Guest post by Susan Branscome, Q10|Quest Commercial Capital
An old German proverb says, “To change and to change for the better are two different things.” This market has not just changed, but very much changed for the better. Each quarter the commercial real estate debt capital loan terms offered by all lenders improves. More lenders are entering the market, underwriting is less conservative, most property types can be financed and interest rates are at all-time lows.
Underwriting and pricing differentiation is minimal between life-company and conduit/CMBS lenders although conduit lenders will consider higher leverage on certain property types in which life company lenders will not. For example, unanchored retail, older multi-family and non-investment grade big-box retail or properties in second-tier cities are property types in which CMBS lenders will offer higher leverage.
Until CMBS lenders begin to offer 80 percent loan-to-value ratios and offer significantly better pricing than life companies, conduit originations will remain lower than historical levels. CMBS lenders utilize a new measure of loan security, ‘debt yield’ or net cash flow divided by loan amount. Required debt yields have fallen below the 9 percent level as the market has become more competitive during the last year.
Another new requirement by conduit lenders is a property ‘cash flow sweep’ if the debt coverage ratio falls below a 1.05 times level. This can be waived on smaller deals but borrowers are reluctant to accept this requirement. There are new and more B-Piece buyers (first loss piece) in the pools and originators are making sure these investors are involved in the underwriting process today, avoiding originating loans not acceptable for pools.
Spreads over treasuries for life-insurance company loans are in the 175 to 250 range with lower loan-to-value transactions commanding spreads as low as 130. Conduit spreads over the 10-year swap are in the 200 to 220 range. With 10-year treasuries and 10-year swaps yielding in the 2 percent range, interest rates are between 3.50 and 4.5 percent. Shorter-term, five- and seven-year terms, as well as pre-payable loans are also offered by life-insurance companies.
All lenders have learned from the great recession that often it is not the real estate securing the loan that is troubled, it is the borrower. Consequently, underwriting of borrowers by all lenders involves much more scrutiny, including evaluating global cash flow of real estate portfolios and liquidity. A number of borrowers were left ‘real estate rich and cash poor’ after the downturn, given requirements to carry poorly leased properties and forced to ‘right-size’ or pay down loans. In cases in which borrowers ‘gave back’ properties to lenders on non-recourse loan properties, there are several considerations for lending new money: 1) How long the borrowers carried the shortfalls in cash flows of the property before giving the property back to the lender 2) The number of instances in which properties were given back and 3) Did borrowers work with the lender during this process and not resist the lender’s ability to gain access to the real estate securing the loan?
With Freddie Mac and Fannie Mae still in conservatorship, what is their future? Edward J. DeMarco, acting director of the Federal Housing Finance Agency, published a white paper in March of 2013. That paper included a couple of noteworthy comments regarding the agencies: ‘Given that the multi-family market’s reliance on the Enterprises has moved to more normal range, to move forward with the contract goal we are setting a target of a 10 percent reduction in multi-family business volume from 2012 levels. We expect that this reduction will be achieved through some combination of increased pricing, more limited product offerings and tighter overall underwriting standards.’
Although the goal is to reduce Freddie and Fannie loan originations, this has not been evident in the market. These agencies continue to offer more competitive multi-family loan pricing and more aggressive underwriting than life insurance companies and CMBS lenders.
The vast majority of originated agency loans are securitized for secondary market sale and most of the originations are single-family residential loans. Mr. DeMarco states in his comments, ‘There seems to be broad consensus that Fannie Mae and Freddie Mac will not return to their previous corporate forms. The Administration has made clear that their preferred course of action is to wind down the Enterprises.’ The future form of Freddie Mac and Fannie Mae continues to be unclear.
The years 2015 through 2017 are large loan maturity years, especially in the CMBS world. It is unclear if these loans are financeable in today’s finance market or will be in the future. Will the real estate markets AND capital market underwriting return sufficiently to accomplish making these loans financeable? It remains to be seen. There may be mezzanine loans or equity required to bridge the gaps or the special servicer/B-piece entity will allow discounted payoffs if the loan-to-values are too high to refinance the loan balances. CMBS special servicers will also extend the loan maturity dates with acceptable loan pay-downs.
The most favored property types continue to be grocery-anchored retail centers, industrial portfolios and medical office buildings. The challenge though has been that there is a considerable amount of debt capital chasing a limited number of these properties, so lenders have had to look elsewhere to originate loans.
Two property types that have been difficult for the last five years to refinance, office properties and hotel properties, have come back into favor in the lending world. With the economy improving, albeit slowly, office markets and hotel economics have improved. Loan-to-value ratios continue to be lower than other favored property types, yet there is finally acceptable financing available.
Multi-family properties are still a favored property type for life companies, although capitalization rates have dropped significantly in the last 18 months and lenders are wary to lend on purchase prices well in excess of their underwritten loan amounts. The more populous and dynamic U.S. coastal cities are demonstrating much lower cap rates recently than they have in the past. These cap rates are lower than they are in the Midwest. Lenders are having difficulty accepting these cap rates as those used in their underwriting.
It is a widely held belief that interest rates will increase, but it is uncertain when this will happen. Inflation will be the future fly in the ointment as the economy continues to improve, leading to rising long interest rates. Borrowers continue to use commercial bank debt often to finance their commercial real estate. Interest rates in the low 3s outweigh the bank requirement for personal or corporate recourse. There are instances in which commercial banks have waived or limited recourse on loans, something that is surprising given the problem loans and auditor scrutiny that many banks experienced during the downturn.
Borrowers would be well-advised to not take this low interest-rate environment for granted because it will not last. And when interest rates begin to rise, they will probably rise fast and in magnitude. Bottlenecks within lending groups will occur as borrowers rush to refinance their floating rate debt on a long-term basis. During this rush, lower quality properties will be refinanced later in the queue, most probably when interest rates are higher.
Susan Branscome is founder and President of Q10|Quest Commercial Capital, a commercial mortgage banking company based in Ohio.