2023 Winter Issue - 110

backpage
JOHN B. LEVY
In the Land
of Broken
Deals
Four key commercial real estate lending
trends for 2023 as the market returns to
a " negative leverage " environment.
The year 2022 started out peacefully
enough. The 10-year Treasury yield was a
borrower-friendly 1.6 percent, and most
Americans, if asked, could not locate
Ukraine on a map. Further, in the minds
of many investors, high inflation was
generally thought to be transitory.
But, seemingly overnight, the smooth
sailing changed. The 10-year Treasury yield
doubled within less than three months-a
speed not seen before. Commercial real
estate transactions, which had enjoyed a
banner year in 2021 and the first quarter of
2022, suddenly hit a logjam.
The year became, in effect, the land
of broken deals. Purchasers found that
borrowing was at once more difficult and
more expensive. Commercial mortgages,
which had been reasonably available from
institutional lenders, such as insurance
companies and pension funds, in the 65
percent loan-to-value range, now tightened
to the 55 to 60 percent range.
Sellers, whose offerings had in many
cases been " priced to perfection, " found
buyers unable or unwilling to complete
and close their acquisitions as previously
agreed to. The increase in " broken deals "
was almost solely caused by the skyrocketing
costs of both short- and long-term
interest rates.
For grizzled veterans of commercial real
estate, this return to a " negative leverage "
environment may have been unforeseen
but surely was not unique. Generally, at
least for the past 15 years or so, interest
rates were lower than capitalization rates
caused in no small part by an accommodative
Federal Reserve banking system. As
a result, buyers were able to increase their
equity yields by adding more leverage to
acquisitions, so-called positive leverage.
The change from a positive-leverage
environment to a negative-leverage one
can dramatically reduce loan sizes.
For example, consider a $20 million purchase
in January 2022 with a debt-servicecoverage
ratio of 1.25x and an interest rate
of 3.5 percent, which requires equity of
$5.15 million. By October 2022, with a 6
percent interest rate, negative leverage is
in full effect. As a result, purchasing the
same property at the same price requires
equity of $8.9 million, a whopping 71 percent
increase.
John B. Levy is president of John B. Levy &
Company Inc.
108
URBAN LAND
WINTER 2023
To virtually no one's surprise, transaction
volume collapsed, as did institutional
lending volume. According to our proprietary
Giliberto-Levy Commercial Mortgage
Performance Index, institutional lending
volume for June, July, and August 2022
was less than half the volume of the same
period during the halcyon days of 2021.
Perhaps even more surprising, the 2022
volume was 15 percent less than during
summer 2020, which was the height of the
COVID-19 lockdown.
Based on a continuation of high inflation,
high short- and long-term rates,
and restrictive leverage from institutional
and bank lenders, here is our view of the
road ahead:
1. We expect borrowers to suffer " sticker
shock " both because interest rates are
higher than those seen in quite a while
and because leverage is lower. Assuredly,
volume will take a hit. To manage the need
for more equity, we expect more requests
for preferred equity, mezzanine debt, and
other forms of high-yield debt, which
are senior to equity but junior to first
mortgages.
2. There should be ample amounts
of high-yield debt to manage the gap
between equity and first mortgages.
According to our proprietary commercial
real estate high-yield debt index, the
Giliberto-Levy 2 (G-L 2) high-yield debt
performs quite well even under stressful
economic conditions. For example, if the
forthcoming recession were to resemble
the Global Financial Crisis of 2008-2009,
which showed a 30 percent decline in
commercial real estate value, we would
expect the G-L 2 Index to show a potential
loss exposure of 9.7 percent. While no
investor is happy with a loss, a loss of less
than 10 percent is thought to be modest.
3. Some lenders will view this environment
opportunistically while others will
take a conservative approach. Now more
than ever, transactions need multiple bids
from lenders to determine the market.
4. Construction loans will continue to be
in short supply until permanent loan rates
show more stability. UL
JOHN B. LEVY is president of John B. Levy & Company Inc.,
a Richmond, Virginia-based real estate investment banking firm
that raises equity and debt for commercial real estate owners and
developers.
2023 Winter Issue

Table of Contents for the Digital Edition of 2023 Winter Issue
