Since earlier this year, when it became clear there were some troubled players among regional banks, investors in commercial real estate that had dry powder at their disposal have been waiting for an opportunity to acquire good properties at substantial discounts or become a source of rescue capital for borrowers struggling to secure refinancing and earn attractive yields. And, in fact, the expectations that regional and local banks would pull back on their real estate loan originations in response to the turmoil within the sector have come true. In the second quarter, commercial real estate originations by smaller banks fell by 53% year-over-year, according to an Oct. 2 note by Jim Costello, executive director of MSCI Research and chief economist with the MSCI Real Assets team. Smaller banks’ share of the commercial real estate originations market shrank from 34.2% to 25.1% between the first and second quarter of 2023, an unprecedented quarterly drop, Costello wrote.
Yet what hasn’t materialized is a significant amount of distress or a noticeable gap in lending activity in the secondary and tertiary markets local and regional banks typically serve, Costello told WealthManagement.com in a recent interview. Some of the business left on the table by the small banks appears to be going to private capital. But that doesn't preclude a bigger liquidity crunch from eventually emerging as the market deals with higher interest rates and fewer lending sources, he noted.
For the moment, the commercial real estate environment in the U.S. is that of “less bad” news as month-over-month drops in investment sales volume are gradually growing smaller and, in rare segments, reaching pre-COVID levels. But contrary to many investors’ hope at the beginning of 2023, interest rates are not coming down and the bid/ask gap between buyers and sellers has yet to be fully resolved.
Below is a full transcript of our conversation with Jim Costello.
It has been edited for length, style and clarity.
WealthManagement.com: Your recent note about small banks mentioned that there was a significant drop in commercial real estate lending in the second quarter. So I wanted to start by talking about how concerned you are about that drop and how it’s impacting the real estate investment sales market?
Jim Costello: It’s been tricky. The regional and local banks pulled back their originations in the second quarter. They lost market share, not just market share though—their level fell. Normally you’d see a rise in their lending activity between Q1 and Q2, just because of seasonal patterns. If deal volume is about the same between the two quarters--deal volume on the equity side--then they’ll be needing about the same amount of debt, so there’s usually an increase. The Q2 increase for the regional banks didn’t happen. It was flat or actually down a little bit. I suspect it’s probably a function of the turmoil with Silicon Valley Bank, Signature, First Republic, all these smaller banks suddenly are facing turmoil. All the others I suspect just really had to pull back on the fear that their regulators are going to look at them more closely. They’ll need the reserve capital just in case and so it became a challenge for them.
I think that this issue is not going away quickly. It’s not the kind of thing that can be reversed overnight. And part of it is they are not sure how much further property prices might decline and they have to be careful in what they are doing in terms of putting credit forward.
WealthManagement.com: I definitely want to come back to the question of property valuations, but was also curious—when you were looking at market activity, have you seen in the second quarter any other types of lenders coming into the market and maybe picking up some of that lending that would normally be done by small and regional banks? Has anyone stepped into that gap in any significant way?
Jim Costello: This is the thing—capital markets, if there is money to be made, someone is going to step in. And total originations did increase from Q1 to Q2. You saw the agencies in particular stepped up. Fannie and Freddie gained market share. But then there were other lenders coming in—the debt funds, the private credit world, their share was fairly constant. But that means that they probably did more if others are pulling back.
The challenge with the small regional banks is that they tend to do a particular type of loan. There was a lot of fear, some people misread the data from the Federal Reserve earlier in the year. There was a survey from the Fed and someone read it wrong and saw that 70% of the bank lending that the Fed tracked was from the small regional and local banks. And they read that and assumed that it meant all commercial real estate lending was pulling back because of that, that these banks were behind 70% of all commercial real estate lending. But it said nothing about the CMBS market, about the insurance lenders, the agencies. There is a much more diverse capital setup there. But it’s also an issue that the different players tend to focus on different product types. The life insurance companies are focused on different asset types and different sizes than the local banks. If you want a $100 million loan for a property that’s priced at $300 million, you are not going to the local community bank down on the corner to get that loan. They tend to deal with smaller properties in their local areas supporting local businesses. The bigger loans tend to be focused the life insurance companies, CMBS, national banks, international banks. And then debt funds, to some degree.
So, the extent that challenges in liquidity for the small banks translates to challenges in liquidity for sales it’s going to be in secondary and tertiary markets and it’s going to be for smaller properties.
Looking at the deal volume, everything is down for the quarter relative to a year ago. But we are not seeing more of a problem in those locations, so presumably somebody is stepping up, but it’s not always clear exactly where and when. I think the private credit is definitely an element of it. But so far the contraction for the smaller banks doesn’t seem to be harming these smaller areas.
WealthManagement.com: Since the smaller banks tend to do this very specific type of transaction, is the capital that’s coming in going toward that side of the business or it’s just going more toward the bigger properties and the bigger loans and it’s going to be the smaller deals that are going to suffer? But it sounds like so far that’s not what you are seeing.
Jim Costello: Not yet. But here’s the thing—maybe it could. These things don’t happen overnight. We have our loan data through the second quarter, but we don’t know what the third quarter looks like yet. There’s a delay in that stuff. Deal volume was still growing in some areas into the fourth quarter of 2022. It was growing at a slower pace, but people knew that interest rates were much higher and you weren’t able to finance the same way as in the past, but some deals got done because they were already baked into the system. They had already lined up the capital, all the participants paid interest rate caps to prevent rate rises from impacting their deals. So it might delay again, the shock to the local banks maybe takes another quarter before it shows up in deal volume.
In our instant world, where everything is on our cell phones, we are used to everything happening right away, but there are structural things or times where the market is a little bit slower to react to news. So far there’s not sign that the smaller markets are suffering, but I don’t know if that’s the reality or it’s just waiting for the next shoe to drop. But so far it looks good.
And when we did our analysis for the debt market, here’s an interesting operational point of view for you. You may have seen in the report the lender composition, all the groups making loans. When we had our data team go and categorize all the lenders making loans. When we did the first cut of that, 5% of the lender types were unknown. We looked at that and reached out to our data team and said “Hey, common, what’s going on here?” And they said a lot of these groups, this was the first time they were coming into the system. So we asked for follow-up research to look at how many new entrants to the lending market we are seeing and a lot of the new entrants ended up in the private credit world. So there is something happening there. We don’t have all the data in yet, I don’t know all the answers, but there is something happening where some new groups came in.
And then I have a couple anecdotes from the people I talk to. This one mortgage broker I know stopped brokering loans and starting doing some bridge lending on his own, from some of the wealth he has collected because there are some borrowers out there who are willing to pay anything to roll the dice one more time. Some folks are coming in for high rate bridge loans on the hope that rates will be down a bit in the future. You look at the expectations around the forward curve ball for SOFR and there is an expectation that rates will come down a bit. And people are acting on that, hoping that maybe they can finance to a more stable, lower rate environment in the future. And some of these groups are coming in with some bridge capital to help people through that gap. How that plays out, that’s anybody’s guess.
WealthManagement.com: I did notice when I was looking at the bigger report that there were lenders that were classified as “unknown” and I did wonder what “unknown” meant.
Jim Costello: We got most of it whittled down to the typical 1% margin of error. But sometimes you see in some public filings here’s a lender with some weird name and you try to find the legal entity and you just can’t find it. There are a few of those time to time and they are usually, if can ever figure it out, there’s a story about some weird relationship that drove it.
WealthManagement.com: My next question is a little bit more on the theoretical side. From your experience, let’s say in the third quarter, in the fourth quarter, when the data comes in, you do start seeing more of the impact from that contraction in the small and regional bank lending. How much of an impact would it have on the larger commercial real estate market if it’s not the big deals that are being hurt?
Jim Costello: This could be interesting. If the smaller market starts to see some pullback in deal volume because of financing challenges from the small banks that were so dominant in those markets, it’s not going to impact the big markets really. Maybe the apartment market in a place like the New York tri-state region, we still have to see how that plays out. Signature Bank was one of the leading lenders for the apartment market in the region. They passed and surpassed the agency lenders. Part of that was just the nature of the apartment market in New York City in particular, it just didn’t fit the agency lenders. It takes a particular kind of lender who’s willing to work with properties that have some type of onerous rent control restrictions. The agencies are taking these loans, originating these loans, packaging them and selling them as securities. When you do that, you want a cookie cutter approach—“I’ve got a certain amount of credit, I’ve got a certain amount of things happening in the building and then here’s this other regulatory environment” and that doesn’t fit well in a package.
If small banks pull back, the New York market might be a little different because the apartment market was so focused from Signature Bank. But the bigger markets and bigger deals were a function of the life insurance companies and CMBS and some of the big banks, so it won’t impact those directly. Indirectly it will, because if I am in Tulsa and suddenly the local banks aren’t lending and I have a property that’s coming up for refinancing, I am going to get on the phone to call my brokers and try to get somebody to get me money someplace else. You start getting a lot of those calls, and maybe some of them redirect a little bit of capital.
WealthManagement.com: What are you seeing with loans that are maybe starting to be distressed, or with loans that are coming to maturity this year or have come to maturity in the past quarter. How are those situations working out? Are we starting to see any kinds of patterns?
Jim Costello: We looked at the distressed data. And it’s still kind of minimal. It’s a slow moving thing so far than the financial crisis. The financial crisis hit December '07—within two years we saw a spike in foreclosure activity. In real estate it takes time for things to happen. There are all kinds of legal stuff to go through. And there is all the friction in the transaction market. And the initial shock here was 2020, we are three years in and the pace of foreclosure is still not where it was. It started to rise and is steadily rising in the office market. It’s still not at the level where it was in the financial crisis. I think some of it is just that it’s distress where there has been some notification, but there’s probably additional stress that hasn’t fully been realized yet because someone is paying their loan hoping it all comes back, even though if they were forced to mark an asset to market they probably couldn’t get the value that they were expecting to get. And that’s the thing—nobody is forcing them to market assets to market value at the moment.
WealthManagement.com: The last time we spoke was right about the end of the first quarter. Back then, the hope was that maybe by the fourth quarter transactions are going to start picking up. And it was already not the most stable time in the bigger geopolitical picture. It seems today we are in an more uncertain environment. Will what’s happening in the world have an impact on the commercial real estate market in the United States?
Jim Costello: There is a lot of craziness in the broader world today. The impact of geopolitical tension I couldn’t venture a guess right now. But I will say this, earlier in the year, it felt like maybe we’ll be better by the end of the year. There were expectations at the time, you talked to a lot of investors early in 2023 and they thought, and it was reflected in the SOFR curve, that rates would be coming down sharply soon and that maybe they would be able to refinance at a more stable level. And because of that maybe deal volume would rise. There were all these maybes that were piling up.
The interest rates weren’t as cooperative as they had hoped. All that said, even with interest rates at this uncooperative level, deal volume has been fairly constant in recent months. And I wonder if we are going to have an improvement in the growth rates for deal volume in the fourth quarter—improvement meaning a less worse pace of decline. It’s just simple math—a year ago was when the decline started and every month since April of this year we’ve seen a steady improvement where it a less worse month every month since. It wasn’t 70% year-over-year decline, it was 60% year-over decline, then 50% and 40% and 30%. And given that we are reacting to a period of excess liquidity that was there in 2021 and 2022 and it was at the end of 2022 when they started reacting to it, I wonder if the growth rates are suddenly going to look a lot better in the fourth quarter. It doesn’t mean the deal volume will be at a higher level, it just means that this high rate of decline goes away as we’ve had a full year of adjusting to a high interest rate environment.
But again, depends on maybe, on if the next shoe drops in some of these smaller markets and nobody can get any deals done if the small banks are still too restrictive. The broader political issues how does that impact real estate? I just don’t know.
WealthManagement.com: I was just thinking back to some of the AFIRE surveys where for the past couple of years people tended to see U.S. commercial real estate as a stable market to put their money in. So I was wondering if the current environment would increase or decrease that sentiment, but I guess we have still to see that.
Jim Costello: I spoke at the AFIRE conference in Amsterdam this summer and there was still a lot of optimism then and people excited about the opportunity to put their money to work in the U.S., but it still had to be at the right price. The cross-border money is here, there are people buying assets, but it’s down like everything else. It doesn’t matter if you are from Europe or Florida, if an owner only wants to sell a building at 5% and I can put my money in a 10-year Treasury that’s at 5%, it just doesn’t fly.
WealthManagement.com: That leads to the next question, which is do you have any sense of how further would prices have to come down to reduce that bid/ask gap? Where are we in that process?
Jim Costello: It’s a little tricky. We do measure—deal volume is down, and you can say to yourself “the buyers are not excited to buy assets at the moment, but how cheap is cheap enough?” We calculated, I have in front of me September 2023 numbers, how big was the gap between buyer and seller expectations and what it would take to close that gap such that we got back to average levels in deal volume. And it’s looking like for the office sector it’s an 11% gap across the whole country. It’s going to be different for individual cities.
But for some sectors, it was much more muted. Industrial was in the 4% range, same with hotel. And it’s a bit of a challenge—deal volume for the limited service segment of the hotel sector is back at the average level that we saw before the COVID crisis. I’d say it’s back to normal. Not all the hotel market though because the full-service stuff still has some challenges with business travel still kind of uncertain and some of the big coastal markets still facing some turmoil. The investors are chasing different stories on the income fundamentals of the properties, so it gives them different comfort levels with each asset class.
WealthManagement.com: For the deals that are still getting today, can you tell if there are any specific investor groups that are more active than others?
Jim Costello: We haven’t done a full decomposition of the buyers that are out there, but when I looked at some of the data, it really points to private capital is the big source of money at the moment. And that’s really what we saw in previous cycles, where there is uncertainty in the marketplace, the institutional buyers tend to pull back first. Simply because they’ve raised a certain amount of money, it’s targeting a certain return profile and that return profile is no longer achievable given how the financing market has worked.
By contrast, the private investors are putting their own money to work, they are willing to take risks at times for specific targeted deals.
WealthManagement.com: That’s across all deal sizes or that’s within specific segments in terms of dollar amount?
Jim Costello: I haven’t looked at the numbers in that kind of a breakdown yet, that was something I was hoping to do next month. I’ve looked only at a very high level across everything.
WealthManagement.com: Is there any advice you have right now for commercial real estate investors, especially the private groups that are active out there?
Jim Costello: This uncertainty we are in, the way to think about it is that what we are dealing with is still a reaction to 2020. When we were all stuck at home on our couches for months at a time, that was a tremendous shock to the global economy. It’s not like you just turn the faucet on and the water comes back on and everything gets back to normal right away. You had a tremendous decline in GDP and then it rebounded tremendously in the following quarters, then everybody did their revenge spending and inflation picked up because people were spending too much at once and there weren’t enough products to go around. That was happening across all elements of the economy.
And so you get that initial shock, and then you get a lot of zigs and zags in commercial property information, and a lot of zigs and zags in financial markets. And the only thing I’d advise people is that if you are making an investment, you’ve got to make sure you are not investing in one of the zigs or zags and pricing as if the zigs and zags will continue forever. You’ve got to think through how much of it is the noise of the still ongoing legacy of COVID and the shocks we experienced from that and how much is the actual underlying trends.
There were a lot of syndicators in the boom period in 2021 and 2022, I am on social media and I was seeing all kinds of ads on my Instagram “Invest money with us, our fund is as good as gold. Guaranteed 20% IRRs!” It was crazy. The algorisms on the social media platforms understood that I like real estate, so they were bringing me all these ads. And I think some of those groups have been in the news recently about having deals go bad.
Those kinds of folks probably got caught in this low rate environment, rising prices, everybody got excited, but it was one of the downswings and the reaction to the medicine that everybody put out there to keep the economy going. And as they take the medicine away, some of the same strategies just don’t work.