Historically equity has been the component of a real estate borrower’s capital stack that has been the most challenging to procure. This capitalization reality often dictated more leverage as equity was expensive and diluted the real estate entrepreneurs take home profit. Real estate was classed as an alternative’s alternative with modest flows of capital available due to its unpredictability and illiquidity.
The real estate industry’s evolution though allowed real estate to join other institutional asset classes with improved discipline, protocol and process as demanded by both investors and fiduciaries. The financial crisis of 2008 and 2009 set in motion another factor, a greatly enhanced regulatory regime. Industry participants argued that such regulation overshot its target, reducing leverage that was furthered by a lack of yield in other asset classes prompting more equity capital flows to real estate given its comparatively favorable yield proposition.
Fast forward to today, where we are well into a new capital cycle which has been prompted by the pandemic crisis, and while the balance sheet of U.S. real estate is not over-levered, it is now the debt side of our ledger that has been most impacted. Interestingly, much of the abundance of market equity has now turned to debt funds and debt capitalizations in order to achieve their necessary equity yields given the dearth of pure equity opportunities.
However, further investigation of these debt funds exposes great underlying leverage that was built upon the predictability and confidence of a project’s subordinate equity and the broader economy. With today’s market illiquidity cycle initiating the downgrading of bonds, the calling of repo lines and collateral devaluation, borrowers have had to now manage through an existing tentative lender or to seek an alternative solution to their new financing request. Mark Strauss, Managing Director of Walker Dunlop, sites “transactions are not getting done that previously had multiple lender bids regardless of the aggressive business plan underwritings with today’s pricing more aligned with the proper risk-return.”
It has been estimated that over 40% of today’s bridge lenders have been sidelined or shelved due to their underlying capitalization make-up. Note a recent article in The Atlantic entitled “The Looming Bank Collapse” (https://www.theatlantic.com/magazine/archive/2020/07/coronavirus-banks-collapse/612247/) as further evidence of the need for the most regulated and most senior lenders to seek yield through the abundant purchasing of CLO’s, otherwise known as “collateralized loan and other obligations.”
As in prior cycles, the debt markets will certainly return to their new normal which will respond with less leverage, increased pricing but with a sound underlying capital foundation. The ability as a capital provider to customize, properly underwrite, structure and price will be well differentiated in today’s market. An extra level of due diligence is recommended by borrowers to not only address pricing, recourse and leverage from your lender, but to value and quantify the origin and structure of a particular lender’s own capitalization to assure not only the certainty of a loan’s closing but moreover, a certainty of a lender’s survival.
Written by Joseph Maehler, Senior Vice President, Buchanan Mortgage Holdings, LLC