Talk About DÉjÀ Vu.
When Ranieri Real Estate Partners closed its acquisition of Deutsche Bank Berkshire Mortgage earlier this year, a familiar face orchestrated the deal.
Jon Vaccaro led Deutsche Bank’s Commercial Real Estate group from 1997 to 2010, building it into a powerhouse of multifamily finance. One of the biggest splashes during his tenure was the acquisition of Berkshire Mortgage, a prolific agency lender and a strong complement to the bank’s active conduit lending operations.
In April 2010, Vaccaro left Deutsche and co-founded Uniondale, N.Y.–based Ranieri Partners with Lewis Ranieri, often credited as being the father of the commercial mortgage-backed securities (CMBS) industry. And 18 months later, there was Vaccaro, acquiring the same agency lending unit, for the second time.
Vaccaro is something of a securitization trailblazer himself. From 1986 to 1992, he led Citigroup’s Real Estate Capital Markets division, developing its CMBS operations into one of the nation’s largest. Yet, for all his background in the capital markets, Vaccaro knows the private sector can’t be the only alternative for multifamily borrowers.
“A world without Fannie Mae and Freddie Mac is a theory,” he says, “and is not viable.”
But is the current market share of the government-sponsored enterprises (GSEs) viable? Together, the GSEs have more than half the market for permanent multifamily debt, a level of dominance that hasn’t changed much since they were commandeered by the government in September 2008.
The GSEs were there when the industry needed them most, providing liquidity as the private sector—banks, life insurance companies, and conduit lenders—licked its wounds. This countercyclical liquidity became the silver lining of conservatorship. But the longer the GSEs’ future remains uncertain, the more important the private sector becomes.
And private-sector lenders are slowly, cautiously coming back to life. Unlike in the past, the GSEs welcome that competition with open arms (see our interview with John Cannon, head of production at Freddie, on page 32). In fact, Fannie and Freddie are slowly starting to underwrite more cautiously, as competition increases.
“The growth in rents is starting to taper off a little. Cap rates are fairly low,” says Vaccaro. “The agencies are now thinking they need to be a little bit more restrictive in their underwriting. They’re just starting to do that, while others are starting to be more aggressive.”
A Post-GSE World?
When Vaccaro started his career at Citigroup, the apartment finance world was dominated by banks, thrifts, and life companies. And to some multifamily veterans, it’s just a matter of time before the private sector again becomes dominant.
“It might not be quite as fluid for a period of time, change will come slowly, but the private sector will, over time, be able to make up the slack,” says Walt Smith, CEO of Dallas-based Riverstone Residential. “When the markets froze up, the GSEs were the only answer just because we hadn’t developed any other model. But the next time it happens, the private sector could be there.”
During the darkest days of the downturn, every borrower had the agencies on speed-dial. After all, if it hadn’t been for the GSEs, cap rates would’ve risen dramatically, and values would’ve plunged, much as they did in every other commercial real estate sector. Yet, the GSEs provided a safety net, minimizing the free fall.
Even well-heeled public REITs leaned heavily on Fannie and Freddie during the downturn. Rochester, N.Y.–based Home Properties, for instance, has traditionally been a heavy Fannie Mae borrower. And that goes doubly so when the public markets freeze up. But according to Home’s CEO, Ed Pettinella, the GSEs’ possible demise isn’t cause for too much alarm.
“Let’s say the GSEs are gone—so what? I believe it will cost us only another 25 to 35 basis points to exist,” says Pettinella. “Banks would kill to get our portfolio, and life companies, too, so I really think it’s going to be a nonevent.”
Still, the private sector’s ability to ramp up will be challenged by a more vigorous regulatory environment. Dodd-Frank will likely alter the way CMBS loans are originated and sold, and Basel III regulations await the banking sector.
Like Home Properties, Highlands Ranch, Colo.–based UDR has its fair share of GSE loans. During the depths of the recession in 2009, the REIT took out a $200 million line of credit with Fannie, and a year before that, UDR and Fannie Mae partnered on a joint venture valued at $650 million. According to Tom Toomey, UDR’s CEO, apartment firms will just have to adjust to a more cautious capital environment should the GSEs be eliminated.
“Further banking regulations are going to restrict the regional banks and what they can do, and I think that’s going to be just the tip of the iceberg,” says Toomey. “The cost of debt is going to rise and start drifting back to its long-term average. And this low-levered model that we think is temporary might be more permanent—you’ve got to get used to the 50 to 65 percent leverage model.”
Once upon a time, life companies dominated multifamily finance. And the way they’ve been behaving, you’d think they’re gunning to turn back the clock.
Life companies went gangbusters in 2011, processing deals hand over fist, and they continued that pace well into the fourth quarter of 2012, giving the GSEs a run for their money. “Some of [the GSEs’] competitive advantages are starting to erode,” says Gary Mozer, CEO of Los Angeles–based George Smith Partners.
Firms like Prudential, Northwest Mutual, New York Life, and MetLife have stepped up to compete with Fannie and Freddie by trying to be less conservative in their underwriting, such as by offering more flexible prepayment penalties.
Yet, the traditionally conservative sector continues to target only the best of the best, cherry-picking the most desirable deals.
“Life companies will be a good source of capital in the foreseeable future,” says Mitchell Kiffe, senior managing director at New York–based CBRE Capital Markets. “Life companies are very disciplined investors; they tend not to get caught up in the market. And they weathered the downturn very well.”
Although life companies don’t have as much multifamily business as they’d like—it’s tough to compete with a government guarantee—they are getting creative and stretching for good deals to round out their portfolios. Many life companies compete on development deals by using construction-to-permanent loans as a way to capture more long-term business.
While the FHA offers a similar product, the Sec. 221(d)(4) program, most borrowers have difficulty dealing with the FHA’s long turnaround times.
In the run-up to the downturn, CMBS was the hottest ticket in town. But is the sector ready to scale up again?
CMBS delinquencies fell for the fourth straight month in September, according to Fitch Ratings. Multifamily-loan delinquency rates, in particular, fell to 9.95 percent, down from 10.18 percent the previous month.
And as the legacy portion of the industry starts to heal, the pace of originations is beginning to accelerate. Interest rates for CMBS loans have come in significantly over the past two months, in a range that makes traditional agency borrowers take notice.
Just like with life companies, conduits flex their flexibility as a key area of differentiation.
Vic Clark, managing director at New York–based Centerline Capital Group, says conduits are winning more and more deals that fall out of the agencies’ credit box. He recently quoted a complex portfolio deal with Freddie Mac, but the deal went to CMBS—even though the interest rate was higher—because of underwriting flexibility.
“The borrower just preferred the CMBS deal,” Clark says. “It had complications that resulted in heartburn for Freddie, including things like fractured condos. There was a complicated ground lease on one of the properties; there was a huge military component on one of the properties. I won’t say agencies won’t ever do those deals, but they make it complicated.”
After closing that CMBS deal at the end of September, Centerline had five others in process, Clark says.
The slow return of the sector becomes more important in light of the uncertain future of Freddie and Fannie. Many industry watchers wonder if the next incarnation of Fannie and Freddie will have access to a government guarantee, but to Clark, it’s not as big an issue given the agencies’ increasing reliance on securitized lending. The overwhelming majority of Fannie Mae’s business is now done through its mortgage-backed securities program, while Freddie Mac has its Capital Markets Execution program.
“I think Freddie Mac is already prepared to walk away from the government guarantee because they’re basically a securitized lender,” says Clark. “They have a three-year-plus history, and they’ve been successful, and with or without the guarantee, they’re going to be successful.”
But the CMBS market was pretty undisciplined during the boom years. While the CMBS delinquency rate is now under 10 percent, it bears repeating that the combined delinquency rate of the GSEs is less than 0.50 percent.
And for all the talk of life companies, they still only muster about 10 percent market share combined in their most active years. Like life companies, banks are also balance-sheet lenders, and balance sheets can only stretch so much.
“The CMBS market, which is a rated market, has demonstrated poor performance, [and] with respect to the bank and insurance company market, there is limited capacity,” says Vaccaro.
Yet, even banks, a traditionally conservative sector, were not immune to the hysteria of the boom years.
Ranieri Partners has a fund that invests in distressed commercial real estate loans, and, generally, that fund buys loans from banks and other large financial institutions. “Surprisingly, in the banks, there’s a high incidence of multifamily defaulted loans,” Vaccaro notes. “In our fund, 45 percent of the defaulted loans we buy from banks are multifamily.”
To Vaccaro, all this talk about the private sector’s firepower is about more than just quantity—and it still remains to be seen whether the conduits, banks, and life companies can fill in for the agencies. The argument is also qualitative—even if there is enough firepower, is the private sector, in its entirety, of the same caliber as the GSEs?
“Many of the replacement lenders to Fannie Mae and Freddie Mac lack the experience of carefully managed underwriting,” Vaccaro says. “As a result, we could be creating a credit problem that currently does not exist.”