Exploring real estate financing market dynamics: Insights from Aaron Appel

Investors entered the new year with high hopes for lower interest rates. But a drop in rates has yet to come, leaving many investors wondering about the current state of real estate financing. Aaron Appel, Senior Managing Director at Walker & Dunlop and co-head of New York Capital Markets, lent his expertise in financing on a recent episode of the Walker Webcast. 

Aaron focuses on sourcing and structuring financing across all CRE asset classes. He leads the team of the highest-producing debt and equity advisors at the firm, managing over $50 billion in placements.

Here’s how he sees the current real estate market challenges and trends and what he predicts for the future of financing in 2024.

The state of capital availability in real estate

With interest rates having remained high and a possibility of lower rates on the horizon, we’re likely to experience a wave of refinancings in 2024. According to Aaron, though, there might not be capital in the market to handle the demand.

“There's a lot of capital in the marketplace. The problem is that capital wants certain types of assets and transactions, loans-to-value covenants, debt service coverage ratios, and debt yields. Those covenants don't work for the majority of outstanding credit on assets. You can source that capital and transact it where there's liquidity. The problem is that those transactions typically require larger cash infusions. Many sponsors don't have either the capabilities to contribute or the desire to.”

Aaron cites the office sector as a prime example. It’s a huge component of the wave of the incoming maturities, and there’s no liquidity for the most part. 

“The larger scale checks that need to get written into that space has been predominantly done through the securitized mortgage markets or an insurance company or foreign-based bank. That capital is not available, for the most part. If it is, it’s available on a smaller scale basis. But if you have a $400-, $500-, $600 million office maturity on the horizon, you're going to extend with your servicer. There is no avenue or outlet at this time to transact. It's putting a lot of pressure on the system, and it's devaluing assets even further in that sector.”

Banks' approach to real estate financing and asset management

The bigger the balance sheet, the higher the losses in the event of a financial downturn. Having spoken recently with a top-five bank by AUM, Aaron sees how major financial players strategize in times of high risk. 

“This bank lent $5.5 billion in credit in 2023 and $4.5 billion in subscription lines to drawdowns for equity funds and credit funds. They did about $1 billion in asset-based lending. We’re talking huge balance sheets. Their Modus Operandi was in the event a deal went sideways or a sponsor couldn’t repay at maturity, they’re not looking to extend loans. They should sell the asset, and we’ll sit with our asset management team to ensure the asset gets sold. They will sell every asset that comes back to them. If the sponsor can’t refinance, they will force the sale to happen. If there’s equity left over for them, great! And if there isn’t, they’ll worry about a market seller.”

Aaron predicts he will see more of this scenario coming. It’s time to clear the decks.

The impact of regulatory changes and market dynamics

Post-Great Financial Crisis, new regulations were supposed to protect the banks. Transactions were supposed to be over-equitized. When Aaron entered the industry, a traditional bank loan was at 80 percent loan to value, and that LTV was taken down to 60 percent, 65 percent. Mezzanine financing pre-GFC used to go up to 95-100 percent of the cost. Now, mezzanine financing goes up to 75-80 percent of the cost. There was a lot more equity in CRE deals. 

That’s part of the reason we’re seeing slow growth. But what wasn’t planned was the abrupt shift in the use of offices post-COVID.

“This impact is most notable in urban infill environments around the country and in coastal cities. That’s where the bulk of the investment capital is, both on the equity side and the credit side. And that’s putting even more stress on the system right now,” Aaron notes.

The political climate and the change in rent laws have had an impact, too. It’s prohibited for landlords to increase rent or return on capital invested. “This has devalued the assets and destroyed banks' balance sheets. And it's made investing in these markets very challenging. That has a reverberating effect throughout the rest of the market. It's been a tough climate.”

Investment opportunities in urban real estate

From an investment opportunity perspective, Aaron sees the most conviction around the multifamily space, particularly in New York where multifamily housing has been historically supply-constrained. Here, there are also no tax abatement programs in place to subsidize property taxes, which makes developing multifamily housing nearly impossible.

“The multifamily space has been the Sunbelt’s growth markets, and there’s certainly ample supply being delivered this year, next year, and probably into ‘26. The development deals that we're doing in those markets are deals where the equity has been committed to the transaction. There's maturing credit on development sites. There are motivations other than just the standard IRR and equity multiple that people look to when they develop those assets. And we are doing construction loans in those markets for those assets.”

Aaron believes the same goes for the industrial market. The big box, speculative industrial development where we used to see a tremendous amount of liquidity has thinned out. Most developers do not want to develop that product right now because there’s a supply glut in the market.

“Large corporations have cut back on signing leases. Those that are going vertical on projects have an ulterior motive other than generating a certain type of opportunistic return. That said, there’s no question there is a strong belief in the multifamily space and even more conviction in the industrial space. There will be a recovery here, or development will again make a lot of economic sense sometime between ‘25 and ‘26 to go vertical.”

Looking back over the last decade, money has been made by groups providing mezzanine capital and preferred equity capital into existing assets and development deals of the returns. We see a plethora of money sitting there looking to inject capital into those positions. Equity groups want to do the same thing credit groups have done for years. 

“If I could say what I thought a smart equity bet would be, I would say you can buy newly built multi or relatively newly built industrial, and you can pay 25-30 percent below replacement cost, and you have staying power. You could sit there for three to four years and let the supply cycle through. On the upswing, you will do very well. Outside of that, it’s difficult to see where there’s a trade right now.”

The role of CMBS in the current market

Commercial mortgage-backed securities (CMBS) provided an unlikely but welcomed capital source in ‘23. Aaron believes CMBS will continue to play a big role in the market.

“People say the market can't rally unless financials rally. You look at banks and how poorly they've done. But the truth of the matter is the private equity firms, the new financials in the market, and the world have changed. Take Apollo, Blackstone, and KKR. You look at their stock prices and what's happened to their stocks and how they've grown. They're the new financials. They're the ones providing substantial liquidity into the market. They all control billions of dollars of insurance company capital annually. Outside of the traditional life insurance company, investors that have $10+ billion credit funds that are lending capital into the commercial real estate markets, they're making a huge impact.”

Aaron believes the only exit strategy for small balance loans will be small balance CMBS—small retail strip centers, smaller office buildings, and smaller industrial parks. We expect the majority of those loans to wind up moving from bank balance sheets to the securitized markets. In turn, this will open an avenue for private capital to continue to expand in the construction space. 

“Smaller developments have been done by regional banks. Those days are over. The cost to build those projects will increase because it'll be privatized capital. But we're seeing it day in and day out, and we don't think those trends are going to change.”

Investment strategies in a changing market

Regarding the current market, Aaron shares there’s no better place to invest than land. 

“I think that the retail inflation has pretty much subsided, but we have severe monetary inflation. We're adding 10 percent to the domestic monetary supply every year. And that trend is not going to stop. So owning land, any sort of asset that you can own that is supply-constrained should technically inflate.”

Ideally, good investments are about finding things people need that also have a scarcity of supply. This allows you to protect your capital—and it’s something he believes will happen with commercial real estate again. 

Navigating the 2024 capital markets with confidence

Aaron shares that the state of capital availability in real estate is a crucial factor affecting market dynamics. Myriad factors contribute to the CRE financial climate, including politics, regulatory changes, interest rates, and creative funding options, along with basic supply and demand principles. Navigating the capital markets in 2024 requires confidence and strategic planning, both of which can achieved by working with knowledgeable partners who track the market and can explore your options with you.

Hear Aaron’s full conversation on the Walker Webcast and contact him to discuss your next real estate financing project.

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