Return of Recourse and Other H2 Trends to Watch
As we pass the halfway point of 2024 and look ahead to the next six months, there are five capital market trends that we expect to impact CRE activity through year-end.
Sponsor liquidity: Middle-market value-add investors and developers are being pulled in many directions and seeing their liquidity dwindle. The causes of this are multifaceted–from capital calls being unfunded by LP investors to projects that are costing more and taking longer to complete and a transaction/sales market that is struggling to find it’s equilibrium. We expect this lack of liquidity to create more loan modification conversations, sales activity and demand for preferred equity and mezzanine debt.
Bank lending: While the large national backs continue to remain uninterested in commercial real estate balance sheet lending, regional and local banks will continue to fill the void in the next six months offering construction, bridge and permanent loans. The product focus will remain on multifamily and industrial properties with openness to retail, manufactured housing and self storage. Office will remain a quick “no.”
Loan origination: While we are seeing a desire from the banks to lend, we have also noticed that the lending, specifically the origination process, is choppier than ever. So far this year, we have had multiple instances where origination teams are not in sync with credit, and are having to either change terms they have quoted or turn down deals altogether. A number of factors may be contributing here, including 12 months of dormancy, changing regulatory pressure and, quite possibly, the remote-work environment. Nonetheless, we are having to qualify loan quotes more rigorously in order to mitigate this risk.
Recourse borrowing: Nonrecourse construction lenders have capped out their leverage around 45 percent loan-to-cost or have pushed leverage to 65-70 percent loan-to-cost with higher, 5.25 to 7.0 percent spreads over SOFR. Through the rest of the year, borrowers needing to move forward with their development projects will need to provide recourse if they want to obtain 55-65 percent leverage at spreads ranging from 3.0 to 3.50 percent over SOFR. This is especially true with regional banks.
JV equity for development projects: Multifamily fundamentals are stabilizing in many markets throughout the country. This is creating an opportunity for developers to deliver housing into markets where supply will be thin by historical standards. The challenge with capitalizing development projects remains the lack of LP equity, especially institutional equity, willing to take development risk.
This apprehension is rooted in a number of factors. JV equity investors are able to attain opportunistic returns in credit products (senior debt, mezzanine and preferred equity), the cost to build today exceeds where stabilized Class A properties are currently trading in most markets, and JV equity is looking for a minimum of 1.5 percent spread between untrended yield on cost and current market cap rates. We expect this trend to continue through the end of the year.
This volatility and uncertainty in the capital markets should present investors and developers with both challenges and opportunities that we typically do not see in a well-functioning “normal” capital commercial real estate market.
Shlomi Ronen is managing principal of Dekel Capital.
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