A Bridge Over Troubled Water: Debt Funds and Mortgage REITs Come of Age

Andrew Foster is Associate Vice President in MBA’s Commercial/Multifamily Group. He is a regular contributor to MBA NewsLink and MBA Commercial/Multifamily NewsLink and can be reached at afoster@mba.org or 202/557-2740.

Landscape for Pandemic Playbooks Emerges

COVID-19 has negatively impacted industries across the U.S., with commercial real estate and its financiers no exceptions.

The commercial mortgage-backed securities industry, with its publicly available data for existing transactions, has driven headlines with a historic number of loans backed by hospitality and retail collateral being quickly challenged.  Further, several commercial mortgage real estate investment trusts reported stress earlier in the year including a few high-profile margin calls in the sector with volatility in the CMBS market being a primary factor cited. Commercial mortgage REITs as well as debt funds focus on short-term bridge lending. These players and bridge lending strategies writ large in commercial mortgage lending will remain front and center as the crisis continues to play out just as they were pre-pandemic. 

While debt funds and mortgage REITs focus on similar niche lending products, their performance and reactions to COVID-19 have some notable distinctions early on given substantially different funding sources. In particular, it can be challenging to raise capital for public companies involved in commercial real estate lending against a backdrop of falling stock prices. This has led to an inward focus on activities such as asset management and building liquidity for public mortgage REITs, making these market participants less active for new loan originations. For private capital, there has been the opportunity for more activity at least for some. As some funds may have some drawdown capital available not all these market participants need to fundraise in the current environment to lend. This has led to somewhat more participation or at least the option by some private funds as compared to public company peers.

Creative Capital Pre-Covid: New Players Continue to Grow their Footprints

The rise of debt funds, mortgage REITs and other players MBA broadly referred to as “investor-driven lenders” remains at the heart of the commercial real estate finance narrative.

Commercial Property Executive wrote earlier this year, “debt funds or ‘the alternative lenders,’ as they are also known, were brought up in just about every breakout, general session and conversation at the February 2020 MBA CREF conference in San Diego. These funds–there are estimated to be about 140 of them–have quickly become a formidable and aggressive competitor, mostly in the short-term bridge lending space.

Much of the discussion surrounding funds, which offer investors a short-term equity alternative late in the cycle, was about whether or not these maturing vehicles will expand their narrow product scope and become a fiercer competitor. And there were questions about whether they would exit the market when capital becomes more expensive and market fundamentals inevitably weaken.”

It is a varied group with old and new players, both large and small with nuanced lending strategies often targeting different markets or borrower types, so not all necessarily competing directly with all others in the group. These lenders are often called non-bank or alternative lenders, even though there are some banks and life insurance companies with debt fund strategies, which means short labels can be misleading when discussing these lenders. Whatever one decides to call them, you can be sure borrowers have been calling them for shorter-term floating-rate bridge loans in the search for yield environment that has defined this business cycle. 

Tale of Two Funds

Enter COVID-19, a bleak employment outlook and a U.S. recession. Given the challenging landscape for commercial real estate, there are several interesting questions about this group of lenders that will only be answered over time:

–Crowded Trade? With so many new entrants and a non-homogenous group beginning to lend or increasing their activities over the last few years, how will non-bank lenders fare once the tailwinds of economic growth are missing?

–Energizer Bunny? Although the growth in investor-driver lenders is notable, this slice of the market is not huge—Do these players and their capital continue to grow after experiencing their first recession as a substantially larger player in the CRE finance ecosystem?

–Tale of Two Funds? Investor-driven lenders are a bifurcated group. The distinctions between public companies on the one hand and private funds on the other is stark. How will their performance as well as response to market stress and opportunities differ given their varied funding profiles?

–Is the Funder of My Funder My Friend? How will the market for warehouse lines that underpins debt fund strategies continue to evolve in a recession amidst falling rents and lower property values? 

Numbers Game: Researchers Sizing of the Industry’s New Players

National Real Estate Investor magazine reported the following statistics in late February before the second quarter economic contraction occurred: “the latest data from CBRE’s fourth quarter lender survey (2019) showed a sizable spike in activity from alternative lenders.

Alternative lenders led origination activity on non-agency deals with 41 percent of total volume–up from 29 percent during the same period in 2018. Those alternative lenders include debt funds, mortgage REITs and other finance companies. Banks accounted for 26 percent of fourth quarter lending volume, life companies at 21 percent and CMBS at 12 percent.

Although fourth quarter showed some big gains for alternative lenders, CBRE’s full year data is less dramatic. Alternative lenders saw a slight uptick in market share in non-agency lending volume in 2019 from 29.0 percent to 31.0 percent. Life companies also climbed from 22.9 percent to 23.5 percent, while CMBS was flat at 16 percent and bank market share declined from 31.9 percent to 29.0 percent.”

Fast forward to the second quarter, when a GlobeSt.com story highlights, “banks were the source of more than 70% of loan originations in the second quarter, a lending share that has more than doubled from recent averages. Much of that growth was driven by regional banks, according to a CBRE report.”

Jim Costello with Real Capital Analytics analyzes underwriting in his article, CMBS Distress Is Only the Tip of the Iceberg, comparing the current downturn to the Great Financial Crisis, “the CMBS market has not been the primary originator of commercial mortgage debt in this cycle. Banks of all scale have captured a larger share of all commercial mortgage activity than the CMBS market.

These bank lenders were also more aggressive at origination, with higher LTVs than CMBS lenders. However, the aggressiveness of bank lending is tame compared to what some of the investor-driven lenders were doing with their leveraged lending platforms.”

The Real Capital Analytics analysis below looks at office, industrial and retail properties and notes high average LTV percentages for investor-driven lenders as compared to other capital providers as well as an increasingly larger market share between 2007 to 2019.Although often thought of as drivers for the CRE Collateralized Loan Obligations market and its investor base, which heated up the last few years heading into 2020, investor-driven lenders have also piqued the interest of other capital providers such as the banks that finance their activities with warehouse lines. MBA 2020 Chairman Brian Stoffers, CMB, Global President of Debt & Structured Finance with CBRE, commented on this trend to National Real Estate Investor: “The irony is that it is bank financing that is essentially supporting the debt funds through CLOs. So, if banks aren’t getting their money out the front door in traditional bank lending, they are getting it out the back door by basically supporting some of the debt funds through CLOs or warehouse lines.”

In an attempt to size the market, MBA’s Annual Origination Survey tracked $32 billion of mortgage debt intermediated to investor-driven lenders in 2016, $52 billion in 2017 and $67 billion in 2018.

Not all debt funds invested in commercial real estate will likely make it through the downturn without substantial challenges given COVID-19’s negative impact on certain property types and markets, but many that do are likely to find better supply/demand dynamics for capital getting paid for risk when transactions ultimately rebound to a more normalized level.