The cost of capital is climbing – and dealflow is feeling the strain

[Music] Hello and welcome back to another episode of the Perry Podcast. I'm your host, Randy Povica. The real estate investment manager market is coming to terms with its latest hurdle this week. The cost of debt has been on the rise for some time, as select managers have told affiliated Perry titles. And in today's market, the cost of doing business may now be outweighing borrowers ability to keep pace and hold their investment strategy steady heading into this market cycle. Though the impact to date has been moderate, as highlighted earlier this week in analysis shared by Perry, central banks are moving more toward defensive positions. The possibility of rate cuts has diminished as a result, as also noted in a March episode of the Perry podcast. All this sets the table for how borrowers will need to reshape their own tack to keep lines open with debt capital markets while they have liquidity to keep capital moving. Pigeon's Brian McDonald provides his perspective on the situation at hand too. He works as head of real estate credit strategies at the firm. Be it at the Newark based manager or beyond, market participants are having to recalculate their basis and reorder how they navigate the next wave of acquisitions, holds, and exits arriving in their pipelines. This week, I'm joined by Lucy Scott and Sylvia's security to break everything down. It's really wonderful to have you both on today. Hey, Rondie. Hi, Rondie. Great to be here. Wonderful to have you both too. And Sylvia, thanks so much for joining. I know actually your piece is going to serve as our cornerstone today. And Lucy, you've also done some really wonderful analysis that I want to highlight. But Sylvia, I want to start with you. How are we seeing borrowing costs move further to the forefront of real estate investment discussions in the current market? Thanks, Rondie. Yeah, so we're coming up to two months of conflict in the Middle East now. And something that I've been talking about with my sources is how this conflict is impacting borrowing costs in the long term. I remember discussing the potential impacts the war might have on real estate markets when I attended MIPIM in March. I spoke to many lenders and borrowers at the time. And as the conference was held just over a week after the war had started, I could sense a lot of trepidation in the air, but not much material impact sources at the time we're thinking about potential long-term impacts of a prolonged conflict like how to operate in an inflationary environment and how this might impact interest rates and the underlying cost of debt. But we're now in April and we're beginning to build a better picture of how things are planning out. And I think, yeah, sources are continuing to be concerned about what an inflationary environment might mean for borrowing costs as interest rates are expected to hold or potentially increase going forward. I would say most sources are showing me that we're in a fairly benign real estate market sale, particularly in comparison to previous shockwaves like the US government's tariff policies of April 2025 or even the interest rate hikes of 2022. They broadly believe that real estate has already reprised unlike other private capital markets. But just how long this real estate rebound will take will depend on the longevity of the war in the Middle East. It's been an interesting facet as well too because I do think that initially when we had the arrival of the conflict and then down the current market, there's been a lot of shifts in thinking in terms of how the midterm and long-term outlets are being shaped. And I think there's been a nice term of quirkiness thrown around both in the market and kind of in the state side market here for us as well as a broad rest of world. Lucian, I know this came up a bit in your prior pieces for real estate capital Europe. I want to hear from your side. I guess how are you seeing lenders maybe echo some of what Sylvia's seeing in terms of caution among borrowers and just getting deals done these days? Thanks, Randy. Yeah. I mean, the impact has been immediate in terms of basically when the war began, we kind of reached out to sources and said, you know, how this is going to affect things. As Sylvia mentioned, there was a lot of kind of, you know, well, it may only impact as if it if the war goes on long term, medium to long term, but actually very quickly we saw sony as what rates rise quite considerably and Europe or as well. So so there's been an immediate impact on people. I think generally in terms of lenders, the sort of the distance of you know the underlying health of the of the lending market is still there. You know, we have come out of a period of heavy competition among lenders to do deals, but I would say that the sort of tone has shifted quite noticeably so we've gone from base of the borough friendly environment in some parts of the market to now people are sort of becoming more protective again. So drawing on conversations we've had, I mean, chat and financial highlighted recently, this is a risk management firm, you know, they they came out of the report last week, say, you know, showing that margins have been stable recently, but actually they are sensing anecdotally that this lender caution is growing. There may be less willingness to stretch on terms, leverage pricing, hedging assumptions that all being strut scrutinize more more closely. So the sort of crisis is not killing liquidity as much as such it's just changing how lenders are expecting to be compensated for that sort of balance sheet risk. I had an interesting conversation with a borough from a major manager about a few weeks ago, you told me they were really sort of quite worried as well about how kind of the syndicated loan markets are going to fair. And they had actually seen US lenders in particular pulling back their risk appetite, heightening their underwriting standards, growing more cautious and you know sort of asking for things like margin, flexibility provisions or advisory mandates and so on to sort of compensate them for kind of doing deals. So so that's sort of that's been very interesting. Was there more that you've kind of gleaned from how these are getting structured now or obviously there was even some talk of withdrawal quotes for loans. I guess what are kind of the other, you know, interesting features that we're noticing now with how lenders are doing business. Yeah, I think I mean one particular area people are worried about is around sort of the development and speculative development area. So you know already going into the crisis we we had a sort of development viability issue. You know there's a lot of pressure. Not only from higher financing costs that we have seen in recent years, but also you know there's other things like rising construction costs and your schemes just weren't viable even a few months ago. So sources are sort of saying this is one area where we're going to see potentially more pull back from from lenders and you know in terms of like structuring those transactions, you know we could see you know maybe more club deals as lenders just get more worried about holding larger larger exposures and as I say if the syndication market is slightly fragile, you know they're not going to want to come forward and do that as a sort of single lender. So yeah, I mean I say I would say development is one area where there is there is that concern. You know it's really for me fascinating because on the front end of deals, you know just getting them actually structure as it's built there is to your point just that kind of sharpness and maybe a bit of a secure situation. Then we would expect typically but I know from your reporting to we've also seen this in some of the securities markets. You know US CBS rates have been a little bit interesting maybe a bit in flux. There's some winding spreads that came up a bit for your reporting initially when you talk to this so can you walk me through what the impact of that has been to date and how disruptive has the US CBS marketer maybe some of the securities inefficiencies. How do those maybe compare to prior periods of volatility. Yeah, absolutely. I think what we saw in the US CNBS spread data was a natural but moderate reaction to increased volatility and economic uncertainty due to the start of the conflict. I think what we saw was a moderate risk premium being priced into holding securities debt. But interestingly, US CNBS spread started to narrow slightly in the days following the failed peace talks. So when I spoke to Brian Clinck's at whose global head of research and strategy at La Salle for the article, he compared those initial spread increases with last year's liberation day tariff announcements and the comparison was quite telling. He said US CNBS markets reaction to heightened risk factors following the conflict in Iran was roughly half of what it was for liberation day. I think also I was quick to make the assumption that we would likely see a similar inflationary environment that we did in 2022. But multiple sources told me that that wasn't the case for various different reasons. We're not in the same economic environment and sources tell me it's not actually obvious what the next move should be from central banks, you know, in an environment where inflation may rise or continue to stay high. We could be looking at more of a risk of a recession right now. And that's something on the forefront of borrowers minds. So the ongoing peace talks, we don't know what's coming next with the conflict in Iran, which makes things more volatile. But what people will be keeping a close eye on is where interest rates will go and how that will impact borrowers and lenders going forward. It really does feel like the most critical watch point as well to when I think of you know how our sources talk about it here in the US are really any very international folks in global markets operating at management outfits. It really feels like, you know, the hardest topic to not address in a given way. in room. Just summarizing a bit of what you both have been hearing in the market. Lucy would love to obviously get your chime on this too. What else is causing some, I'll call it frothiness to use the classic jargon-y term, but what else is causing some of that frothiness in today's commercial real estate borrowing market today that you're seeing and hearing about? On the other side of things, Sylvia mentioned the inflation point. I think even if the war stabilizes in the next few weeks, I think one important factor is the expectations and how that feeds into cost rise. It's already having an impact on consumers, on perhaps discretionary spending in the shops and on travel. I think in terms of the lending environment, that's very underwriting rental growth right now or looking at the occupier side. There is going to be a big impact there. That is definitely something to consider. Oxford Economics has been flagging this in recent weeks. That's something to bear in mind in terms of the stresses in the market. We were talking about the immediate impacts in terms of what borrowers are doing. At one borrowers' perspective, they have just where they can. They're just adopting this kind of weight-and-see approach now in terms of refining anything that was coming up. It was due to be refinanced in 2022 and 2007. They had been previously thinking, "Well, we're going to actually bring it forward to 2026." Now, they're saying, "We're going to just delay, delay, delay as long as possible." As we've been discussing, things are just very unclear right now. Delaying any decisions they can at least to second half of the year. Basically, because there's just this lack of a stable base case, nobody really knows what's going to happen in the interest rate environment. It's changed so quickly. People aren't clear on what's happening. How the consumer occupier is going to be impacted by this. Where people can they are just delaying. Of course, in terms of hedging costs, that's relevant as well, because hedging costs today could change in the next few weeks. But again, big picture. Obviously, everyone, it's hard to generalise these things, but Moody's actually yesterday sent out a report warning that phrase that we haven't heard for a while. Refine-uncing risk is on the rise again. They're just saying that forward rate curves are moving higher. Bonneilds are up sharply. Since the Middle East conflict began and a big chunk of loan maturities coming up between 2026 and 2027, were written at peak values. Overall, they see boroughs facing high debt costs, less headroom and no easy capital gains on exit as the investment market potentially dries up. That's quite a stark warning there from Moody's. That notion of no easy gains is a true point for real estate equity and debt managers going forward. Lucy, you make a great point. Wait and see a certain approach from my side. It really feels like there are going to see a lot of strategies and a lot of evolutions in those. Beyond that, I think the real estate investment market, as we've all detailed, is really going to keep involving with each passing month or really each passing week at this point. Lucy and Sylvia, you both make really excellent points about the evolution of borrowing in the current market especially. I also had a chance to catch up with Brian McDonnell at P. Jim this week on the same subject. He works as head of real estate credit strategies at the Newark based manager. Brian, it's so great to have you on today. I'm really glad that you could make it to be on the Perry podcast. Great. Thanks a lot. And I really want to start by maybe setting the stage a bit in terms of what you're seeing from the global real estate markets at large. When we think of financing, when we think of headwinds, when we think of the conflict in Iran, I guess what's kind of the big picture on your plate right now when you have to look across the industry and see what all has to be considered by a manager when it comes to operating in today's market. Yeah. We certainly have seen over the last several years an uptick in geopolitical events or however you want to look at it. It's really focused on leaning in on where we focus for a while, which is more necessity driven investing. If you look at it, we like assets that are durable, long term tailwinds. So the boss that means housing and urban infrastructure are kind of areas that we feel our time and doesn't have to be perfect. We've got some room to think about where this needs to be in the long term. They're also not discretionary. They're tied to everyday life where demand tends to persist through cycles. So as the markets get a little bit more volatile, we tend to lean there. I think at the same time, this is where credit tends to do well. So as the markets get uncomfortable, investors tend to move towards credit. Downside protection matters far more in this environment. If you're getting a pretty nice compelling entry point, real estate is not at the peak valuations. It's off 20 to 25% since 2022, whatever the number might be. That's really an entry point now where you can come in and get pretty strong returns. I think what's also playing out is it's about execution. And this is kind of the other area around as the markets are fairly liquid, more people are moving to credit. Given some of this volatility in the market, we have to lean in on speed, certainty, consistency, and how relevant are we are to borrowers is the key focus that we spend time and time again. When you are thinking about bucketing, designing the portfolio, really strategizing around composition, obviously we talked about approach on a sector by sector basis. But I guess how else are you guys thinking of the evolution there and obviously setting it up for future success? So we talked about leaning in on necessity-based investing kind of in this market. And again, Frank, that's where we've, that's our DNA. So it's kind of easy to lean in when you get to times of uncertainty. For us, that means housing and that means housing globally. And so we see a lot of opportunities, not just in, you think about US multi-family, but seniors is a huge component for us that we've been leaning into for quite a while and we see some compelling opportunities there could be manufactured, it could be student housing. And so housing and a broader sense in tradition and multi-family, we still have leaned into necessity to retail. And retail is having its day, a grocery acre and then necessity to retail there, as well as what we think urban infrastructure, urban infrastructure and how cities work. And I'm separating that from the traditional, you know, big box bomber outside, but really because that's really what we're seeing is something that is needed for cities to work and play. So we're going to do a lot, we're a big lender, but those are the ones where we're going to overweight our portfolios and try to lean in on during times like this as the core of performance. How are you seeing borrowing costs, factory and discussions with sponsors a day with your counterparties as they're trying to either recapitalize, go out and make acquisitions, anything of the sort. How is that coming up in conversations today versus even a few months or maybe even a couple quarters ago? It's not coming up a lot to be honest. You're having, there's still a little bit of two worlds, I just got off the call with a sponsor who has a large finance asset and there's not a lot of bids there. But if you have something that's compelling, it's a very liquid environment. We have not seen real changes in the credit spreads in real estate since, you know, they're on conflict playing and or anything else. I think it's held pretty firm. So the bigger focus right now is certainty, execution. And are you going to be there for me six, nine months from now for the next transaction? That's the conversation. It's not really about spreads or returns. Those are, you know, compelling to borrowers and frankly, investors at this point. They definitely value that repeat relationship, which is I think is something that we've spoken about before and certainly has come up in coverage. I'm curious when it comes to kind of where the clear runways, where the speed bumps and I call it, you know, other bit of shakingness in the real estate investing market is today. I guess what are the kind of macro issues you all are thinking about beyond the headlines that we see on a week to week basis? I guess where else might the pressure points or obviously points of ease arise in today's market. I think a lot about the entry point we talked about earlier in that if you come back to real estate having a compelling entry point, which we believe you have 20 to 25% off pricing, you've got pretty strong income profiles right now and say good strong income and you've got a good entry point. That's offensive by nature. So the question then comes down to how stable are your cash flows? It's not just about the base case. It's about the scenarios around the base case of if x, y or z happen, what's the difference here and does it perform in all of those? That's where we, you know, as a credit investor lender lean in because a cash flow composition really does matter. We tend to over lean granular durable cash flows in this sport of time as opposed to the binary ones. And so what you see in times like this is the basic conversation we have internally is, are we getting paid for that risk? And that's really the comparison as a player who's sitting there looking at 40 transactions any one day. So I forgot the one or two or four that just feel like I'm getting paid for much less risk. Let's go there. And we spend a lot of time talking this is my talk track with the team, which is I want to access the deals we want, not the deals were shown. And so that's the try to pick through all those deals, which ones are the ones that we think are the outperformers and try to make sure we get access to those. Brian, you raise a good really good point there too. And something that we've been thinking a lot about across the Perry titles really has been how do you future proof a capital stack? And really how do you you know set up a borrowing profile or debt portfolio, your investment strategy for the long haul in a 2026 that has been maybe a little bit different than what we initially expected. So maybe as you guys look out forward into the next quarter here, into the next half of the year, I won't make us do any crystal ball predictions, but I guess how are you guys kind of approaching that? And maybe how does that kind of portfolio mindset that you demonstrated there, factor into that thinking when it's like, we get 40 deals on the desk, but obviously you only want one, two, or four of those, and you don't want to just put out capital because you have capital. Yeah, I would start with, I don't find a shortage of opportunities. There's a lot of compelling opportunities today, despite the competition and everything that's out there. If you think about where we are and where we see the cycle, is the cycle is fundamentally different than before, you know, the rate rise, which is, it's an income driven cycle across real estate. And that's your globally. And so returns are durable income, how resilient is cash flow. So that's kind of the baseline of how we see the market playing out. And so if you take that as a premise and you have an income led environment, our focus is diversification means critical. And so we have pivoted and focused, we're a bit for a long time, but even more today on maybe you define this mid market so that we get a diverse amount of portfolio by nature. So think of that as will may, maybe close 500 transactions a year, so that our various strategies can have exposure to many of borrowers assets and markets rather than a concentration and complex capital stecks. Because as we have gone through this long enough, structure matters. In a one bar or one lender loan, alignment's clear, decision-making straightforward and agreement tense, straight forward. When things go wrong, you work it out. And as we see and releaning away from syndicated or tront structures, where coordination could be misaligned and sentives add friction. So for here, it's almost like let's just be simple. Let's go back to mid market lending. Let's stay focused on cashless stability and focusing on getting a naturally diversified portfolio. I would also add in that we're spending a lot of time today thinking about the portfolio construction is asset by asset, not macro. Last cycle, you could have done well, just investing in industrial and multi-family and almost having no stock selection. I don't think that's going to be true going forward. So we have a lot of debate on is this the right one versus the one across the street? And that sort of granularity really matters. So it's a lot more work, but that leads to I think more resilient portfolios to your question. And I think that old cliche of simplicity is beautiful can be true both in real estate portfolio construction, but maybe also life. So that's maybe the salient takeaway point there if I'm not mistaken. I think that's right. You know, sometimes complexity for complexity sake is not a good thing. You know, simple investing basic fundamentals tends to be pretty good outcomes. An appropriate end cap in statement I would say from Brian. The current market is one where winds can still be had. No matter the side of the capital stack you're sitting on. Even if the math is a little harder to pencil today compared to even one quarter ago, borrowing in the current market may still have more room to move as investors and lenders refactor how and where they want to enter and expand in the global real estate investment market. But that adaptation is a natural and proven picture across the landscape through all of its cycles. As we heard from Lucy and Silvia, finding easy borrowing conditions in the current market is not a binary issue. Whether investors are looking to be active or passive, a lot hinges upon where rates move in the future and how valuations get set and reset in the present market. You can read a deeper dive from the borrower and lendersides on both Perry and Real Estate Capital Europe respectively. This has been the Perry podcast. Thanks so much for listening and tuning next week for more insights across our affiliated titles.