“Any concern we may have about higher rates or wider spreads would be beyond 2013. We may see one of the best years ever in terms of debt cost.” —Matthew Rocco, national production manager, Grandbridge Real Estate Capital
Indeed, the consensus advice from finance pros for 2013 is akin to: This is about as good as it gets, so jump in while it lasts.
Given the Fed’s commitment to prevailing monetary policies, the low-rate environment won’t retreat any time soon. Meanwhile, the budding re-emergence of Wall Street conduits should help keep other conventional apartment lenders quoting tight spreads.
“Any concern we may have about higher rates or wider spreads would be beyond 2013,” relates Matthew Rocco, national production manager with Charlotte, N.C.–based Grandbridge Real Estate Capital. “So we may see one of the best years ever in terms of debt cost and availability.”
Conduits, the government-sponsored enterprises (GSEs), growth-minded life companies, and even recovering commercial banks all appear willing to quote tight spreads over today’s artificially low index benchmarks, making for free-flowing debt in the permanent, bridge, and construction finance spaces.
Add it up and 2013 promises a continuing borrower bonanza with permanent, bridge, and construction quotes all typically coming in below 4 percent, with floating-rate debt often starting sub-3.
“Astute investors are able to borrow with reasonable leverage at sub-4 [interest rates], allowing for very strong cash flows” at prevailing cap rates, observes apartment investment veteran Bob Hart, president and CEO of Beverly Hills, Calif.–based repositioning specialist Kennedy Wilson Multifamily (KW).
And Hart should know, considering the extent of KW’s GSE-centric borrowing of late, totaling roughly $425 million for full-year 2012. These financings illustrate just how competitive Fannie Mae and Freddie Mac can be, allowing KW to finance value-add programs and meet permanent needs on attractive terms with single debt sources rather than securing separate bridge facilities.
“We can just put it away for 10 years” at 70 to 75 percent leverage, while getting the benefit of reduced debt-service obligations during early-term interest-only (IO) periods, Hart explains.
Even at today’s compressed cap rates, KW can borrow from a GSE mostly at a mid–3 percent fixed coupon—or floating in the “low 200” basis points (bps) over Libor—and still occasionally generate double-digit, first-year cash-on-cash returns as properties are being upgraded, adds CFO Phillip Wintner.
In the wake of so much arguably rational exuberance in the market-rate capital markets in 2012, KW’s activities also portend a potential shift to a somewhat more conservative underwriting environment in 2013.
While Freddie’s acquisition loans feature IO periods running to four or even five years, Wintner cautions that both agencies may become somewhat less flexible with nonamortizing components going forward.
Indeed, experts warn that other underwriting policies may tighten up a bit as single-family homes—and the active construction pipeline—absorb some of the resilient renter demand. However, the finance pros eagerly anticipate several borrower-friendly trends to continue in 2013.
Participation by more high-yield debt suppliers should bolster the availability of so-called A/B notes and related secondary financing structures, allowing for higher leverage as investors look to refinance and acquire properties.
Rocco notes that the GSEs’ credit-enhanced securitizations keep loan-to-value (LTV) ratios in the 75 percent to 80 percent range. But he’s now perceiving greater interest at Fannie Mae and Freddie Mac lenders in offering A/B notes featuring higher-cost subordinate tranches that might boost overall LTVs up perhaps another 10 percent.
Other trends to watch for in 2013 include increased competitiveness among conduit lenders; banks becoming more aggressive on bridge and even permanent executions; more life companies prioritizing development deals; greater availability of mezz; and return expectations on equity hovering at historic lows.
Yield-challenged apartment buyers gravitating away from the prohibitively competitive first-tier cities should expect at least some permanent lenders to follow, says Jeffrey Erxleben, senior vice president with NorthMarq Capital.
Sources of debt targeting secondary and tertiary markets should continue expanding, particularly as more active conduits look to “re-securitize” so many maturing CMBS loans.
While the GSEs are more willing than life companies to fund outside major metros, the conduits appear particularly well-positioned to win business in secondary markets where rents and values generally boast more upside potential, Erxleben and others suggest.
CMBS loans are priced based on what bond buyers are willing to pay for the security. And that leaves conduit lenders with a distinct pricing disadvantage relative to the GSEs and life insurance companies heading into 2013. Interest rates are now generally in the mid–4 percent range, Erxleben adds.
Hence, in addition to their generally greater willingness to play in secondary and tertiary markets and loan against lesser-quality collateral, conduit lenders will aim to compete through the ability to close a deal very quickly, not to mention offering higher leverage, running all the way up to 85 percent LTV.
But back in the first-tier markets, conduits are unlikely to match Fannie Mae and Freddie Mac in permanent-loan pricing. Nor will conduits be able to match the term flexibility life companies are able to offer as balance-sheet lenders.
Local, regional, and national banks might prove surprisingly competitive on long-term fixed-rate transactions this year, with five- and even 10-year deals at institutions comfortable holding paper that long, Erxleben relates. Banks will also predictably lead the construction-lending pack.
And the bridge-lending niche appears increasingly competitive, hinting at wider options in rate structures, term lengths, and recourse requirements, with generally attractive pricing.
Logically, banks rank among the leading players in bridge lending, typically quoting floating rates in the mid–200 bp range over Libor. Nonbank financial institutions will also be active in this product, generally quoting floaters at 250 bps to 300 bps over Libor. Leverage limits typically amount to 80 percent of cost with an exit target of 75 percent of the post-improvement value, adds Rocco.
With conventional construction facilities, bank rates in the coming year seem likely to float in the low-200s over Libor, with proceeds typically running to 80 percent of expected costs, Rocco adds.
Meanwhile, Erxleben is seeing life company fixed-rate quotes in the high–2 percent and low–3 percent range for five- and 10-year deals. This rate is “very competitive” with Fannie and Freddie at the 65 percent to 75 percent LTV level for high-quality collateral.
As balance-sheet lenders, they can inherently be more flexible, customizing key terms such as prepayment penalty schedules and term lengths. In contrast, the GSEs and conduit lenders, which sell their loans to investors via securitizations, have much less wiggle room in structuring a deal.
But life company allocation chiefs also perceive strong opportunities to provide construction-to-permanent combos, along with select forward take-outs, and occasionally negotiate take-outs while projects are in lease-up, Erxleben continues. Again, insurers are clearly prone to stick with high-quality product built by proven sponsors.
These executions are a good way for life companies to capture long-term business. They can offer a much quicker execution than the Federal Housing Administration (FHA), though the agency has its own advantages.
NorthMarq’s pipeline of FHA construction-to-permanent loans under the 221(d)(4) insurance program likewise remains robust, even with more nimble banks and life companies banging heads over attractive projects.
“We’ll never see one-month closings with the FHA transactions,” says Erxleben. “But with ‘d4’ all-in rates in the high 2s for 40 years, it’s a very compelling program.”
Equity and Mezz
Cap rates and leveraged returns on equity will likewise hover at historic troughs this year, reflecting the low debt costs as well as the abundance of aggressive equity.
The year may also see some developers secure mezzanine capital yielding in the midteens rather than taking on equity partners to fill out their capital stack.
Addison, Texas–based Behringer Harvard, for instance, is providing such debt to help fund construction via a $300 million investment program. Erxleben says the 14.5 percent coupon rate the Behringer team is charging developers of a large Dallas-area project can work well for all parties involved. Behringer Harvard has several such fundings in its 2013 pipeline, he notes.
As for the equity component of the equation, in the continuing low-yield fixed-income environment, finance professionals predictably expect a broad spectrum of investor types to continue targeting apartments—shallow yields notwithstanding. Managers of tax-exempt institutional equity are frequently comfortable bidding at prices factoring to sub-5 cap rates for core-type communities in favored markets, Wintner confirms after recent KW sales of such assets.
Given the positive leverage between caps and mortgage rates, many investors will target leveraged going-in returns in the 7 percent to 9 percent range, with acquisitions of stabilized properties, Erxleben specifies. As today’s ultra-low interest rates appear unlikely to move much in the coming year, Erxleben doesn’t expect cap rate expectations to shift notably in 2013.
As for preferred equity internal rate of return (IRR) hurdles in market-rate development ventures, Rocco says well-regarded sponsors of top-notch projects will be able to drive hard bargains, what with so much equity gravitating toward a limited number of such opportunities.
Depending on how much equity sponsors put up, capital partners in development-oriented joint ventures these days typically claim all the initial profits until the partnerships reach IRRs in the 10 percent to 12 percent range, with developers taking a cut afterward. The promote share frequently bumps up when ventures hit 15 IRRs, and again at maybe 17, although Wintner echoes other professionals in noting that 20s have become quite the rare breed indeed.
Add it all up and generally deal structures nowadays bring development partners a 25 percent to 30 percent share of ultimate profits, Erxleben relates. “And I don’t see that changing in the year ahead,” he concludes.
Brad Berton is a freelance writer based in Portland, Ore.