The wisdom and ability to tap “cheap” capital for commercial real estate investments
There’s very little doubt the 2020 global economy isn’t pretty. Ravaged by COVID-19 and government actions to curtail the public health crisis, there is record unemployment, record stimulus-relief packages, and record-low interest rates.
Many view these “easy money” rates as sound economic policy to head-off—or at least better manage—the recession. That said, economists and lenders are looking at the long-term implications for a post-pandemic economy. And in practice, the rates set by lenders are often significantly higher than the target rate set by the federal reserve.
The LIBOR transition has not happened yet, and could be slowed
In addition to direction from the Federal Reserve, banks also look to the London Interbank Offered Rate (LIBOR). Based on five currencies (the US dollar, the euro, the British pound, the Japanese yen, and the Swiss franc), LIBOR determines the average interest rate at which major global banks borrow and was, at one time, considered the world’s most influential interest number. In the United States, it was the most popular index for adjustable-rate mortgages.
Then came the scandal. More than a decade ago, regulators discovered that traders were manipulating rates set by some of the largest banks in Great Britain. For 10 years, there’s been a phase-out process as countries worldwide seek alternative risk-free reference rates.
COVID-19, though, may be delaying this transition, which was expected to be completed in 2021. In a world of pandemic-related uncertainty, many officials in different markets are sticking with the devil they know rather than look toward something new.
HousingWire states that a Moody’s Investors Service report shows that “Regulators such as the Federal Reserve have increased the nation’s reliance on LIBOR by using it as an index for emergency lending.”
Lessons learned from 2008
Not looking to repeat the harsh lessons of 2008, banks wandered away from collateralized debt obligations (CDOs)—since such loans made to homebuyers before the subprime housing collapse led to the Great Recession. Instead, lenders shifted toward collateralized loan obligations (CLOs). This has created a new vulnerability:
After the housing crisis, subprime CDOs naturally fell out of favor. Demand shifted to a similar—and similarly risky—instrument, one that even has a similar name: the CLO, or collateralized loan obligation. A CLO walks and talks like a CDO, but in place of loans made to home buyers are loans made to businesses—specifically, troubled companies. CLOs bundle together so-called leveraged loans, the subprime mortgages of the corporate world. These are loans made to companies that have maxed out their borrowing and can no longer sell bonds directly to investors or qualify for a traditional bank loan. There are more than $1 trillion worth of leveraged loans currently outstanding. The majority are held in CLOs.
Loans in a CLO are bundled together, and if they default, the risky bottom layer loses more. Once the lower levels are wiped out, the damage trickles upward to the safest loans. Right now, the CLO market is bigger than the CDO market at its peak.
To offset these losses—pending and actual—banks have kept more capital on hand to protect against a downturn. But no one could have predicted the across-the-board economic wreckage caused by COVID-19.
On their own, CLOs will not eat up capital reserves. But when they’re combined with losses in other asset areas and dried-up revenue sources, financial institutions could be looking at a Lehman Brothers-sized meltdown.
This, of course, had caused them to look for ways to hedge this risk. This effort includes charging interest rates well above the fed target rate and carefully scrutinizing borrowers’ creditworthiness.
The inflation question
On the tips of tongues and in the backs of minds is the idea of post-pandemic inflation. In a sense, it could be the second gut-punch in the fight with COVID-19. In fact, the ingredients are already in the pot—trillions of federal dollars in the economy via loans and relief packages that translate into trillions of dollars of national debt, people out of work, defaulted loans, businesses either shuttered or skimming by, and disruptions in supply chains.
The ingredient that’s missing is a vaccine. That will be a great and glorious day, of course. But once it exists, people could entirely leave lockdowns and resume their consumer lives, which will result in increased demand—but this could involve shortages and stagnant wages that can’t keep up with rising prices. The result is inflation.
It will then fall to the Fed—followed by the banks and other lenders—to determine a course of action to slow it down. Generally speaking, higher interest rates tend to lower inflation—and this, in turn, can slow down available capital for investing.
Easy money isn’t always so easy
When it comes to raising capital, most investors turn toward banks or private lenders. In general, banks are typically more affordable but have more requirements to be approved. Private lenders, although more flexible, are often more expensive because they get funds from investors looking for decent returns and/or banks that lend them money. As a result, the private lender’s cost is passed on to the borrower.
The uncertainties surrounding COVID-19, though, are forcing banks and private lenders to apply more stringent risk assessments to loans, and pricing accordingly. For example, while the Fed establishes a specific rate, LIBOR helps the bank determine points above that interest rate, making it more expensive to borrow money.
At the same time, loan standards have tightened to make the process even more rigorous. This includes more significant documentation, larger down payments, and higher credit scores.
What’s an investor to do?
Investing in anything has a bit of uncertainty in the best of times. But the current environment has loads of it. To better prepare, investors need to ask themselves some serious questions before raising capital:
- How long do you plan on holding onto the asset? Short-term and long-term holdings can have different risk factors, and these have to be weighed against the best predictions for how long COVID-19 will last, when a vaccine will become readily and widely available, and the time it takes for the economy to rebound in a vaccine and a non-vaccine environment.
- Will the investment be a good hedge against inflation? Generally speaking, real estate values and rents increase with inflation. This, however, is a COVID world, and that creates its own set of questions: Will people be able to afford higher rents in a post-pandemic economy? Will small business tenants be able to secure loans? What will be the demand for different property types?
- Are my office/retail buildings going to be worth anything? Because of social distancing, lockdowns, and remote working, the office and retail sectors were especially walloped by the pandemic. Will that change with a vaccine? Will you be able to adapt your structure to meet the new conditions of the new normal? Are you prepared to work with new tenants to help them survive, for your own survival?
- If you’re unable to secure funding through a bank, can you afford financing through a private lending firm? Remember, these options are more expensive, and detailed due diligence and projections for the investment are still required.
- Are you able to weather the uncertainty? Because of uncertainty, values are expected to encounter volatility as the market adjusts and corrects. There will be significant opportunities, but the time horizons for anything are unclear.
A heightened awareness
Many of the issues raised here are nothing new. In many ways, they’re the same concerns and questions to have during any investment time-frame. COVID, though, demands a heightened awareness because of the degree of uncertainty.
While the cheap cost of capital via low interest rates will drive some investments, an investor must also consider both mid- and long-term scenarios based on intended hold periods and the nature and future of the property.
For assistance in determining how to proceed with an investment or to find the right property for your needs, please call Morris Southeast Group at 954.474.1776. You can also reach Ken Morris directly at 954.240.4400 or via email at kenmorris@morrissegroup.com.
Tags: COVID-19, CRE, CRE Capital, CRE Financial Issues
