As 2019 draws to a close, investor interest is growing in several emerging assets, including co-living, workforce housing and cannabis tenants. Matt Wurtzebach, senior vice president in the Commercial Finance Group at national real estate services firm Draper and Kramer, Incorporated, shared his thoughts with Midwest Real Estate News about what he’s seeing from the front lines, including lender appetite across these emerging segments of the multifamily market as well as special challenges associated with financing cannabis real estate.
How do prospective lenders view co-living deals?
Wurtzebach: Co-living is a practical solution for price-conscious middle-income earners in their 20s and early 30s who want to live in top-tier locations with modern amenities, but lack the budget for a conventional apartment. In a co-living community, where rents are by the bed rather than the unit and often include furniture, utilities, cable, internet and other services, total monthly expenses can be 30-50 percent less than the cost of renting a traditional studio in a similar building.
We are seeing increased appetite for this asset type among bank and debt-fund lenders, and expect more permanent lenders to enter the space as additional transaction and operating data becomes readily available. We spend a lot of time upfront with borrowers compiling comparable data, showing the underwriting from multiple angles and creating a narrative for the business plan to demonstrate the merits of the project. This includes benchmarking rents against comparable studio and one-bedroom apartments in the submarket, stress-testing the underwriting against traditional apartment execution and making sure operating expenses are supportable.
Most permanent lenders will want to see around 12 months of stabilized operating history on a pure co-living project. For co-living concepts that utilizes a master lease structure, we have seen resistance from some lenders once the lease exceeds 20 percent of the space. And, since the agency lenders are still evaluating the co-living concept, engaging and building relationships with balance sheet lenders is critical. Co-living is still new to many loan officers and their committee members. To find the best terms, borrowers need to invest the time to educate the market and find the right fit for the loan.
What kind of financing is available for workforce housing?
Wurtzebach: Workforce housing is another area where we are seeing increased interest from lenders and owners. Some Midwestern cities estimate the local gap between supply and demand to be in excess of 100,000 units. According to the National Low Income Housing Coalition, most Midwestern states are meeting 40 percent or less of the demand.
As workforce housing can sell at a 300+ bps premium to luxury apartments, we are seeing more entrants in this market. This is particularly true in areas with an outdated housing stock near transportation, retail and other public amenities, and with low to moderate crime levels. The permanent loan market provides a variety of attractive finance options for loans beginning at $1 million with loan-to-value ratios of 80-85 percent. It is important to receive quotes from all the GSE lenders, as well as traditional balance sheet lenders, to find the best execution. Current rates are inside of 3.50 percent for loan terms to 35 years. Small loans will price with a premium.
The workforce housing bridge and construction finance space is lagging the permanent loan market, especially for loans less than $5 million and/or tied to projects with a heavy value-add component. During the last recession, many banks sustained losses in affordable housing and have been slow to re-enter the space. Local banks, and banks with a need for Community Reinvestment Act (CRA) credits, have shown the greatest interest. Finding those lenders requires a lot of local knowledge and longstanding relationships.
Bridge lenders looking to create a pipeline for Small Balance Loan (SBL) agency platforms are active but often require a starting debt service coverage ratio (DSCR) of 1.00 – which eliminates heavy value-add – or higher loan balances.
Similar to other asset classes, debt funds are filling the funding void, but the pricing delta can be substantial. Where loans greater than $5 million or with a DSCR approaching 1.00 can price below L+250 (below 4.50 percent today), smaller heavy lift loans that do not fit a bank program can price in the high single digits. We expect rates in this market will compress as more sponsors and lenders chase yield; however, it is important to methodically cast a wide net in order to obtain the best-in-class terms.
What challenges do borrowers face for properties with cannabis tenants?
Wurtzebach: As more states legalize cannabis, the conflict between state and federal regulations is having an increased impact on commercial real estate transactions. While this is not a business line we actively seek at Draper and Kramer, it is an issue we are encountering more frequently, and borrowers should know how it will impact their capitalization. Even though Congress continues to advance legislation easing banking regulations for cannabis-related tenants, nationally chartered banks, life insurance companies, CMBS lenders and other financial institutions directly under the purview of federal regulators are not financing properties with cannabis-related tenants.
For these lenders, properties with cannabis-related tenants, which often includes tenants that service the industry but do not touch the product, are off-limits. In some instances, lenders have received letters from federal regulators post-closing after unknowingly financing assets where a cannabis tenant was a small portion of the collateral. This is starting to prompt changes in loan documents and required standard lease forms specifically prohibiting cannabis tenants. Given the headline risk, even when federal law changes, many of these lenders will be slow to follow.
Despite the challenges, there are lenders financing these properties. Debt funds, particularly those not relying on a CLO exit, are active in the space at rates as low as 5.50 percent. State-chartered banks will also provide competitive loans, but even here, borrowers need to do their research first. Banks with meaningful retail deposits, and therefore FDIC insurance, are less likely to compete. Additionally, both groups of lenders have varying standards on tenants. For example, some will not allow product on-site or will only quote the opportunity if the cannabis tenant is a small portion of the revenue. To improve certainty of execution, it is important to clearly define the use, describe the tenant’s business and demonstrate that the tenant is paying a market rent.
Matthew Wurtzebach is senior vice president of the Commercial Finance Group at Draper and Kramer, Incorporated, a national real estate services firm based in Chicago. Draper and Kramer’s Commercial Finance Group is the largest single-office mortgage banking group in the country. Since joining Draper and Kramer in 2005, Wurtzebach has closed more than 360 CRE loans totaling in excess of $5.5 billion.