April 17, 2024
While there was a renewed sense of optimism among lenders at the Mortgage Banking Association’s annual conference in February, the commercial real estate industry isn’t done fighting against major headwinds. And, arguably, the most problematic factor in the industry today is the high cost and low availability of financing.
The banking environment continues to be challenging and, in my opinion, will remain so throughout the remainder of 2024. While there are undoubtedly bank deals still getting done, their cost of capital, depository requirements, and strict underwriting metrics often lead to underwhelming term sheets. Moreover, the amount of inconsistency within the banking environment makes it increasingly difficult and time-intensive to navigate. When presented the same deal, pricing and leverage between multiple banks can vary as much as 300 basis points and 20%, respectively. The inconsistency disrupts the market by hindering investors’ ability to underwrite and procure attractive financing. Alternatively, debt funds and commercial mortgage-backed securities lenders have plenty of capital to lend and have a higher risk tolerance, but the cost of funds remains hard for many borrowers to justify.
All of these factors surrounding other capital sources create a void in the market, which insurance companies are stepping up to fill. While their risk tolerance has not shifted drastically there are several aspects of insurance company lending that present an advantage over other capital sources in the current environment: 1) They are governed by state insurance regulation; 2) they typically lend off of their unlevered balance sheets; and 3) they are not depository-driven institutions. First, the lack of federal monetary regulation gives insurance companies more freedom to tailor their loan offerings to their preferences and capabilities. Fixed versus floating rate, hedging requirements, loan term, interest-only and prepayment structures are just a few examples of the nuances within loan programs. Second, lenders holding loans on their balance sheets have the most control over their capital. This is in contrast to lenders who leverage their balance sheets and must adhere to warehouse line requirements or lenders who securitize their loans and must satisfy investor parameters. Lastly, the source of liquidity for insurance companies is from premiums, therefore, there is not a comparable need for deposits as seen by the banks. These characteristics offer the ability for insurance companies to adapt and provide more financing options, as seen most prominently in four ways outlined below:
Breadth of lending. Over the past decade, insurance companies have started to broaden their financing capabilities from traditional long-term, fixed rate, low leverage loans. Whether that be developing their own internal programs or placing capital for separately managed accounts, we’ve seen more and more move into the short-term lending or structured finance space. As the rise in short-term interest rates has put many banks on the sidelines, this trend has accelerated, and insurance companies are making concerted efforts to grow or create programs to respond to the demand and capture strong opportunities at the right yields. Just within the first third of 2024, two insurance companies have rolled out construction lending programs, one has rolled out a fixed-rate bridge program, and one has rolled out a participating bridge program, with talks of more in frequent conversations. Insurance companies that we have represented for more than 20 years now have programs that offer all of the following: construction loans, bridge loans, participating loans, preferred equity or mezzanine debt, and property-assessed clean energy financing.
Broadening asset types. Insurance company lenders have long been focused on the “highest-performing” asset classes, which they’ve generally deemed to be: multifamily, warehouse industrial, grocery anchored retail and credit tenant office. Given the concerns surrounding office and the agencies’ dominance in the multifamily space, there are fewer available options of desirable assets for lenders. As a result, we’re seeing appetites for well performing assets outside of these specific categories gain interest and price more competitively. This includes other subsets of traditional asset classes, such as flex industrial and unanchored retail, as well as alternative asset classes, including self-storage, outdoor storage and hospitality.
Shorter-term money. Historically, life insurance companies have been a “long-term” lender, with minimum loan terms of seven to 10 years, which is a result of matching assets to their long-term insurance policy liabilities. With the sharp rise in interest rates and the market’s optimism that they will come back down, the demand for long-term, fixed-rate loans dissipated in short order. Insurance companies have increasingly shifted their internal strategies to offer more loan options with terms of seven or fewer years. This entails matching real estate loans to shorter-term annuity insurance policies and finding other long-term assets to match against their life insurance policies. Where there used to be a few select insurance companies capable of offering short-term solutions, there’s now a competitive landscape for three- to five-year fixed-rate loans.
Flexible prepayment. While the prepayment flexibility of insurance companies might never compare to that of banks and credit unions, we have seen a significant push in the industry to offer more options in this realm. The majority of insurance companies are able to offer stepdown prepayment structures or an open window in the final years of the loan, in efforts to be more competitive and win good business. Some price a premium into the interest rate in exchange for this flexibility; others are able to offer it free of charge. The combination of shorter-term money available and added flexibility allows insurance company loans to accommodate hold strategies of three to five years, which accounts for a lot of the market’s investment timeline.
Although it may not be as enjoyable or efficient as it once was to finance a property, there is still liquidity in the debt markets and executable financing options. The market will continue to adapt and, together, we will continue to fight these headwinds and await smoother economic conditions.
