CMBS offers liquidity for non-mall retail borrowers

Since the restrictions imposed by the Covid 19 pandemic and probably before, the US commercial real estate (CRE) sector has by and large been in the doldrums. But experienced CRE investors can find value and remain funded by a combination of traditional bank loans and CMBS financing.

Gary Rappaport is nothing if not experienced: he has been a CRE investor in the Washington DC area for around half a century and started the business that bears his name some 40 years ago. His firm, which has 115 employees, manages 76 properties with 14m square feet worth around $3.5bn.

Experience is not his only asset, however. He manages only non-mall retail properties, which means that he is not exposed to the downturn many US malls have suffered. His field is a complex area of the CRE market, but with appreciation of the complexity come rewards.

“This is a complicated area of the market. There are long-term leases, sophisticated tenants, co-tenancy requirements, exclusivity restrictions. But, because it’s complicated, there are fewer players, and the cap rates and return reflect that. The cap rates on multi-family properties are lower because it’s simpler,” Rappaport told SCI.

Of the 76 properties he manages, Rappaport controls the financing decisions on 50; for the other 26 financing is handled by the owners themselves.

Commercial loans fund 36 of those 50, and 14 are currently funded by CMBS loans. The CRE CMBS market has displayed signs of stress over the past couple of years, but Rappaport is an advocate, despite the restrictions imposed on borrowers.

“CMBS loans are difficult, and the terms are set for the investor. This is tough to change but if you understand it you can deal with it,” he says.

Proceeds in CMBS are lower and the rate of interest offered to CMBS borrowers is higher than in previous years, but investors who have lived through many upturns and downturns accept this as the new cost of doing business.

Moreover, the CMBS market continues to offer liquidity, and at a time when bank lending is retrenching, this is important. “This market is still lending money. It has liquidity and fits into a specific need for specific properties. It is still a good vehicle,” he says.

Bank exposure to commercial real estate has been much in the news lately. Banks doubled their exposure to CRE landlords between 2015 and 2022, to US$2.2trn. Yet if exposure to CMBS backed by CRE and loans to firms that on-lent to landlords is considered then the number is US$3.6trn. This is about 20% of total deposits, say reports. 

Refinancing has become problematic for many CRE investors. Rappaport says his relationship banks are renewing his debt, but if he went to a new bank then he’d run into problems. This is why maintaining a relationship with lenders in good times and bad times is so important, he says.

With current rates at their highest for four decades it would make perfect financial sense to take any cash surpluses out of banks and invest in Treasury bills and receive a higher rate of return than any bank offers. But Rappaport desists from this as right now his banks need his money, and the relationship needs to be cultivated.

An inflationary environment offers some advantages to the CRE investor. For example, rents can be raised in line with CPI. There are inherent structural attractions too: in the retail CRE space, real estate taxes, insurance payments and maintenance costs are generally borne by the tenants.

The nation’s capital also offers a cushion against recession. It is the base for the government and armed forces and all the contractors that supply their needs; these interests cannot simply move out.

This is not to say, of course, that non-mall retail investment is plain sailing; far from it. Investors that took a stake in properties three or four years ago could face acute difficulties. Rappaport tells the story of a local investor who lent to a large shopping entrepreneur three years ago and received attractive returns every quarter until suddenly faced a capital call last quarter even though the property was 100% leased.

The problem is that the sponsor contracted a short-term loan three years ago and the interim rates have risen so much that refinancing has become a tall order. Neither can he sell the property at the price he bought it. The only option is to refinance a smaller portion of the loan, make a capital call and hope for the best. This is happening across the US.

“Investors need to look closely at the sector and even more closely at the financing in place. I did a 10-year fixed rate loan at 3.25% in March 2022. Today, that would be 7.25%. Most people in the business haven’t seen rates rise this far and fast,” says Rappaport.

Simon Boughey