Rates & Leverage: Understanding the Shift in Transaction Motivators in Today’s Industrial Market
Today’s industrial market has not been immune to the challenges faced by the commercial real estate market at large. According to CoStar, overall industrial sales volume has dropped 36% over the last year across the U.S., and financing volume has suffered an even greater decline. That comes as no surprise as the 10-year treasury rate has increased 80 basis points in the last year as the Fed works to combat inflation.
The main transaction motivators today are either maturity related or a completed business plan. The days of the sub-4.0% loans are long in the rear view and have been replaced with 4.0% treasurys. Many floating rate products have risen to 9.0%, with SOFR hovering around 5.3%.
Where are Rates Today?
With treasurys at 4.0%, we are seeing most fixed rate pricing on industrial around 6.0%. Pricing is determined by a spread over the index or is set internally by a bank’s investment committee. With the recent treasury swings, we are seeing an increased appetite for the spread-based products. The most active spread lenders today are life insurance companies and conduit lenders (CMBS). The life company product is much preferred given the ability to rate lock, receive an initial loan commitment, and customize prepayment terms, all with no deposit requirements. While CMBS loans can offer similar features, they remain the lender of last resort because of execution risk and inferior pricing, often 100 basis points wider than a life company. Furthermore, CMBS pricing almost always starts at 300 basis points over the treasury rate, while life company spreads start as low as 150 basis points. That being said, we just closed one CMBS loan for a client and are working on a second, so CMBS lending remains a viable solution in certain situations.
Bank and credit union lending activity has slowed down more dramatically. These groups typically rely on internal pricing guidance and are sensitive to their cost of funds. As they navigate their own headwinds related to deposits, they are hard-pressed to request fresh cash from all new customers and even existing ones. In turn, investors have become increasingly frustrated with their service and are actively looking for new lending relationships. Our team went into detail on these and other complexities impacting the retail banking sector in a recent whitepaper.
Bridge and construction lending has become painstakingly difficult as well. When interested, banks are still pricing most requests in the SOFR + 300 to 400 basis points. Consequently, life companies, debt funds, and private lenders have been picking up the shortfall. These lenders don’t require offensive deposits and can typically obtain higher loan amounts. As a result, they have been playing a much larger role in short-term lending while many remain sidelined.
Lenders Are No Longer as Focused on LTV, So What Are They Focusing On?
Most investors we work with are looking to minimize their cash needed for a given project. Typically, we’re only getting to 65% of the purchase price. In today’s negative leverage environment, max loan proceeds have fallen from the 75% loan-to-value we’ve seen in recent years. Many are pointing to cap rates, expecting bigger increases as a result. However, leverage has not been the limiting factor.
Almost everything is driven by the debt service coverage ratio (DSCR). Lenders need comfort that there will be sufficient cash flow to service their loans. CMBS groups can get as low as 1.20X based on an interest only debt service calculation. This has been an attractive option for groups recapitalizing deals and seeking the highest leverage possible from a senior loan.
Consequently, the best priced options are from the life companies. Life companies are typically sizing to 1.30X DSCR’s with 25- or 30-year amortization, depending on the asset. Their spreads are driven by various factors including tenancy, market, and building quality to name a few. Real estate is one of many ways these firms allocate their funds to drive stable returns for their investors. As a result, they are usually more conservative on leverage based on their investor preferences.
Who Remains Active in Today’s Market?
When looking at the active market participants, institutions are the ones driving most of the decline in investment sale and financing volume. Some of the top buyers for 2022, including JPMorgan, Ares, and Stockbridge, are nowhere to be seen on the top 10 buyer charts for 2023. A couple of these firms are even found on the top sellers list for 2023.
So, who’s buying these negative leverage deals with larger down payments? It’s the private and sub-institutional groups that are most active in today’s market. They are finding ways to raise additional equity, increase property income quickly, and still deploy raised funds. The active private buyers are focused on longer hold times. New, well-leased product is still favored with an increasing focus on replacement cost. Rising costs are playing a role while values have dipped. Transaction volume is expected to remain muted until the spring, and once the fear and current environment are better understood, investors should come back slowly. Savvy investors, however, may find that it makes more sense to keep buying during these down times instead of holding off until the rest of the competition re-enters the market.
