The first half of 2022 closed out at a steady, rather uneventful pace. Volume has been lower than expected across the market; lamented by buyers, celebrated by sellers as capital remained plentiful and well in excess of available loan purchase opportunities. Consistent with prior quarters, competition for assets was fierce and investors quest for additional loan discount and yield remained elusive. All of this in the face of rising rates, increasing volatility and tightening liquidity in practically all other fixed income markets (SFR, CMBS, CRE CDO).
Equity markets are down ~20%, single-B yields have doubled, and fixed income volatility is as high as its been since March 2020. Why have we not seen material degradation in liquidity or pricing? We think the answer is two-fold. First, the market is simply under-supplied relative to available capital. This has been a common theme over the past 24 months, and it hasn’t changed so far in 2022. Secondly, capital in this space tends to be more “sticky”, less sensitive to day-to-day rate movement, and far less likely to exit or dramatically adjust based on short term primary market volatility. This is consistent with historical periods of temporary primary market dislocation where secondary market buyers stepped into the void as primary liquidity deteriorated (Q4 2007, Q1 2016 and Q1 2020).
If one believes that today’s volatility is more a function of unprecedented rate of change in rates, and less a function of broadly deteriorating credit, and we remain in a supply (loans) – demand (capital) imbalance, then one would expect pricing to remain elevated. On the other hand, if one believes that meaningful credit deterioration is right around the corner, then secondary market loan sale pricing will follow. Said differently, are we sitting at Q1 2016 or 2020 and about to rebound, or Q4 2007 unknowingly whistling past the graveyard?
Office moving to center stage: Class B-C office has been a discussion point for 12+ months and the deal flow is starting to appear. We sold a handful of substandard loans in the 90’s and reviewed many more that haven’t found their way to market, yet. We think this is likely a long process and each deal will have its own set of challenges and likely different exit strategies.
That said, one thing that is very clear is that A LOT of capital will be required for much of the 1980’s – 90’s, even early 2000’s office inventory to have any chance of survival. According to our sources, new origination capital for value-add office has largely gone “no-bid”, even from aggressive non-bank lenders. This is either an opportunity for others to fill the void, or a leading indicator that primary market liquidity is evaporating and values will soon follow. We suspect its the later, but are often wrong, so only time will tell.
Tightening primary market liquidity: Credit standards are tightening and cost of capital is increasing. Non-bank lenders are slowing as warehouse line capacity is shrinking. We’re not hearing of widespread credit lines being pulled, but there is little appetite to expand unless/until existing inventory can be sold.
Bifurcated market: Multifamily and industrial remain the darling asset classes with ample, albeit more conservatively underwritten liquidity. B-C “value-add” office has largely gone “no bid” amongst lenders and lower quality assets and lower tier borrowers can expect a higher cost of capital, lower leverage and significant scrutiny in underwriting. All in all, we suspect that marginal deals will linger a bit longer on bank’s balance sheets as refinancing options for criticized / special mention / watchlist credits appear to be dwindling. These are top loan sale candidates for many banks.
Repeat sellers and business purpose / special use loans: Repeat sellers have been a common theme over the past couple of years and this trend continued through Q2. Multiple banks tapped the market again, exiting watchlist credits while pricing remains elevated. As we’ve seen throughout 2022 these banks are often focused on exiting special use and business purpose loans as stimulus funds are depleted and marginal businesses come in to focus.
Representative Transactions (representative photos, actual collateral assets confidential)