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Capital Markets: The Rearview Mirror and the Road Ahead

Last year’s capital markets volatility considerably slowed both development and investment. In this first article of a four-part series, Connect CRE asked experts to provide clarity about what happened in 2023 and their 2024 forecasts. In the coming weeks, additional topics will focus on what projects lenders are more likely to finance, what creative capital solutions are evident and trends to look for.

Adam Weissburg

There’s no doubt that capital markets struggled in 2023. A continuous increase in the Effective Federal Funds rate (EFFR), the bank industry turmoil, and the ongoing traditional lenders’ retreat from CRE exposure left borrowers low on liquidity. This put the brakes on construction and investment.

To obtain more clarity about where capital markets have been and where they’re going, Connect CRE reached out to capital markets experts for an in-depth examination of the previous year and to learn what might happen in 2024.  

What REALLY Happened in 2023?

The Challenges

Brian Heflin

The main challenge in obtaining capital in 2023 boils down to three words: Rising interest rates. “The rise in short-term rates requiring more equity from developers and owners in new projects and at the time of renewals,” said Brian Heflin with PlainsCapital Bank.  Added to this was the increase in direct costs due to ongoing inflation. “As a result, most projects required additional debt/equity to solve the shortfall, burdening these construction projects,” Heflin said.

Banking industry volatility didn’t help the situation. “Some lenders went out of business, and the industry, in general, was hit hard,” commented Adam Weissburg with Cox, Castle & Nicholson. And according to Shahin Yazdi with Colliers Structured Finance Group, remaining banks tightened their lending standards to rebalance their books. “Many were stuck with a portfolio of fixed, low-interest rate loans that were below current borrowing costs,” he explained. “They also had to right-size their loans, as higher interest rates impacted values.”

Gary Bechtel

Furthermore,  in the wake of the Silicon Valley Bank, Signature Bank and First Republic Bank closures, “regional banks received a great deal of scrutiny from regulators,” noted MetroGroup Realty Finance’s Ivan Kustic. “As a result, they were even more careful in their underwriting.”

The takeaway is that 2023 was a year of uncertainty. Said Jeff Salladin with Revere Capital: “When the future gets foggy, it doesn’t matter if you’re a bank or an investment fund or an endowment or an individual managing a 401k. Investor activity slows.”

Tower Capital’s Adam Finkel agreed, citing the impact on underwriting. “It’s difficult to forecast what an exit cap rate could be or what the interest rates might be on the exit of a bridge loan or a construction loan or on a possible refinance,” he explained. “This made it challenging to underwrite deals while obtaining the leverage people sought.”

The Silver Linings

Ivan Kustic

But not all was negative. Gary Bechtel with Red Oak Capital Holdings, for one, acknowledged that borrower expectations baame more realistic in late 2023 while the structures under which debt was available solidified. The result? “An increasing amount of higher quality transactions that we could transact on as well as having a better forward view of the take-out market in the near term,” Bechtel said.

Furthermore, lender interest rates fell in Q4 2023, leading to less-costly refinance activities. This meant “borrowers that were in a position to move quickly could lock in rates that were 50 to 75 basis points below where they had been most of the year,” Northmarq’s Jeff Erxleben commented.

Jeff Erxleben

And those well-capitalized borrowers found themselves in an ideal competitive position. “They were able to launch construction projects and be among the few being built in a tight market,” Yazdi commented. The same held true on the investment side. “These borrowers could also jump on buying opportunities from sellers who were pressured to dispose of their assets,” Yazdi said.

According to T.R. Hazelrigg IV with Avatar Financial Group, the capital market situation also meant that well-capitalized private lenders became more competitive, giving them “the ability to cherry-pick the highest-quality deals and set their own pricing, with higher interest rates and fees, proved to be of paramount importance going into 2024.”

The (Possible) Spillover into 2024

Jeff Salladin

What else will happen in 2024? Most agreed that this rests on the Fed’s actions. And the Fed’s actions will depend on inflation. As of December 2023, the Consumer Price Index growth – a measure of inflation – stood at 3.4%. This is higher than the Fed’s targeted 2% rate. Meanwhile, overall GDP in Q4 2023 grew by an unexpected 3.3%.

As of this writing, the Federal Reserve hasn’t indicated how these metrics will impact its handling of the Effective Federal Funds rate. At the end of the year, there was a great deal of excitement that the Fed would start slashing rates in 2024.

Adam Finkel

In quoting the Mortgage Bankers Association, Kustic said that the EFFR is anticipated to drop from the current 5.33% to 4.62% by the end of 2024. The MBA also forecast a drop in the 10-year Treasury bills. “This anticipated reduction in rates is a good sign and creates a spirit of optimism,” he said.

But Finkel isn’t quite so optimistic.

“We’re not completely sure about the Fed lowering the rates,” he said. “I’m hearing a lot of mixed signals. There’s still considerable uncertainty about where the rates are going to be, where cap rates are going to be, or if there is going to be a swarm of distress that hits the market.”

T.R. Hazelrig IV

And even if the Fed begins lowering their rates, Hazelrigg believes this will be offset by increasing debt maturities.

Still, Bechtel pointed out that the current market is stable from a lender standpoint. “We’re not seeing a lot of volatility in being able to raise capital, and borrowers interested in transacting are becoming more reasonable in their pricing and leverage expectations,” he said. As a result, “we generally anticipate a ‘more of the same’ environment for 2024 from an interest rate and capital availability standpoint.”

Yazdi with Colliers Structure Finance added that capital providers will continue using discretion in issuing new loans. “Lenders will continue to limit their capital outputs but will start to increase their CRE lending toward the second half of the year, as markets begin to stabilize,” he predicted.

Shahin Yazdi

Salladin agreed that banks would likely increase lending activity, but nowhere near the 2021-2022 levels. “The deal flow will vary based on the investor type,” he explained. “Banks are famously cautious for many reasons, not the least of which is they have to answer to regulators.”

But doubt remains, going beyond interest rates and markets. Said Salladin: “Ongoing wars in Ukraine and Israel, Red Sea distress, China-Taiwan tensions, a divisive election here in the United States—each of these will add their own form of uncertainty that is hard to handicap.”


Inside The Story

Avatar Financial's T.R. HazelriggPlainsCapital's Brian HeflinCox, Castle's Adam WeissburgColliers' Shahin YazdiMetroGroup Realty's Ivan KusticRevere Capital's Jeff SalladinTower Capital's Adam FinkelRed Oak's Gary BechtelNorthmarq's Jeff Erxleben

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