One-on-One With CREFC’s Lisa Pendergast

There was a lot of separating hype and headlines from reality at yesterday’s CRE Finance Council conference in New York City. Regional banks, for example, do not hold as much real estate debt as the mainstream media thinks they do, and lenders are more eager to extend loans than foreclose on borrowers. But there was no sugarcoating things: the CRE debt markets are facing several major challenges, including $1.6 trillion of maturing debt at a time when interest rates are high and values are declining,

In between the panels and punditry, CPE sat down with CREFC Executive Director Lisa Pendergast to find out what she is seeing and hearing at the conference and in her role at the organization.

CPE: How would you describe the current CRE debt market environment? How does it compare to what the industry was facing during the Great Financial Crisis?

Pendergast: I think the best way to describe it is constructive. It is a challenging environment, and yet we entered the period with loans that were conservatively underwritten. We learned our lessons from the GFC, and they have been applied. That’s a positive development. However, the market is the issue this time around. The Fed has been aggressive. They have raised rates 11 times. We are at a 5.25 percent to 5.50 percent benchmark Fed Funds rate, which is the benchmark of benchmarks. When you add to that a five-, seven-, or 10-year Treasury swap rate, and you add spread to that, your loans now are quite higher.

So, if you’re looking to refinance the almost $600 billion that comes due this year, it’s going to be challenging because that 4 percent loan has become a 7 percent, 8 percent, or 9 percent loan. And, even if you were to get that loan, there is good chance that your lender would ask you to pay down some portion of the loan because it just doesn’t work anymore. That’s because valuations are down. It can be painful.

Some office owners, for example, I think are saying: “If I see long-term value in the asset, I might be willing to put more capital into it. But, if I don’t, I’m probably handing you over the keys.” And that’s a business decision. In this current environment, where there has been such a violent knee-jerk reaction to the rate market, you’re going to see more of that. At a certain level, lenders would prefer to get repaid rather than take back an asset that’s probably, hopefully worth as much as the loan. But maybe not. So there could be a loss.

The reality is, however, there’s less vitriol in this period than there was during the GFC because I think there was the sense that everything was a bit more stressed. Leverage was higher. Coverage was lower. There was less structure or complicated structures that may or may not have worked back then.

CPE: Many panelists today are try to unpack and debunk some of the hysteria around CRE’s massive debt burden. How concerned are you about the increase in delinquencies and defaults?

Pendergast: I am very concerned. There is very little argument for no increase in delinquencies. You will see delinquencies rise. What is surprising, and interesting, is in the CMBS market delinquencies are only about 4 percent or so, and delinquencies for banks and life companies are in basis points—less than 1 percent—by a significant margin.

Again, it goes back to loans that were properly underwritten in a fairly conservative way. However, it’s uncomfortable to know that valuations have declined as much as they have, especially in office, because of the work-from-home dynamic. Yet I’m hearing more and more that there are more four-day in-office requirements than there were even just six months ago. That’s a good sign for office.

What’s going to happen in the office market, though, is that you will start seeing some of those really old office buildings just go away. They may have potential for conversion to multifamily, but it’s really only those smaller office properties that work from a conversion perspective. I think what’s going to happen is some of the B & C class, smaller, older vintage office properties might be good fodder–if not for the asset itself, for the pieces of land on which they sit.

CPE: Bank capital standards are being debated in Washington. What impact could that have on CRE’s relationship to banks?

Pendergast: To us, the Basel Capital rules—they are calling it the Basel Endgame or the Basel IV—would be extremely harmful to the commercial real estate market. Bank capital would rise around 20 percent for CRE, which is significant. And this is just one more assault on CRE debt liquidity at a time when it really is essential that we pull the sector through. It always has the potential, like other core markets, to negatively impact the U.S. economy in a reasonably solid way.

CPE: CMBS and CLO issues are down to roughly one-third of what they were last year. Do you see that improving as the year wraps up?

Pendergast: It’s way down. I think that has to do with many things, including the decline in the SASB market, which is based on SOFR and large floating-rate loans. It goes back to the issue of it’s just difficult to make those loans work, and it’s mostly driven by rates as well as valuations coming off the properties. And the CMBS markets is also the capital markets. There has been a good volatility in rates, and it is hard to close a loan and make sure you are getting it right.

For CMBS, the other side of it is the demand. Institutional investors buy CMBS—not Mom and Pop—and they are concerned, not knowing where the office market is going to go, for example. The biggest concern is: Does the bond pay off? Does the bond pay off in time? Is it extended? Or does it default outright?

Issuance is down and, when issuance is down, it oftentimes negatively impacts bond liquidity. If you have a lot of issuance, a lot of float in the CMBS market, it makes it much easier to buy and sell bonds on the secondary market.

I think what going to happen here is the conduit market is going to gain strength. First of all, (investors) are not committing to a $100 million loan, and investors are going to appreciate the diversity in terms of what goes into a conduit—multifamily, industrial, retail, hotel, office and then some other little sectors that are usually no more than 5 percent of the pool.

That’s an interesting dynamic because, for a while, the pendulum went completely to the SASB big giant deals. So, the CMBS market will come back. I think it will come back first, surprisingly, via the conduit market.

CPE: What is there to be optimistic about?
Pendergast: We need the world to stand still a bit. We need the Fed to stand still a lot. The Fed seems like they have at least another 25 basis point move in them. It would be fantastic if that would be the end. It is, again, the uncertainty that roils markets. Having the sense that they are getting close, even if it’s not the next 25 but the one after that, is better than where we were at the start. So I think you need some stability in rates.

Basically, when you raise rates, you’re slowing the economy. Stop raising rates and the economy may start to grow again, though I don’t know at how fast a clip, given how far they have moved rates. But it’s the beginning of the recovery where you feel like the Fed feels like they have done enough to stave off inflation, and now you could actually start to see some growth but not outsize growth that would cause inflation to recirculate.

Also, if you have banks with all of these new capital rules, you might find that the best way to disintermediate risk in capital is, once again, through the conduit CMBS market. It’s the reason why it started to begin with. So I think that can be helpful. And, like I said, the markets need to feel better before you start writing large SASB loans gain. Not to say they’re not doing any. But for a lot of those large SASB loans, if there’s efficacy in the property and the ability to resume payments, I think you’ll see some of these lenders just extend the existing loan, and that is a great option to have. It is not used lightly. You do it for solid borrowers and assets that are really going to work on a going-forward basis the way they were or close to the way they were.

It’s an interesting time. Honestly, I have always found the cycles—I’ve been in this business for a couple of decades—are fascinating to watch, even though it’s painful to participate in.