Ares US Real Estate is preparing for a significant uptick in its commercial real estate lending business as more investors become aware of the benefits of debt as an investment and banks retrench in the wake of recent distress, according to Bryan Donohoe, partner and co-head of the group.
The firm made its initial case in an eight-page white paper released last week, which cited rising base rates, wider credit spreads, increased equity subordination from lower loan-to-value ratios, and a growing funding gap.
“Part of the backdrop of everything we do at Ares is pattern recognition,” Donohoe said. “When we look at the landscape and see financial institutions getting into trouble because of a mismatch between assets and liabilities, we know that what follows in many instances are periods of illiquidity and increased regulation. This creates the opportunity for private capital providers to partner with or replace banks and drives higher yields for investors.”
There is a market-wide expectation that interest rates will be higher for longer as the Federal Reserve works to control inflation. After the introduction of a hawkish interest rate policy in March 2022, base rates have climbed for floating- and fixed-rate benchmarks.
One-month term SOFR, the most common rate used to determine dollar-based US commercial real estate loans, rose from a level close to zero in January 2022 to more than 4.6 percent at the end of the first quarter. Similar European and UK benchmarks have seen commensurate increases. While rates can move quickly, the white paper cited forecasts in which base rates will remain elevated for the foreseeable future.
“Part of the reason that the narrative today is moving first toward real estate credit is that there is a shortage of debt available. The equity opportunity set will grow out of credit opportunities at the outset,” Donohoe said. “The yields available are very attractive and a new loan today could have a rate of 8.5 percent on an unlevered basis with levered yields in the low teens.”
According to May data from the Federal Deposit Insurance Corporation, the average loan-to-value ratio of new bank loans which have been underwritten since the failure of Silicon Valley Bank is around 50 percent. That is a 30-year low, Donohoe noted.
“We see an environment where there are attractive opportunities given leverage is lower, asset values have reset and, uniquely at this point in the cycle, base rates are remaining high. Even if they come down a little bit, there is still an attractive unlevered yield on cost in the real estate lending spectrum.”
The global financial crisis led to increased regulation in the US, the UK and Europe, which in turn led banks to scale back their commercial real estate lending. Ares is expected to see this trend continue in the wake of recent bank failures, broader market volatility and the long-term impact of the covid-19 pandemic.
“The pullback is happening as banks are being attacked on both sides of their balance sheets at the same time with their liabilities, or deposits, exiting for various reasons, and asset level issues in commercial real estate and credit are beginning to surface,” Donohoe said. “This means they will be less able to participate in the next iteration of real estate lending. When that pullback occurs, someone needs to step in and the folks to step in will be private lenders.”
While the transaction market continues to be slow, with few comparable sales completed, Donohoe notes that Ares is underwriting cautiously.
“As we wait for rates to stabilise, pointing specifically to a value remains difficult,” Donohoe said. “But if we can write a 60 percent loan against a valuation that is down 15 percent or 20 percent, the equity subordination is very significant and allows for a very attractive lending situation from a principal protection perspective.”
The firm also looks at the historic relationship between the 10-year Treasury and BBB corporate bonds, especially in the real estate sector, and cap rates.
“But it is really the cashflow profile and what we can see happening during our hold period,” Donohoe said, noting that the real estate market’s strength varies by sector. “In industrial, when we look across to our Ares real estate equity colleagues, we are seeing strong fundamentals where tenants are staying put, renewing their leases and are seeing their rents increase 70 percent to 75 percent.”
Lenders have the upper hand today in terms of negotiating higher credit spreads, lower detachment points for LTVs and better structural protections. “In a normal market, or a market in equilibrium, equity valuations inform the value of debt,” Donohoe said. “And in a market like today, it is the debt that informs the value of the equity.”