Traditional banks have long dominated commercial real estate lending. But in light of massive loan maturities, the game is changing. As existing loans reset and more than 64% of US banks tighten standards, borrowers have a pressing problem – where will funding come from?
The answer lies in alternative lending. Preqin projects that private debt funding will experience a compound annual growth rate over 11% from 2022 to 2028. As traditional avenues become more constricted, these flexible capital sources offer credible solutions to fill financing gaps.
Sponsors can leverage additional financing through preferred equity and mezzanine debt. These instruments allow for increased leverage deeper within the capital stack, enabling sponsors to secure funding without giving up control of their equity.
Private lenders can throw lifelines to quality sponsors in today’s monetary policy environment. Here’s what you need to know.
The rise of private debt
Commercial banks hold nearly $3 trillion in commercial real estate loans, but S&P Global Market Intelligence forecasts the private debt market to reach $2.3 trillion by 2027. As conventional lenders face greater constraints, typical funding options for GPs shrink. Factors impacting lending sources include:
Regulatory constraints
Traditional bank lenders face increasing constraints, opening up opportunities for alternative private debt financing. Since the Global Financial Crisis, regulatory pressures and consolidation have led to banks reducing borrowing options.
Loan-to-value ratios
Banks have grown increasingly strict with loan-to-value ratios. As of Q2 2023, the average loan-to-value ratio on commercial assets was 61.4%. Meanwhile, private lenders may provide upwards of 70% leverage or more.
Speed and flexibility
Where banks follow strict underwriting checklists, private debt lenders place greater emphasis on the borrower’s expertise and capability. This nimbleness is key for developers, who often battle long entitlement and engineering timelines. Projects can languish for years before construction finally begins. Economic cycles fluctuate constantly, so the flexibility of private debt creates opportunities.
Preserving equity
The other key advantage of private debt is preserving equity. GPs often prefer paying higher interest rates for a few years versus giving up long-term ownership interests. This helps them secure the funds they need and still maintain control.
Market dynamics and private debt’s role
Amid tightening monetary policies, we are observing significant shifts in project financing – here are the key trends and their implications.
Interest rates
As interest rates rise, traditional lenders are capping financing at lower percentages based on tighter criteria. As a result, sponsors must bring more equity to complete projects.
Supplementary private debt vehicles like mezzanine loans and preferred equity are increasingly filling this equity gap.
Private debt costs more than traditional bank loans. But it can fill financing gaps and allow stalled projects to proceed.
Policy fluctuations
Beyond interest rates, developers face another squeeze from lenders – tightened standards that shrink loan-to-value ratios.
This lending pullback forces sponsors to fill expanding equity gaps themselves. More dollars must come from GPs pockets rather than financing.
Impact of real estate cycles
In 2014, the commercial real estate lending landscape was vastly different. At that time, The Wall Street Journal reported on the easy availability of capital, with commercial property loan volumes reaching $400 billion amidst low interest rates. This inexpensive and plentiful debt helped strengthen the overall CRE market.
As ten-year loans from 2014 reach maturity, properties now face financing renewals in a far more restrictive lending environment. Where owners previously financed at inexpensive rates, today’s higher interest rates require refinancing at an additional premium of 2.5% to 4% on top of current market levels.
This significant rate spike combined with tightened lending standards leads to lower debt-service coverage ratios. Tighter margins between property income and now larger debt payments leave less wiggle room if market fluctuations impact operations.
Opportunities and strategies with private debt
Almost $1.4 trillion in commercial loans will mature in 2024 and 2025. This presents a challenge and a significant opportunity for strategic financing and recapitalization.
In this context, private debt lenders are adopting several strategies that are particularly relevant for GPs looking at options:
- Pre-funding interest at closing to handle unexpected project delays.
- Limited senior leverage in the capital stack to 4x the size of junior capital.
- Requiring minimum equity from sponsors to confirm commitment alignment.
- Structuring shorter 2-4 year loans to enable flexibility in repricing.
- Modeling repayment timing and exit paths early in underwriting stages.
- Provide operational expertise based on years of multifamily experience to help sponsors enhance returns through strategies to improve performance.
Some banks with large reserves may temporarily extend loans and offer concessions to delay maturity. However, most properties will still require alternative financing.
Evaluating private debt partnerships
For sponsors looking at private debt partnerships, here are key questions to consider:
- What leverage thresholds can you accommodate above typical senior bank loan-to-values?
- How much equity commitment do you expect from the sponsor? Is parity preferred?
- Do you pre fund interest?
- How quickly can you commit and close capital?
- What domain expertise can you contribute to enhance project outcomes?
- What communication cadence do you expect around project status?
Key Takeaways
- With traditional lending tightening, flexible private debt can cover sponsors’ capital gaps while limiting ownership dilution and support projects amid uncertainty.
- Impending commercial debt repricing provides opportunity for specialized lenders to aid quality sponsors, who can in turn capitalize on distress sales.
- Sponsors should proactively model scenarios, bulk reserves, and forge partnerships to best position themselves as the market shifts.
