Debt Maturity Wall, Overleverage, and Non-Bank Lending
Periodically, FNRP shares the experience and insights of key members of the team to give our investors an inside look at the people and work that drives our success as a private equity commercial real estate firm. We value the trust and ongoing support of our partners, and through the FNRP Spotlight Series, we strive to create a two-way street where our leaders can share ideas, thoughts on the investing landscape, and provide a glimpse into the projects that are top of mind.
As a vertically integrated commercial real estate private equity firm, First National Realty Partners employs a team of capital markets experts to source debt with speed and flexibility while managing risk for our firm and our investment partners.
FNRP’s Debt Capital Markets Group is led by Managing Director, Jack McLarty, who works closely with Director, Stephen Hassenflu. Together, they maintain relationships with a vast network of lenders to ensure that FNRP is able to borrow capital to fund acquisitions across the country. Since May 2021, they have successfully sourced over $820 million in debt to finance FNRP’s acquisition of necessity-based commercial real estate.
The following is based on a recent interview with Jack and Stephen where they shared insight into the importance of their function within the firm, their thoughts on the key events that have shaped the real estate capital markets over the last few years, and some thoughts on where the market is heading.
Question: What’s the “maturity wall” and how will it affect retail commercial real estate?
Recently, The Wall Street Journal estimated that approximately $900 billion in commercial property loans will mature by the end of 2024. There are concerns throughout the industry that this will create what is known as a maturity wall, or a scenario where a large amount of debt comes due within a short period of time.
Many of the loans coming due by the end of 2024 originated during the low-interest rate environment that persisted through the pandemic. Now, there is concern that borrowers will be forced to refinance this debt at much higher interest rates, which will reduce the amount of cash flow available to investors after making the monthly debt payment. Some property owners may be forced to choose between refinancing at a high rate and accepting negative cash flow or quickly selling the property to avoid ongoing losses.
Jack and Stephen believe that grocery anchored retail will mostly remain insulated from the negative effects being felt by investors in other commercial real estate asset classes due to positive tailwinds which include strong demand from retailers and limited retail space availability. They point out that retail properties are typically financed at lower debt levels, so the need to refinance at higher rates will be less onerous compared to other sectors.
Question: How has retail avoided the overleverage plaguing other property sectors?
Recently, the financial press has highlighted weakness within certain sectors of the commercial real estate market. Notably, office and multifamily assets have come under pressure due to changes in work arrangements and the overleveraging that was brought on by the low interest rate environment we saw during the pandemic. The term “doom-loop scenario” has been used to describe a situation where losses on commercial property loans cause banks to reduce lending activity, which leads to a downward cycle of further drops in property prices and more losses for investors.
When asked about a downward cycle in the industry, Jack and Stephen take a more nuanced approach. They have observed irresponsible borrowing in certain commercial real estate sectors – notably multifamily and industrial. On the other hand, owners of retail properties have largely avoided overleveraging, and as a result, Jack and Stephen are seeing very low levels of distress across the necessity-based retail real estate sector.
They point out that retail property acquisitions are usually underwritten on conservative terms, with loan-to-value ratios in the 55%-65% range. Loan-to-value is calculated as the loan amount at the time of acquisition as a percentage of the purchase price. For comparison, some multifamily and industrial senior loans in recent years have been underwritten at loan-to-value ratios exceeding 70%. Lenders seem to have let their guard down under the premise that multifamily and industrial assets would perform to perfection and the economic climate would remain strong. In recent months, this idea has come under pressure as recessionary fears linger and the performance of these properties has stalled in many cases.
Question: Why aren’t retail property values falling like they are in other property sectors?
Much has been written this year about declining property values, especially in the office sector. Jack and Stephen note that retail properties have not been impacted by cuts to appraised values like other sectors have. They point out that retail properties have remained a strong point this year, which reinforces the idea that necessity-based retail as an asset class is here to stay. It has become an asset class that investors and lenders have taken notice of, and many have decided to add exposure to it as part of a long-term strategy.
While the FNRP Capital Markets Group does not anticipate significant property value declines in the necessity-based retail sector, the firm stands ready to take advantage of forced selling. The FNRP Capital Markets Group maintains a strong network of lenders, which continues to provide the firm with access to debt on acceptable terms.
Question: Why does non-bank capital work well for retail property acquisitions?
A lot has also been written about the scaling back of commercial lending activity at some of the larger banks across the country. One of the major advantages that a private equity firm like FNRP has is the ability to source capital from non-bank lenders. In fact, Jack and Stephen have spent a lot of time in recent months building an extensive network of non-bank lenders, especially life insurance companies. This innovative approach has allowed FNRP to move forward with acquisitions on terms that are expected to produce strong risk-adjusted returns for our investors.
According to Jack and Stephen, life insurance companies focus their lending operations on stabilized, low risk assets and typically lend only on conservative deals. In other words, the underwriting criteria that life insurance companies favor is a near-perfect fit for grocery-anchored retail assets. The ability to borrow funds from life insurance companies to acquire grocery-anchored retail centers is a powerful competitive advantage for FNRP.
As a commercial real estate investor, it’s important to know that many private equity firms operating outside the retail sector are not able to obtain financing from the sources that FNRP has access to as an acquirer of necessity-based retail.
Jack and Stephen point out that investors focused on other sectors are relying heavily on bridge debt to fund acquisitions. Given the current interest rate environment, these variable-rate loans usually come with interest rates that start in the high-8% range and increase from there based on the perceived riskiness of the property. Many investors nowadays are finding that these loans simply don’t allow for profitable acquisitions.
Question: How does FNRP safeguard investor capital?
The FNRP Capital Markets Team understands the importance of risk management and places the highest priority on protecting investors’ capital. Jack and Stephen point out that focusing on necessity-based retail provides a built-in risk reduction mechanism for the firm’s investors and lenders.
Necessity-based retail real estate is a stable asset class, characterized by strong foot traffic and repeat customer visits, even during economic downturns. In most years, grocery sales increase, and during recessionary periods, sales typically remain strong as consumers focus on eating at home to save money. Jack and Stephen note that during the pandemic many retail establishments struggled, but grocery stores performed very well, which reinforced the strength of the necessity-based retail investment thesis in the minds of investors and lenders.
Necessity-based retail real estate has proven to be recession-resistant. It is a fundamental part of modern life, and it caters to the daily economic activity that consumers engage in across sociodemographic segments. This ensures consistent foot traffic and demand for retail space, which offers investors a reliable income stream, even during economic downturns. The stability that is characteristic of necessity-based retail real estate flows through to the financing side of the business. While investors in other sectors were taking on elevated levels of debt during and after the pandemic, necessity-based assets were conservatively financed. Because lenders have become comfortable with this stability, established purchasers of necessity-based retail, like FNRP, continue to enjoy financing options that are not always available for other commercial property types.
FNRP remains one of the strongest players in the necessity-based real estate sector, and credit continues to be available to acquire property. Investors who partner with FNRP share in unparalleled access to deals offering high risk-adjusted returns based on disciplined underwriting. To explore partnering with FNRP, please contact our Investor Relations team by clicking here.