Given Wall Street bond buyers’ seemingly insatiable appetite for securitized multi-family debt, investors looking to buy or refinance market-rate apartment properties can look forward to blistering competition for their borrowing business in 2007.
And that’s not the only good news for borrowers; it comes against the backdrop of an interest-rate environment that’s improved markedly in the last half of 2006. The 10-year Treasury yield, the benchmark index against which permanent apartment mortgages are typically quoted, had fallen from higher than 5 percent six months earlier to below 4.5 percent as Apartment Finance Today went to press in mid-December. With full-leverage spreads for well-positioned properties often coming in below 100 basis points over the 10-year Treasury, the typical coupon rate should start the year below 5.5 percent—pretty attractive from a historical perspective.
“There’s just no other way to put it: 2007 is going to be a bonanza for borrowers,” said high-volume loan originator Andy Little, a real estate investment banker with John B. Levy & Co. “Absent some world-altering event, it’s going to be a brutal environment for lenders.” “Multifamily debt continues becoming more and more of a commodity, and that’s pushed the [spread-based] pricing down and will most likely continue to do so,” added active borrower Bob Hart, president of repositioning specialist Kennedy Wilson Multifamily. “The market continues to become more efficient and liquid” as conduits, government-sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, and other lenders compete through ever-innovating programs and structures, he continued.
Very aggressive underwriting practices
The competition is bound to generate “very aggressive” underwriting practices providing borrowers with both attractive spread-based mortgage pricing and abundant total loan proceeds, said Little. The environment should likewise keep borrower-friendly interest-only repayment schedules available for extended loan periods, even for higher-leverage mortgages.
Rate spreads quoted for 75- to 80-percent loan-to-value loans secured by stabilized, well-managed properties have typically remained within the historically tight range of about 90 to 110 basis points, and even a bit tighter in highly competitive cases. While finance pros question whether it can be profitable—or prudent—for lenders to go any tighter, competitive pressures as the new year approached seemed to leave that question up in the winter air.
One thing seems certain: Spreads aren’t about to widen any time soon, at least as long as no unexpected shocks hit the market.
“Where there’s an experienced borrower, a quality asset, and an appropriate leverage level, we’re still seeing pricing moving down,” said multifamily finance specialist Andy Weiss at Meridian Capital. “It seems we’re going to see all kinds of pressure on spreads in 2007,” Little lamented.
An October Federal Reserve survey of bank lending officers indicated that some 40 percent of lenders had moved toward tightening commercial real estate lending standards during the third quarter—a dramatically higher proportion than the single-digit level seen early in the year. However it appears conduit lenders and GSEs, the biggest players in permanent apartment lending, continue underwriting with quite optimistic assumptions about multifamily market fundamentals going forward.
For instance, some of the more aggressive lenders are underwriting rent growth in the strongest markets at maybe 7 percent in the first year and 5 percent thereafter, noted R. Lee Harris, president of multifaceted commercial real estate operation NAI Cohen-Esrey Real Estate Services, Inc. “But in reality, it’s probably more prudent to underwrite rents more in line with inflation expectations generally.”
The decline in the 10-year Treasury rate in recent weeks has generated quite a bit of refinance and acquisition activity, a trend that may boost early 2007 borrowing as well, said Chad Hagwood, senior vice president at giant property finance firm Capmark Finance. “We’re not seeing any slowdown; it’s been a very busy fourth quarter.”
With investors still finding both debt rates and apartments quite attractive, Hagwood anticipates plenty of financing activity in 2007. “But the deal flow could slow if long-term rates start moving the other way,” he acknowledged.
Harris expects conduit lenders to remain the most liberal with underwriting assumptions. They have also been the most aggressive with interest-only periods and leverage. For instance, Kennedy Wilson Multifamily late last year tapped a conduit lender for an “IO” loan running the full 10-year term at an attractive 5.85 percent fixed rate, Hart noted.
But Fannie and Freddie are obviously seeing a good share of business, as both posted increases in third-quarter apartment loan originations. The agencies’ so-called “supplemental” loan programs should remain attractive alternatives for apartment investors who expect to boost operating incomes over relatively short value-add periods, yet also aim to continue holding them long-term, predicted Little.
These plans pre-set arrangements for additional permanent financing that borrowers can tap when a property achieves targeted operating income parameters. It’s a structure that’s not efficiently compatible with Wall Street’s securitized mortgages, Little said. Fannie is also becoming more competitive with conduits through a new program allowing larger borrowers to substitute the original collateral with a comparable property if an attractive sale opportunity arises. As long as underwriting demonstrates equal or better characteristics including loan-to-value and debt-coverage ratios, borrowers can essentially transfer the same rates and terms for the balance of the loan period to the substitute property and free up the original for sale or refinance.
Of course, some pros worry that exuberant high-leverage, high-valuation lending might ultimately come back to haunt lenders and borrowers alike if the marketplace suffers a significant downturn.
“We haven’t seen a real hiccup in the market since the early ’90s, and lenders are getting sleepy when it comes to worrying about potential loan workouts,” said Michael Melaugh, executive managing director of capital markets at Trammell Crow Residential.