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Spencer Levy
Hot off the presses this month, a new Viewpoint report from the CBRE Global Research Group breaks down the real estate capital markets and foresees a solid year for real estate investment. That's despite economic headwinds blowing back against the recovery trends that began last year. On this episode, we'll hear directly from some of the leaders who contributed to the report, look at the big picture and put it all in perspective with one of CBRE’s top advisors in debt capital markets.
Val Achtemeier
I will say the shop is still open. Business is getting done. So it's a changing dynamic.
Spencer Levy
That's Val Achtemeier, Vice Chair of CBRE’ s Debt and Structured Finance Group. Based in Los Angeles, Val brings more than three decades of experience and expertise to help us make sense of the numbers, the trends and where the markets may be heading. Coming up, a world of perspective and the latest CBRE Viewpoint on the real estate capital markets. I'm Spencer Levy and that's right now on The Weekly Take.
Spencer Levy
Welcome to The Weekly Take and this week we're going to be talking about what everybody's talking about, the state of the commercial real estate capital markets with several of our leaders from around the world, in addition to Val Achtemeier, one of the smartest minds in debt and structured finance. Val, thanks for joining the show.
Val Achtemeier
Thank you, Spencer.
Spencer Levy
We're speaking about the capital markets today for the reason probably most related to your area of expertise, the debt in structured finance markets. I'm not telling you any secrets here. It's been a choppy ride over the last several months. It's been made worse by the rise of interest rates. It's made worse by the expansion of spreads. Val in a few words, how do you see the markets today?
Val Achtemeier
Well, the markets are really dynamic is probably the most positive things we can say about it. But there's just a lot of movement. Right. We always measure the debt markets, you know, within a few metrics. How strong is the liquidity? How attractive is the pricing? You know, how favorable are the covenants? And really what can we structure for our clients? And we've seen changes in all of those. You know, last year liquidity was extremely abundant. Today there is still liquidity depending on the asset type and profile. But it's definitely more constrained. And then we've also seen price in interest rates across the board from core opportunistic increase both in terms of the index rates and the spread. So we've got less liquidity, higher interest rates and more of a risk off mentality with lenders. But I will say the shop is still open. Business is getting done. So it's a changing dynamic which we expect. There's always cycles within any business model and certainly within the debt, debt environment. So last year was really frothy. This year it's a little more constrained.
Spencer Levy
You were obviously covering all the debt and structured finance market, but you primarily do industrial. Tell me about where pricing is today versus where it was in January for comparable assets.
Val Achtemeier
Sure. So our business model, we focus a lot on industrial and logistics assets and those deals in the sector. We’re also doing a lot of data center, which is flowing fairly closely right now, depending on the profile, to industrial. But if we talk about industrial and logistics financing. In the beginning of the year, in January, we had low index rates, meaning treasuries and the floating rate index were very low and we had really low spreads. But we were really at historic lows both in 2021 and in very early 2022. We started to see cracks kind of in February. You know, we're seeing the index rates creep up a bit in November, December, January. By February you're starting to really see a changing landscape. One thing that's interesting is last year in 2021, in general, bigger was better. Lenders were wanting scale, they were in diversity. It was really great for everyone because bigger was better. But there was money across the board. Right now, depending on the size of the deal, it's really changing the depth of the market and pricing. And round numbers for a fixed rate deal today instead of two and a half to 3%, you're four and a half to five in industrial. Maybe say four and a half to four, seven, five. We have an inverted yield curve. so it's odd because you're actually paying more for a three or a five year loan than you would a seven or a ten. I just had a dialog about that one, $100 million deal. And, you know, really working with the client on the best strategy that they go three years and now pay almost 5% or they do go seven years and pay four and a half, which sounds counterintuitive. But in general, you're kind of four and a half to five for fixed rate money. What's moved even more dramatically is the floating rate money, because the SOFR, which is the short term floating rate index, go from almost 0 to 2.3% today is forecasted to be three and a half percent by December. That has had huge ramifications in the floating rate debt world.
Spencer Levy
Given how strong the rent growth has been in industrial north of 20% or so last year and still well into the double digits this year. Are some of our clients prepared to take negative leverage? Meaning that they would take a cost of debt, capital in excess of the cap rates that are paying for the assets?
Val Achtemeier
You know, we are seeing that is becoming somewhat of a positive financial engineering environment. Right. And so we're still seeing incredibly strong rent growth in many markets Southern California, Northern California, Seattle, New Jersey, you know, many places around the country. So we're really looking at the rent roll and trying to find opportunities. You know, historically, everyone just looked at ten year fixed rate debt. Right now, in some cases, you're better off to even go short term and wait. till you have that noi growth. Loans are generally sized to either debt yield and debt service coverage or debt yield and or debt service coverage.
Spencer Levy
For the purpose of our listeners what a debt yield is, is the debt cap rate. So essentially, if your debt goes up to, say, 60% of your capital stack and the cap rate you paid on an equity basis will say four, your debt cap, your debt yield might be six.
Val Achtemeier
Right. Correct. So a typical sizing mechanism has been a debt yield, which is simple NOI divided by the loan amount. We're now seeing debt service coverage come into play. And even if you get an interest only loan, most lenders are factoring that in, assuming a constant and an amortization of 30 years. So we're really being strategic and talking with our clients. We're always showing all the options, right? Here's what you do if you get a ten year fixed. Here's what you go if you go five or seven year fixed. We could float the short term. Looking at the rent roll, we use CBRE forecasted rental growth and kind of show where we think that that remarket will be on NOI. And you know, if you're looking at your internal rate of return, in many cases you're better off still to go short and plan on refinancing or selling and keeping that optionality to get those higher proceeds as NOI grows. So proceeds matter a lot more sometimes in the interest rate. And so we do find some clients that well on a short term basis accept negative leverage if there's an avenue to get to that higher NOI relatively soon. It varies by client. We're kind of finding if you can get to that higher in NOI through either a contractual renewal or rolling to market with new tenants or a fair market renewal, you typically will find clients accept that for 2 to 4 years. It’s harder to accept it for five, six, seven years because you get to negative. But getting those higher proceeds based on NOI growth really, really helps your levered IRR.
Spencer Levy
Well, at this point, I'd like to bring another perspective into our discussion, namely Chris Ludeman, CBRE Global President of Capital Markets. Here's Chris on what he's seen and heard from clients regarding the impact of rising interest rates.
Chris Ludeman
You know, I've been at this for more than four decades, so I've seen my fair share of cycles. This is a unique set of circumstances in that in most instances, in most geographies and in most product sectors, fundamentals are actually quite good. But we're doing, we're seeing these valuation changes as a result of a math problem. The cost of capital. How capital wants to be paid. Whether it's debt or equity in the face of economic and geopolitical uncertainty as well as inflation has caused investors on both the sell side and the buy side to enter a discovery period. And they're doing this on the heels of very robust activity in terms of how their assets have performed. So in a time like this, it is not uncommon that we’ll experience fluctuation in availability of product as well as the appetite for capital on what to spend, where to spend it and at what kind of expected yields so they can satisfy their own investors.
Spencer Levy
So Val, we just heard Chris Ludeman talking about market conditions and how because of the rapid increase in interest rates, there's been increased uncertainty and it may lead to some less product coming to market. I don't know that was actually our experience in the first half of the year. Where we had near record deal volume as maybe some buyers accelerated or sell decisions partially because they had so much pent up gain. What's been your experience about the amount of product that's on the market,Val?
Val Achtemeier
Well, it's really interesting. For the first half of the year, we have seen in the industrial and logistics sector very strong volume. Some of that was baked in earlier because deals were in process. But I will say, in working very closely with our investment sales team, I think it's going to be a busy fall. Now, we'll everything trade? Maybe not, but I think buyers and sellers, there's a lot of discovery going on. I think a number of investors on the industrial side have made very significant profits and some of them are considering that it still may make sense to sell. Others have a long term view and feel that it's incredibly hard to get entitlements for Industrial. The rental growth is still really strong and they believe in the sector. So it depends on the client. But we're still seeing strong trade volume both on sales and on the debt side. I will say debt has changed where you're seeing less long term fixed rate debt right now.
Spencer Levy
Sure. So let me go back to a word you just used, which is price discovery. And so Val are we at a point now where we have a true reset to the market. Where if you had, say, a core asset in the inland Empire that had everything going for a year ago when it was trading at a three. It's going to trade at something north of that today. I'm not going to put a number out there, but it's 50 to 75 basis points higher. Have sellers said, okay, that's the new market I'm prepared to deal?
Val Achtemeier
Not all sellers have decided that. I think many sellers have decided they've made good profits and they need to move on to the next fund. Or there's a natural life of their investment period. We have some clients that really believe in the sector and feel there'll be a shift at some point in time in the interest rate environment. And that the United States is going to be a great place to invest and they're not ready to accept the lower returns. It really varies by clients. I think gradually people are getting used to a structural shift that we had unusually low interest rates for several years here. And that was coupled with, at least in the industrial sector, the best supply demand fundamentals and rental growth that we've ever seen. And so I think some people are accepting that there's going to be a bit of a new dynamic in terms of cap rates. Others believe it may shift. And that's the beauty of the industry, right? It's dynamic and we keep seeing it change.
Spencer Levy
Well, another beauty of our industry, I think, is that this go-around, we do not see the overleveraging problem that we saw back in the ‘07-’08 period. And so I think that many of our clients will have greater durability today to make that choice to buy, sell or hold. And on that hold decision, we believe interest rates are going to drop starting in ‘24. So there is tremendous logic to just holding and waiting for the cost of debt to come back down.
Val Achtemeier
Right. I think at the asset level and at the corporate level in general, borrowers are in good shape. They're not overleveraged. They don't have a lot of other liabilities that are going to drag them down. We've had other cycles where people had really cash constraints. Huge, huge, significant cash flow considerations and demands. We're not really seeing that at this point anyway. And so it's really more of a how much profit do they want to take or whatever, at least in the industrial sector. We're not seeing any sense of desperation. Most importantly, the fundamentals are still staying strong. At the same time, I think there's a realization when you look at the forward curve, you know, hard to predict, but most people are thinking that, you know, treasuries are going to have a three handle on it for the foreseeable future.
Spencer Levy
So Val, to maybe interrupt you here for a second. You use the word forward curve for the purposes of our listeners, what the forward curve is projecting out the yields for securities, for bonds, for corporate treasury bonds from three, five, ten, even 30 years out. But, Val, you're suggesting that most of our investors believe that it's going to stay at around that 3% level for several years. Is that fair?
Val Achtemeier
Yeah. You know, when we look at the ten year Treasury rate, it's around 2.75%. We were up above 3%. We're following the forward curve, which is the forecast for treasuries and so far more closely than we ever have, because we've seen such a rapid increase in those. We've seen the forward curve for treasuries calm down a bit and stabilized. But, you know, we got very used to Treasuries being in the 1.5, 1.75% range. When you look forward, what's being forecasted is more of a 2.75 to 3 or three in a quarter range for Treasuries. So I think there's a realization that most investors are not expecting Treasuries to get down in the 1.5% range again. I think the credit spread or the risk premium still has a lot of volatility and that may move up and down. But we're following the curve a lot. And I believe most investors are expecting that to stay closer to some five or 3%.
Spencer Levy
Well, I think the risk premium is not going to come down materially until two things happen. One is that we need to see more lenders come back into the market. That plus inflation coming down, I think will make the market spreads come in. What do you think, though?
Val Achtemeier
Yeah, I may add a few comments there. So the insurance companies have remained active. What we're seeing is that they either have literal or figurative allocations each year. And most of the large insurance companies that have had very, very strong production years. So candidly, they're just not that hungry to stretch and win. And so they're still doing deals. They're a lot more selective. They're out there. I really think on the life co-insurance side, we'll see liquidity get strong again as we move into 2023. Because they always have allocations. It's true life co lenders follow the corporate bond market, but they also have a nice allocation to real estate. They've had very good performance with their real estate. There's not troubled loans. So I think you're going to see liquidity improve. We're kind of the victim there. That life co’s have placed a lot of dollars. And they're kind of tapped out a little bit for the rest of the year. On the bank side, we're seeing the stress test really play a factor right now. All the large banks are going through stress tests. What's happening is the banks aren't getting paid off as much as they were in the past two or three years. So there's been this big burn off over the last several years. And now a lot of people are just staying put. And then they're getting the stress test analysis and they just don't have as much balance sheet capacity. So they're also not quite as competitive or hungry. There are a number of very large banks that are essentially on pause. Will they do certain deals? Yes, but they're not hungry for a transactional basis just to do more business. And that's impacting larger loans more than it is medium-sized loans. We have seen the middle tier banks really step up and perform well and stretched to win business. Trying to lure some clients and get business. We're starting to see some early cracks in that where they're also getting a little fall and doing some testing. We've seen a few of our middle tier, medium sized banks start to pause a tad. We're hoping it's not a long term effect, but I would keep an eye on that. We're starting to see them pause a bit as well. And then, you know, the debt funds, which is really more of a bridge lending function, a little bit higher yielding, little bit more of a transitional or opportunistic type thing. They're still on the market, but their cost of capital has went up dramatically. So we're seeing some retrading there and we're seeing certainly spreads increase and the overall cost of capital for debt funds go up. The good thing is, depending on the sector, there's still liquidity, but there's definitely more constrained liquidity and there's a lot of price discovery.
Spencer Levy
And I think a lot of that will come in as we see inflation begin to tick down. That will bring spreads in as the risk profile of the worst case scenarios get further off the table.
About now is the perfect opportunity to share thoughts from our colleague Brian staffers CBRE’s Global President for Debt and Structured Finance, who recently ended a stint as chair of the Mortgage Bankers Association.
Brian Stoffers
I just came from a mortgage bankers conference that was largely populated with single family lenders and their pipeline of active applications in May fell off a cliff. As they put it. The interest rate increases in the single family world are profound and having a very serious impact on everything in that arena. And there's discussion now of price declines. Certainly more availability of housing that has been very, very tight over the last three or four years. So the attitudes seem pretty, pretty dismal on that side of the ledger. I would offer that commercial real estate is a little different, but we are going to feel some of the same types of pain ultimately, in my opinion. And I do think that the likelihood of a recession later this year, next year, is quite high.
Spencer Levy
Well Val, Brian Staffers talked about some of the volatility in the banks related to single family, how it will bleed into commercial and also use the R-word recession. So that when you're speaking to your clients, the R-word recession, how much is that coming into play?
Val Achtemeier
The recessionary risk is a big factor, and I think our clients are definitely looking at it. Most of our clients believe we may enter a recession, but they'll be a soft landing. And as relates to commercial real estate, it feels like we're at least not leading this into a recession at this point in time. As we mentioned earlier most of our clients have solid balance sheets and they're not over leveraged. But it's a concern in certain sectors about the growth prospects and how to really forecast your business going forward. But I think there's a, you know, odds on favorite that there'll be a recessionary environment, but hopefully a soft landing. And not as severe as it could have been if no action was taken.
Spencer Levy
If there's any silver lining to what is going to be what is and is going to be a challenging environment for some time, is that maybe some of the downturn in the single family housing market will drop some of the prices of the commodities that are needed to build industrial and other classes. The price of wood, price of concrete and other things, but also the price of labor. So we hope that the market bounces itself out and the Fed does its job talking the market down rather than necessarily forcing it down.
Val Achtemeier
Well, there was definitely a bit of an asset bubble and a commodity bubble going on. Right. So I think it's good to stabilize those things and have more sustainable growth. At least that's my opinion.
Spencer Levy
I would agree with that. But let's now move on to a topic of ESG and its effect on the capital markets. For that, we turn to CBRE’s, head of capital markets in Europe. Chris Brett. Europe has been leading the charge in this area, so we asked Chris for a view on that priority and how ESG related conversations continued to evolve, if at all.
Chris Brett
It is number one on the list of every bank, number one on the list of every buyer, every seller, every advisor and every tenant. Right. This is a tenant – largely, I believe, a tenant driven change that we're gonna see. The big impact that we're seeing most recently has been embedded carbon and how that is affecting the redevelopment of assets – which, you know, I don't think was necessarily as big an issue 12 to 18 months ago. Not being able to take a building down is a big change in the way this is evolving. The focus on EPC – energy performance certification – across different countries. The different regulations that are being brought in by the regulatory authorities across different European countries is having a massive, massive impact. And at no stage in any part of the sales process or an acquisition process are we able to get away from how big an issue ESG is.
Spencer Levy
So Val, if we were having this conversation three years ago, I probably would have said Val, ESG or really the E matters most, if not totally in the office sector where the tenants are demanding it. And if you're not green, if you’re not LEED or Energy Star certified, good luck getting a top quality tenant. But the world has changed. And I believe now we're seeing the need to be ESG compliant in all asset types, increasingly in industrial. What's your point of view and houses impacting the market?
Val Achtemeier
We believe that ESG is going to continue to increase in importance and relevance. We're seeing more and more lenders and more and more investors consider it a high priority. So I think it's here to stay and it's going to grow in prominence, you know. So I'm with you. I think getting your LEED certification and focus on your carbon footprint and being green is a big factor. And it's going to continue to grow in popularity. And really the demands are going to be there that it's a smart business move to move in that direction. I'm also very much a big fan of governance as well. I'm a big proponent of diversity. And so we talk a lot about the energy aspect of it. But I'm also hoping we see more gains in true diversity and opportunities as well.
Spencer Levy
Amen to that. And I think we are still at the beginning stages there, though, where you certainly have heightened awareness of it. And we were seeing some results from the board level down to our subcontractors.
Val Achtemeier
I think you'll eventually see public pension plans demand a lot more on the governance side as relates to diversity. And I think they're going to force companies to share a lot more information and be more transparent. So it's something we should all be prepared for.
Spencer Levy
I think we're already seeing it. Already seeing it. Let me ask you a very specific question about lending and Industrial for just a moment. On the ESG front, I was speaking to a large European lender who was very ESG focused on the equity side, but said that on the debt side, they're not requiring it because it would put them out of the market – basically imposing another requirement on their borrowers. We're also not seeing a lot of the occupiers in many of the large industrial sites demanding green either. At least that's my perception. What's your perception on lenders requiring it and occupiers requiring it?
Val Achtemeier
I would agree with your earlier comments that on the lender side, we're not seeing it be a requirement yet, but I believe it's a preferred route. We're starting to see it become more prominent. But it is not a requirement at this point in time. We're getting some questions. A few of the European lenders will ask more questions about it. I think you're going to see it grow in popularity and really become more of a requirement. But right now it's really getting loud on the equity side more than the debt side.
Spencer Levy
Got it. And the occupiers are sort of hit or miss on whether they require it?
Val Achtemeier
Hit or miss, I mean, candidly, historically, they've always looked at the cost differential. And I think you're starting to see that wane a little bit. Right. And there was a big discussion for a long time about how much more the lead certifications cost and what you really got for it. But I think they're becoming more and more understanding, you know, to be socially responsible and also in a tight labor market attract talent. So it's becoming an issue. But I think the equity sides are definitely leading it more than the debt side. I think the debt's in arrears on that and I'll follow a little bit they're lagging.
Spencer Levy
LEED and Energy Star are important, but they aren't the only game in town anymore. I note with a plug to our friends on the GWS side just wrote a whole paper on carbon capture, and we hope to have a future episode on that as well. But now let's pull back the lens for a moment and get more strategic – specifically on the question of debt versus equity investment at this point of the cycle. Here's Greg Hyland, head of Capital Markets in Asia- Pacific.
Greg Hyland
I think this is a difficult question to answer, and it really depends on what an investor’s strategy is. I think if you look in debt at this time of the cycle, obviously with rising rates, you can secure attractive returns and often on a first mortgage secured basis. So on a risk adjusted returns that can be achieved can be quite attractive. But genuine debt strategies are also capped on the type of returns that you can make. With regards to equity we are starting to see some dislocations or the evidence of dislocations in markets as rate rises. So equity investments are going to still remain important and they could be opportunities that emerge if interest rates continue to rise and those groups that are forced or in a stress position to sell that equity investment could find an attractive point of entry.
Spencer Levy
So that brings up a very important question about capital flows from Europe and from Asia and how it's impacting the market. What I'm hearing is that because the U.S. dollar is so strong, it's hard for that money to come in because hedging costs are so high. How are you seeing foreign money impacting the market? How many foreign either buyers or lenders do you work with?
Val Achtemeier
We definitely have a global reach when it comes to capital on the debt side and also with clients. I've had a few observations. We're seeing some of the large infrastructure funds. We're doing a lot of data center financing. We have seen them be incredibly competitive on data center construction loans. Little bit different group than the traditional commercial real estate. And a number of the Asian and European sources of capital are strong there in their infrastructure groups. I think it kind of ties in a little bit with ESG, a little bit different orientation. So we've continued to see that be strong. On the other side, we do a lot of triple net lease deals in the industrial world, right, with a lot of large investment grade tenants. And there were a number of European banks that were really leading that sector. They couldn't get enough of the paper and they backed off. Right. There's a flood of certain credits out there, and so we've definitely seen some of the European banks pause a bit on the triple net deals. Hey, everything’s cyclical. And there's things that have to clear the market. But I would say we have seen the infrastructure side with some global capital actually increase in activity over the last six months. And maybe be a little more competitive than some of the U.S. regulated banks. While we've seen some European banks that used to be very competitive at white hot pricing for triple net investment grade deals, slow down a bit.
Spencer Levy
Well, I love what you're saying about infrastructure funds. And by the way, shameless plug we're hoping to have an infrastructure episode on The Weekly Take soon.
Val Achtemeier
Great.
Spencer Levy
Because I think it's such a big, important category that encompasses more than people think. It now encompasses data centers. It obviously encompasses traditional infrastructure, water treatment plants, roads.
Val Achtemeier
Airports.
Spencer Levy
Transportation. Some might argue, does it cover logistics? And so I think that you might see that definition expand, which would bring more capital into our sector for traditional assets as well.
Val Achtemeier
I think so, too. I think we're going to see a lot more capital and competitive transactions in the infrastructure world. Even we do a lot of municipal ground leases on our team. It's an expertise that we have with airports and ports and marinas. And I think there'll be additional capital coming from the infrastructure funds for some of those. So we're starting to do a number of transactions, bringing that relatively new source of capital to our clients and it's accretive and very beneficial.
Spencer Levy
Great. I could speak to you for hours. I would also say and I say this with great affection Val and my wife are good friends, too. Every time we go to an event together,Val wants to hang out with my wife more than me. And I'm like, have at it.
Val Achtemeier
I do. We're great friends and companions and we have a lot of the same interests, so I can't wait to see her again.
Spencer Levy
Oh, well, I hope to get her out to one of our events soon so you guys can hang out.
Val Achtemeier
Excellent.
Spencer Levy
But, Val, in the last minute or two, why don't you just give us your final thoughts on where the debt capital markets are today. What's the basic advice you're giving to our clients?
Val Achtemeier
Yeah, well, I'm trying not to overreact. Right. I think we've had an incredibly low interest rate environment over the past few years with really robust liquidity. But our market is cyclical. Good projects and good teams continue to attract capital, continue to make money, and continue to make good investments. And what we're trying to do and we are doing is being a good strategic advisor that offers excellent optionality and outlines what can and can't be done. And we also like to search for that unicorn quote. We have a knack of finding a quote that's really an outlier that makes everything work. You know, I used to hear anybody can give it away and it's a little more of a challenge to get that outlier quote that really satisfies the clients and hits everything. It takes more effort. It takes more. I personally don't think commercial real estate financing is a commodity. I think it's very relationship oriented. And knowing your client and their strategy and the product and really connecting the debt capital with your client is an expertize. So we like to search to get that above average kind of excellent quote. And it's more challenging today. But we like challenges, right? We've had a few years. We're pretty easy, so it's a good time to rise to the occasion.
Spencer Levy
Well said, Val, on behalf of The Weekly Take, I am delighted to have our friend, colleague, Vice Chair Val Achtemeier, one of the leaders of our debt and structured finance practice based in Los Angeles. Thanks for joining the show.
Val Achtemeier
Well Spencer, thank you. It's always a pleasure to talk with you. And I really, really appreciate the opportunity. And I can't wait to see you in person again.
Spencer Levy
Can't wait, too, Val.
Val Achtemeier
Thank you.
Spencer Levy
For more on the debt, capital markets and CBRE’s Viewpoint Report, please visit our website CBRE.com/TheWeeklyTake. We'll post a link to the complete Viewpoint with all the analysis from the leaders featured on our show; Global President of Capital Markets Chris Ludeman, Global President of Debt and Structured Finance, Brian Stoffers, Head of Capital Markets in Europe Chris Brett, and Greg Hyland, head of Capital Markets in Asia-Pacific. We thank them all for offering their insights on our air. As always, our website features lots more information on our show, including ways to share the episodes. And you can also subscribe, rate and review us wherever you listen. Thanks for joining us. I'm Spencer Levy. Be smart. Be safe. Be well.
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