- With banks and senior lenders feeling risk-averse, senior debt LTVs have dropped 10 to 20 percentage points, leaving gaps in capital stacks.
- While there are no shortage of private debt, mezzanine debt and CMBS lenders in the market, funds may be best off working with established lending relationships.
- The promise of low federal interest rates creates an environment for stable long-term yields.
Institutional lenders have been pulling back on their willingness to finance real estate deals. Before the pandemic, loan-to-value ratios for senior debt were between 80% and 85%, according to RSM US Partner and Real Estate Senior Analyst, Laura Dietzel. However, those numbers have now dropped to between 55% and 75% as senior lenders look to protect their financial positions.
Senior debt providers may be willing to offer more attractive financing to borrowers that they’ve worked with before or who have established track records in distressed investing or recapitalizing assets. Dietzel suggested firms exhaust all of their existing relationships with lenders to find the deal terms most suitable for their fund or project.
While GPs may be able to make up some of those gaps by raising more equity, it’s likely that they will have to turn to another source of debt to fill out their capital stacks. And with low interest rates creating high liquidity in the market, there is no shortage of other debt sources: mezzanine debt players, CMBS lenders, life insurance companies, private debt funds and even hedge funds may be willing to provide funding for distressed projects.
But even these private sources of capital may have shrunk their LTV tolerance, Dietzel said, and with these sources asking for anywhere from 8% to 14% guaranteed returns, fund managers will have to carefully negotiate and project their return rates to make sure that they can achieve the yield investors expect.
The Federal Reserve has made it clear that it has no intention of raising interest rates any time soon, which has led to a flurry of recapitalizations across the real estate market. That low-interest rate environment could offer high risk-adjusted long-term returns for investors who are willing to take a longer view, but may not matter to distressed investors who are looking for shorter hold times and higher value-add projects.
The debt that funds can raise is also going to be highly dependent on their project details, location and type. While some asset classes, like industrial or multifamily, might not raise eyebrows with lenders, others may be a tougher sell.
According to Dietzel, “A lot of real estate transactions are getting done without making it into the public markets. It takes a deep knowledge of the market and neighborhoods with boots-on-the-ground intelligence to understand block by block how an asset will perform.
Tipping point: Taking on debt may be necessary for making the large acquisitions that funds have in mind, but taking on too much mezzanine and private debt will lower levered returns.