The financial crisis that escalated in 2007 with the residential subprime collapse and later the bankruptcy of Lehman Brothers in 2008 changed our financial markets forever, particularly real estate capital markets. When you layer on the impact of technology and changes in preferences and tastes for space use, the combined effect is even more profound. The debt capital markets industry hit bottom before a recovery began, and many casualties would never recover. The public outcry was loud, and regulation was implemented to help mitigate the perceived greed and the losses in the future.

While the recession ended in June 2009, it took longer for the markets to come back. Unemployment levels now match lows that haven't been seen in 18 years and, before that, since that late 1960s. The challenge for many companies is finding and keeping the right people - how much space they occupy per person; where people live, work, and play; where and how they shop; and what they spend their money on - and that now presents challenges to capital markets participants. So how did the industry fare in 2018?

Today's Debt Markets

On the debt side, liquidity continues to flow. Options for a debt bid are broad, varying from local banks, debt funds, commercial real estate collateralized loan obligations, commercial mortgage-backed securities shops, mortgage real estate investment trusts, private lenders, insurance companies, and even developers who have started lending businesses.

Overall, the deals are less complex since CMBS 2.0 began in 2010, although many large loans are being cut into several pieces to be spread out across many CMBS deals. The amount of leverage in the system has declined significantly since the peak of the financial crisis, and while competition is growing to invest capital, several alternatives are muting any undue aggressiveness, at least for now.

Single-asset, single-borrower deals have seen significant growth. For example, consider the 2016 loan on a single office property like 9 West 57th Street, a 1.6 million-square foot property in New York City; CMBS debt was combined with private debt in the form of privately placed B-note. Another example is a single loan to a single borrower on a cross-collateralized portfolio of assets, like a pool of hotels. During the first half of 2018, 50 percent of the new issuance CMBS were single-asset, single-borrower deals, matching the total conduit issuance.

Floating rate bridge financing has come back to the securitization market, with a strong resurgence in the commercial real estate CLO sector. Originations more than tripled from 2016 to 2017 ($1.8 billion to $7 billion), according to Morgan Stanley's commercial real estate CLO tracker, and are on track to more than double again this year. In addition to the securitized floating rate product, bridge lenders have liquidity to provide anywhere from $3 million loans to $500 million loans. Sponsors who raised capital range from smaller debt funds to multibillion-dollar private equity funds and global asset money managers. Even traditional developers who aren't finding the yield they seek on the equity side of the balance sheet are entering the lending market.

Public REITs also have been active in the lending space. Blackstone, Starwood, KKR, ARES, and TPG all created publicly traded mortgage REITs to tap the demand for liquid high-quality mortgage investing. Some of these individual REIT loan investments exceed $500 million, illustrating the scope of the current mREIT market.

When including traditional money center banks, regional and community banks, insurance companies, and foreign banks and institutional investors - all of whom continue to lend actively - it's clear that the debt markets are not suffering from a liquidity shortage. But too much liquidity in the system isn't necessarily a good thing.

What's in Store for 2019?

As the market moves into eight years of a strengthening real estate cycle, remember that recoveries are not consistent. While both major and non-major market property categories have surpassed the prior peak, a significant spread exists between the major and non-major categories. Drilling down further, multifamily markets have shown the greatest recovery, while suburban office and retail have shown the least. On a national basis, retail is the only major category that has not returned to its pre-financial crisis level.

While the fundamentals still appear strong, at some point the band will have to take a break. The recent tax reform bill injected some energy into the system, but the effects will wear off. Transaction volume year-over-year has declined, according to Real Capital Analytics, and much of the 2018 volume has been portfolio- and entity-level deals.

Interest rates. Rates continue to move up slowly, potentially impacting the ability for assets to be financed. However, in the two and a half years leading up to the end of 2007, the 10-year Treasury averaged 4.65 percent, ranging between 4.1 percent and 5.1 percent; in 2018, the 10-year hit 3 percent, according to Real Capital Analytics. That's still a 150-basis point difference. As for the spread between cap rates over Treasuries for commercial properties (excluding multifamily), the average for that same 2007 period was 2.1 percent, while the average for the first seven months of 2018 was 4.7 percent. Looking at average cap rates for these respective periods, the prior peak is only about 30 basis points higher on average. When looking at Treasuries and real estate spreads, there is room for movement.

Another indicator of room for further rate increase is the spread of historic mortgage rates and the 10-year Treasury. During the same two-and-a-half-year period, the spread ranged from 80 basis points over the 10-year up to 230 basis points, spiking over the last five months of the year, when the capital markets started to face significant challenges in the subprime residential and collateralized debt obligation space. The average, excluding those last five months, was a little over 100 basis points. In comparison, the mortgage rate spread to Treasuries is just shy of 200 basis points during the first seven months of 2018.

In short, interest rates need to be on the radar going forward, especially when looking at refinance risk for shorter term bridge loans that assume some repositioning of an asset.

Current expected credit loss standards. Beginning in mid-December 2019, the new Financial Accounting Standards Board reporting for the accounting of credit losses for certain instruments takes effect. The new measurement is based on expected losses, commonly referred to as the CECL model. It applies to financial assets measured at amortized cost, including loans, held-to-maturity debt securities, net investment in leases, and certain off-balance sheet credit exposures, such as loan commitments. While not a regulatory change, it is a financial reporting change, and it could have significant implications to lenders - banks, funds, or anyone who has financial assets like commercial real estate loans. Firms need to reserve from the date the asset is originated using a repeatable, defendable, and supportable process, so that in the event that losses do occur in the future, a reserve has been captured based on a consistent model over time. The implications are tough to measure in terms of implementation costs, requirements, and timing. The challenge for external auditors will be to look for documentation and evidence used by management in preparing their estimates.

When a correction in the market will come is uncertain. When it does occur, it will look different than the last one. It will not be a highly levered capital markets across-the-board implosion like last time. Some major private equity funds are out raising capital, some of the largest amounts that they have ever raised - perhaps either to buy, to bet on further improvement, or in anticipation of distress. The capital will be available, along with the technology to analyze deals quickly, and the experience and wisdom gained from the last implosion.