Värde Co-CIOs Brad Bauer, Ilfryn Carstairs, and Giuseppe Naglieri share their views on the state of credit markets coming into the second half of 2024 and discuss the evolution and emergence of investment opportunities across Värde’s platform.
Download Värde Views here.
Värde’s Head of Real Estate Lending, Jim Dunbar, spoke with PERE Credit for a keynote interview discussing opportunities and trends in commercial real estate lending. Jim outlines the macro forces converging to reshape the CRE finance landscape, the sectors Värde finds most compelling today and the role CRE debt plays in investors’ portfolios.
Värde Partners sees the current market environment as the second key phase in the growth of non-bank lending in commercial real estate, the first being the aftermath of the global financial crisis, when alternative lenders stepped in to fill the void left by banks and commercial mortgage-backed securities markets.
The firm was an early mover in the post-GFC world of non-bank lending. Jim Dunbar, partner and head of real estate lending, spearheaded the build-out of Värde’s commercial real estate lending business, which today has originated over $7 billion in loans. Anticipating a continued trend toward non-bank lending, Värde acquired Atlanta-based commercial real estate asset management and servicing firm Trimont in 2015, which services over $230 billion of loans.
“We have been investing in real estate for 30 years, up and down the real estate capital structure in different forms: credit and equity, from nonperforming loans through the origination of new loans,” says Dunbar, who is based in the firm’s Minneapolis office. “We’re incredibly excited about the lending opportunities in commercial real estate and believe we are at an inflection point with a highly compelling environment ahead of us over the next several years.”
“The way we think about our CRE lending platform within Värde is consistent with how we think about credit investing across our broader business,” he adds. “It’s about first understanding why that real estate asset exists – the underlying fundamentals – then basing our view on how to create exposure to it from that fundamental perspective.”
As the market grapples with a looming refinancing wave, higher-for-longer interest rates, and the retrenchment of regional bank lenders, Dunbar points to multifamily, student housing, and hospitality as areas of opportunity. This strategy, he says, resonates with investors looking to capitalize on the premium return in senior debt, backed by hard assets and with current income.
Why is now an interesting time for commercial real estate lending? What market forces are at play?
There are two main macro forces converging right now, squarely impacting commercial real estate.
First, real estate owners need to recapitalize or refinance during a time when the cost of capital has increased significantly driven by what’s happened to rates over the last 18 months. This higher cost of capital has led to a decrease in asset values across the entire market. Even for real estate owners who have hit all their business plan objectives and where rents are steady, there is still a downdraft on valuations.
Further, there is the wall of maturities over the next three years, about $2 trillion in total – and starting in 2024, there’s the expiration of the interest rate caps that were put in place for three-year floating-rate debt originated back in 2021. As these caps roll off and maturities hit, borrowers will face a decision: either fund or raise additional equity to facilitate a refinancing or extension, or sell the property.
The second macro point is that the largest lender to commercial real estate, the regional banking system with about $1.5 trillion of exposure, is pulling back right when this recapitalization needs to occur. With those two forces coming together, we think it’s going to be a very attractive time to lend to commercial real estate owners.
What informs your lending approach? Where have you been active and what kinds of loans are you originating?
We look for themes from a lending perspective that we believe in across our broader real estate business.
In our lending program, we typically focus on $40 million-$125 million floating rate mortgages throughout the US, and our average balance is right around $55 million. These are generally three-year terms with extension options out to five years. We generally look to target an LTV between 65-75 percent depending on the underlying property type.
Historically, we’ve been fairly balanced between refinancings and acquisition finance. Today, we’re seeing a heavier tilt toward refinance opportunities as borrowers look for lending partners to support a business strategy or bridge to a better, more normalized market. However, with the Fed indicating fewer rate cuts, this potentially pushes real estate owners toward selling properties as the cost of extending has increased, and that may support more acquisition financings.
Have you evolved your approach to underwriting as the market has changed?
Our fundamental approach has remained consistent over time: we focus on understanding the assets, the markets they operate in and the sponsors behind them. Also, given Värde’s background in distressed investing, downside protection is always top of mind.
Importantly, we constantly evaluate and re-evaluate the factors feeding into our underwriting because real estate dynamics and market drivers are always changing. We are not only looking at what’s happening in the market but also evaluating what we see within our portfolio and how our existing borrowers are addressing challenges. This is supplemented by Trimont, who provides us with additional underwriting services and can bring to bear their broader market level relationships and information to our due diligence process.
Office tends to dominate the headlines. Can you tell us what sectors you find most compelling, what sectors are a pass, and which ones are worth a second look?
Office is only about 15 percent of the overall market, but it gets more than its share of the headlines. We agree that there are real structural demand issues in the sector and aren’t actively lending in it, but there are lots of opportunities outside of office.
We are focused largely on housing – multifamily, primarily, and also build-to-rent and student housing. While multifamily has pockets of supply in the southeastern and southwestern markets that need to be absorbed over the next 18-24 months, fundamentally, we believe those housing units will be needed over the medium term. Student housing is another place where we’re active on the debt and equity side, particularly with larger universities where there are positive enrollment trends and in gateway markets where supply is limited and students compete with high market rents for traditional multifamily product.
Hospitality is another area of focus. In 2021, we saw a significant opportunity to finance high-quality hotels across the country when banks and insurance companies retreated. Hotel assets can be seen as challenging because of the short-term and economy-sensitive revenue cycle of room rentals, and they are also very capital-intensive – but we have deep expertise in that sector, and those factors limit the number of groups we compete with in this market.
Outside of housing and hospitality, we see opportunities in medical office, which has historically had a very sticky tenant base, creating durable yield that we like both on the debt and the equity side. We are also active in the self-storage space and are seeing opportunities in data centers as well.
Overall, I wouldn’t say we pass on any sector – we bake into our underwriting our fundamental view of values for each asset. Recently though, we have done less heavy renovation or repositioning trades and generally avoid construction lending today.
What do you anticipate will be the biggest challenge for real estate owners over the next several years, and what does it mean for your strategy?
Sponsor liquidity is certainly top of mind for us. Real estate owners are experiencing increased expenses and costs associated with owning and operating assets. You have the impacts of what’s happening in offices and hybrid work impacting city budgets. That flows into real estate tax pressures. You also have weather events – fires, hurricanes – driving up insurance costs in certain states, and that’s bleeding in on a national basis, too. Add to that, the wage growth we’ve seen in recent years is impacting different properties because of the labor components to operate these buildings.
Sponsorship and access to liquidity become an important part of our analysis given the pressures borrowers are facing. These costs all flow into our analysis around profitability, valuation, and ability to support today’s cost of capital.
Considering where we are in the market cycle, what role does commercial real estate debt play in investor portfolios today?
We believe commercial real estate lending should be a core allocation in investor portfolios, especially in today’s market environment.
We have invested through many cycles and our approach at the beginning of any of them is to be senior in the capital stack and the most downside protected, especially while clarity in the cycle emerges. Today, we see a return premium investors can capture for the senior part of the capital stack driven by mortgage rates and forward net operating income growth.
There is certainly a place for more opportunistic allocations to real estate, but we believe that will be a larger opportunity later in this cycle whereas we have this refinancing wave upon us now.
We also think an allocation to CRE lending acts as a valuable diversifier to complement investors’ direct lending allocations – especially in today’s cycle, it seems prudent to have security over hard assets that have already seen a reset in valuations, instead of corporate cashflow.
One of the hallmarks of the last decade has been the rise of the non-bank lenders. What is it about Värde’s platform or approach that sets your firm apart?
Värde invests across the capital stack and across asset classes in a variety of geographies allowing us to take in diverse views on sectors as we aim to ensure we’re protected on downside risks. We have been investing in real estate for 30 years, so we have certainly built-up significant expertise and relationships over that time.
With Trimont as part of the broader Värde platform, we believe it gives us a very strong platform, after loans are made, to work with borrowers on a day-to-day basis.
Then from a pure sourcing perspective, we’ve been active in this market for eight years, having originated over $7 billion in CRE loans. Approximately 35 percent of our lending is with repeat borrowers, which we believe is a testament to our reputation for partnering with borrowers and providing certainty of execution.
This article was sponsored by Värde Partners. Originally published by PERE Credit.
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Download Värde Views here.