in the market when rates are high and prices have come down but not necessarily lock in long-term suboptimal financing terms. So, (some borrowers are) taking shorter-term debt (or) closing all cash and then hoping to come back to the market in six months or something when things normalize—either spreads come in or rates come down. Maybe it’s not six months. It could be two years out. I think a lot of people are very hesitant about locking in 10-year fixed-rate loans in the current rate environment.
How has this environment impact large and institutional investors?
Betesh: Larger investors are able to borrow lower-leverage debt because they can write bigger checks. So, earlier I mentioned that we are seeing a trend of fewer investors taking 80 percent-type financing and really getting 50-60 percent to manage the cost of capital. So, those larger investors are able to take advantage of those opportunities. I think this is definitely an important trend that we are seeing in the market.
However, I will say that really large deals—deals with loans in excess of $100-$150 million—are fewer and farther between because the large banks and large insurance companies have been the ones who pulled back the most in terms of allocations for the third and fourth quarter of this year. I think that will also change early next year, but on a $10 million or a $20 million transaction, the local community banks, the smaller regional banks and other market participants are very active. For larger syndicated transactions, it’s much more difficult.
The office sector has slipped from lenders’ favorites list. When do you think the property sector will be back on its feet and what conditions need to be met for us to see that happen?
Betesh: In the office sector, similar to retail, there’s sort of a—I don’t know what the right word is—maybe reallocation or reconfiguration of space. Some space that is obsolete is going to be problematic and then there is other space that will be in higher demand. So, I don’t think there is necessarily a lack of office demand, but there is definitely a change in where people want to be and what they want their office to look like.
They make take a smaller footprint and be able to afford more rent per foot, so they might upgrade to Class A office from Class B in a slightly smaller footprint, and it’s going to take several years to work through what the right type of office investment is and what gets done with the rest of it. It’s going to be regional. It’s going to depend on where you are.
In the same way, people can say that “malls are dead,” but there are certain malls that still do extremely well. You’re going to see the same thing with office, where office as an asset class will be viewed negatively but there are going to be certain office buildings that will be best in market, with good ownership and good tenancy, where people want to be and continue to pay high rents to be there.
What deals are easier or easiest to finance in today’s environment?
Betesh: Cash-flowing multifamily has always been the easiest. It remains the easiest and that’s primarily because the GSEs remain a constant source of capital throughout market volatility—so Fannie, Freddie, HUD are all still there. They will continue to be there to provide floor and support for the market, regardless of the market volatility.
And, of course, the asset class itself is sticky. Even throughout COVID-19, people still paid rent, people still needed to live somewhere, and it remains the most resilient asset class and the one with the most capital chasing it.
What about the opposite? What types of deals have become more difficult to finance?
Betesh: Class B office in urban markets with a short-term lease roll. Very challenging.
What are your predictions on capital markets for the year ahead?
Betesh: There’s going to be a lot of volatility over the short term, but over the long term, rates will normalize and probably come down a bit and spreads will compress. And we will be back in a more fun, active market environment, but there is going to be a significant volatility between now and then. The Fed is going to raise rates again. They are going to unload treasuries into the market and that will have an impact on rates, but the U.S. remains a global safe haven. Investors from Europe, the Middle East, Canada, Asia will continue to invest capital in the U.S.
The more uncertain the world becomes, the more the demand for U.S. treasuries and real estate. I think we will be back in a lower interest rate environment sometime in the next two-three years, but on the way there it’s going to be pretty bumpy and there’s going to be a lot of opportunity for real estate investors to buy great long-term assets at prices they probably wouldn’t have expected to see.