April 2023

2022 was a volatile year by almost any measure, as public equity markets, fixed income and numerous speculative sectors got smashed by rapidly increasing interest rates. Long duration fixed rate performing loan pricing was squeezed just like any other fixed income instrument. Properly priced fixed rate loans, however, offered to the proper investor segment showed robust investor interest and activity. Liquidity remains abundant and large transactions can be bid and closed on accelerated timelines.

The market for small balance and middle-market NPL / criticized / substandard loans remained the little engine that could, keeping trade rates at historical highs across the industry. NPL levels remained at historic lows which kept supply constrained throughout the year against abundant capital keeping a multi-year supply-demand imbalance intact and favoring sellers.

2022 also seemed to be a year of speculating about the future- the effect of interest rate rise, shrinking bank deposits, general economic stress on bank loan books, etc. Turning the calendar from 2022 to 2023 seems to have ushered in a sharp change in our client conversations which moved from the abstract to the specific. Rather than speculating about the future, discussions now focus more on specific loans and portfolios, recent transfers to watch list, and the impact of loan deterioration on earnings and capital, not to mentioned simple workload in special assets. None of this is a huge surprise. Seasoned lenders have been monitoring their portfolios closely, recognizing that the oft-cited long and variable lags of monetary policy would eventually and at a minimum, topple the marginal credits previously supported by low rates, stimulus, or both.

So this must mean that the loan sale floodgates have opened, right? Well, not exactly, but it certainly seems like a tipping point in lenders shifting from analysis to activity. Inquiries have increased significantly, but we think that sellers will be thoughtful and strategic with their loan sales while the full impact of monetary tightening to work its way through the system. Meanwhile, we’ll provide a few market anecdotes below.

Pricing Varies Wildly: Pricing for small criticized loans and portfolios is holding up very well, off from the peak but well within a trade-able margin of error. Meanwhile, larger single assets trade case by case, asset by asset and market by market. So why the divergence? One theory is that while small loans and portfolios are impacted by higher interest rates (what isn’t?), overall performance is more closely tied to general economic conditions. When the economy is fully employed and wages are increasing, “Main Street” does okay and this is reflected in small loans. On the other hand, larger loans are secured by collateral that is very sensitive to changes in interest rates, cap rates, broader market sentiment, and availability of primary market capital (“Wall Street”) which has gotten more expensive in all cases and is very limited in some cases (office).

Office: The concern is palpable, sometimes warranted, other times not. This asset class is the best example of the dynamic mentioned above, with collateral/loan performance and therefore loan pricing varying wildly asset by asset and market by market. We are seeing both ends of the spectrum in our loan sales and doing a deep dive on every credit to sort out winners and losers. Several large banks have told us that regulatory pressure is increasing, with regulators requiring principal paydowns in return for loan extensions. While the primary origination remains largely no-bid, transactions are happening in the secondary market, in particular with small balance and middle-market loans (sub-$50MM).

Stress-Testing DSCR/Refinancing/Interest Carry: We’ve reviewed numerous deals with outstanding trailing DSCR only to find that the forward projections drop below 1.00x when applying today’s higher rates. This dynamic is also playing out with bridge and construction loans where the twofold blow of construction delays and doubling of interest costs exhausts interest reserves requiring further equity injection or loan advances. Its hard to believe that a SOFR or Prime indexed rate could more than double in the space of 12 months, but that’s where we find ourselves.

Healthcare: A more under the radar asset class but a primary concern for lenders with exposure. Office gets all the headlines but this sector is also suffering from a Covid induced hangover. Inflation has thrown the expense structure for a loop and labor is a nightmare. Fannie Mae and Freddie Mac are tightening lending in response to a rapid increase in credit issues which will reduce refinancing and permanent financing options for bridge and construction loans. Like office, pricing varies, but it always has and is in part based on the level of acuity (IL to SNF).

Representative Transactions

(representative photos, actual collateral assets confidential)

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