As 2015 dawns, many multifamily investment professionals are letting out long and heartfelt sighs of relief as the heady days of the recession finally fade into the rearview mirror.
The engine of the U.S. economy is once again a shining example to the rest of the world. Public indices are breaking records, housing starts are increasing, unemployment is decreasing, and consumer confidence is high.
With all this positive news, multifamily investors may be tempted to view the future with rose-colored glasses, but, first, they have to consider an approaching specter of the past: a 72% increase in loan maturities in 2015, mainly driven by the easy credit boom in 2005.
The Fantasy of
Perpetually Rising Values
To understand the oncoming wave of loan maturities, one must travel back in time to 2005. The 10-year Treasury rate that year was 4.59%; the one-month LIBOR benchmark, 2.85%; and the prime rate, 5.75%. Investors had just wrapped up their first full year of consistently rising prices and were finally shaking off the lingering shadows of the dot-com bust.
Meanwhile, the capital markets began seeing the first signs of investors and lenders buying into the fantasy of perpetually rising values. At the time, lenders were primarily sizing their loans as a percentage of the appraised value of a property, limiting proceeds with a loan-to-value (LTV) constraint. LTV and risk to the lender are positively correlated, with a higher LTV resulting in a smaller equity cushion to absorb value losses before the property goes underwater. Therefore, lender spreads over Treasury bills on highly leveraged loans provide a strong indication of the outlook for future values. In 2005, George Smith Partners was regularly closing 80% LTV, 10-year, fixed-rate loans at barely 100 basis points over the 10-year Treasury—possibly the strongest indication that the market fully believed in uninterrupted value appreciation.
Fast-forward 10 years, and today’s low interest rates, with correspondingly low cap rates, have lessened the relevance of traditional LTV and debt-coverage ratio (DCR) underwriting metrics. Lenders, however, are much wiser this time around. While LTV and DCR remain important metrics in a lender’s underwriting, a new constraint arose during the financial debacle of 2008–2012: the debt yield (DY), which is calculated by dividing the net cash flow of a property by the total amount of loan proceeds.
Unable to find market-comparable sales due to the flood of real-estate owned (REO) and distressed sales, LTV became irrelevant. Comparing a property’s value with a neighboring property’s discounted payoff value made no sense. Debt-yield constraints are designed to divorce the lender’s underwriting from interest and capitalization rates and offer an additional layer of protection from future expected rate rises. When lenders first put their financial toes back in the water, post-recession, DY was very high (conservative), at 10% or more. With rents still recovering from recession levels, this left most multifamily owners unable to refinance their debt as it matured. With most capital sources standing on the sidelines, those that were lending were generally oversubscribed and felt no pressure to compete.
Capital began to trickle back into the markets in 2013 and strengthened to a torrent in 2014. As the economy continues to pick up steam in 2015, capital is flooding into the marketplace, and the stalwart lenders of the post-recession era are facing increasing competition for loans. This has begun a shift from a lender’s market to one that is ever more a borrower’s market.
Multifamily owners and investors have much to look forward to in 2015. Rents are returning to pre-recession levels at the same time that lenders are loosening their underwriting standards and aggressively lending. Liquidity has returned to the market as capital has come flooding back in. Debt yields have dropped from 10%+ to 8% and lower in certain scenarios. Suddenly, borrowers are faced with a multitude of choices for competitive long-term, fixed-rate debt. It is more important now than at any time since the recession for a prospective borrower to understand the strengths and weaknesses of each type of financing.
The 800-pound gorillas in the apartment finance world are Fannie Mae and Freddie Mac, also known as the government-sponsored enterprises, or GSEs. Both offer mid- to highly leverage, nonrecourse loans at very competitive interest rates, usually focusing on affordable rental product. The average GSE loan is in the $10 million to $15 million range.
In 2013, GSE lenders originated $47.6 billion worth of multifamily mortgages, taking 28% of that year’s multifamily origination market. In 2014, Fannie and Freddie increased their originations by 20%, putting out $57.2 billion in financing, in a market that saw an overall decrease in debt maturities year over year. Freddie Mac was so oversubscribed that it was forced to delay $800 million in financing until 2015 because it had reached its government-mandated volume cap.
For 2015, both GSEs have had their caps increased to $30 billion each, for a total cap of $60 billion in Fannie and Freddie funding. This brings up an important point for the GSEs: They are extremely popular options for financing multifamily and have been gaining in popularity each year. Owners who have loans coming due this year can’t afford to run up against the government cap and have their financing delayed until next year. GSE originators require a thorough and exhaustive documentation process in order to ensure that their loans conform to Fannie and Freddie requirements. Investors considering financing their properties with the GSEs should start the process as early in the year as possible.
and CMBS Lenders
Fannie and Freddie’s preference for affordable housing can often leave a gap in the market for high-quality, Class A properties. These highly valued, low–cap rate, well-located properties tend to be the purview of life company lenders. These lenders want to take the smallest amount of risk possible and are willing to offer some of the best interest rates to secure it.
Life companies are extremely strong players when it comes to low-leveraged, Class A multifamily properties in dense urban infill. Due to the typically high value of these properties, the average size of a life company mortgage hovers around $22 million.
Life companies also keep their loans on balance sheets, which allows for creative structuring of prepayment, amortization, and other terms. In addition, keeping loans on balance sheets permits the hands-on administration of loans (as distinguished from using a third-party loan servicer). If a life company borrower should find itself battling unfavorable headwinds, it can talk with the life company contact or mortgage broker about renegotiating the terms. In contrast, the GSEs and commercial mortgage–backed securities (CMBS) lenders both sell their originations in the securitized markets. Securitized loans are serviced by master servicers that have proved extremely inflexible when properties have problems.
Besides providing access to securitized markets, CMBS lenders can offer highly leveraged, nonrecourse financing on any class of multifamily property, generally at a slightly higher rate than one would get from the GSEs or life companies. CMBS lenders justify this higher price by taking on slightly riskier, “story” properties.
For example, perhaps the borrower had a rough time in the downturn, or the property only recently was restabilized but doesn’t show a strong-enough trailing–12 month operating statement to garner GSE or life company interest. Since CMBS lenders aren’t as heavily regulated as the GSEs and draw upon a market of investors who are willing to pay for additional risk, they can be a fantastic tool for financing the many properties that don’t fit within the GSE or life company boxes.
Securitization markets put particular emphasis on the debt-yield constraint, which results in more-favorable pricing for higher-cap properties, usually located in secondary and tertiary markets. One danger to consider, however, is the inherent instability of cap rates in these markets. Since many of them don’t enjoy the stabilizing benefits of infill, highly urbanized major metros, cap rates in secondary and tertiary markets decompress more quickly in downturns and rising–interest rate environments. This can quickly leave a maximum-leveraged property underwater, unable to refinance, and poorly located.
CMBS buyers demand a standardized and homogeneous product to ensure that every bond sold with a particular rating will perform exactly the same as every other bond carrying the same rating in that securitization. This requires copious and ironclad loan documents to ensure that every loan underpinning the pool fits into that homogeneous mold. This makes the due diligence process particularly strenuous to navigate while also limiting the borrower’s options and flexibility if something goes wrong with the property after securitization.
A good real estate investment banker can be a valuable resource to an investor navigating the labyrinth of financing options. Because real estate investment bankers are in the market 24/7, they have the most current information on the latest products that various lenders are offering. And the most common refrain we heard while interviewing lenders for this article was that they planned to tackle the wave of maturities by being more aggressive. This means new programs, new standards, and new terms throughout the year.
It can be tough for any borrower to keep track of who the leader is in financing for a particular asset class or situation, and competitive programs change regularly. Real estate investment bankers are constantly kept apprised of new products, as lenders compete to attract their business, and can also act as an influence multiplier, using the strength of their pipeline to negotiate better terms on individual loans.
With the Fed facing various indicators of increasing employment, an accelerating economy, and possible deflation, the Board has signaled a potential tightening and increase in rates by midyear. Despite that, 2015 will be a year of great opportunity for multifamily borrowers. With fierce competition between the life companies, the GSEs, and CMBS lenders, long-term fixed-rate financing hasn’t looked this favorable for many years.
It’s time to lock in your long-term financing to enjoy the benefits of historically low rates through the remainder of this cycle and well into the next—before the Fed starts raising rates and lenders reach their lending quotas later in the year.