With market fundamentals justifying more and more market-rate apartment development, and with both short- and long-term interest rates generally on upward paths, a growing roster of top-tier insurance companies has started combining construction facilities with forward permanent-financing commitments – all at one fixed interest rate.
Predictably, apartment developers such as Sares-Regis Group and The Habitat Co. are jumping on opportunities to guard against potential interest-rate hikes during extensive construction periods.
In the current rising-rate environment, these developers are willing to pay a modest interest-rate premium to lock in a long-term fixed rate before construction gets under way. Given that benchmarks for short-term floating-rate debt have actually been higher than the long-term benchmarks in recent months, builders also see benefits in financing construction at the locked-in long-term rate.
Nor does it hurt that a construction forward commitment entails one set of closing costs and fees, rather than a second round when a permanent mortgage from another lender takes out the construction loan. These savings might amount to a half-point or so.
“Given the flatness of the yield curve today, developers are attracted to these programs that lock in a fixed construction rate and 10-year permanent rate at application with one set of closing costs and fees,” said John Cannon, executive vice president at Capmark Financial (formerly GMAC Commercial Mortgage). Not only are developers looking to avoid the risk that permanent rates will rise during construction and lease-up, but they’re also averse to floating construction debt, which is significantly more expensive than it was two years ago, Cannon added.
Running the risks
Of course, a developer locking in a long-term rate two or three years before a construction facility rolls into a permanent mortgage is also taking a risk that long-term rates could fall during the interim. Similarly, if short-term floating rates fall during the construction period, developers could end up paying a bit more in interest costs than they would under a traditional variable-rate structure. It’s impossible to specify where relevant indexes and rate spreads will be two or three years out, but some apartment developers see the fixed-rate forward structure as a pretty reasonable gamble given the historically attractive rate environment prevailing over the last couple of years.
For example, though financing on Sares-Regis’ 540-unit Reserve @ 4S Ranch development might not roll into permanent mode until late 2008, the Irvine, Calif.-based developer was able to lock in a 5.75 percent rate at application last fall. The package for the suburban San Diego apartment community includes $80 million in fixed-rate debt from Massachusetts Mutual Life’s Babson Capital Management unit, along with $43 million in floating-rate debt from Bank of America covering the balance of construction costs.
The fixed-rate debt locked at a rate that Sares-Regis Senior Vice President of Finance Marty O’Hea estimated at about 125 to 130 basis points over the then-prevailing 10-year Treasury yield. Life insurers typically quote a forward rate by adding a premium to the lender’s prevailing base spread (the spread it world quote on a permanent mortgage for the same community if it was stabilized). In other words, if Babson’s typical spread was 100 basis points over the 10-year Treasury at the time of the application, that means its forward premium amounted to around 25 to 30 basis points.
But from Sares-Regis’ long-term perspective as a developer and a borrower, the base and premium spread calculations aren’t nearly as significant as the all-in borrowing rate for a project that couldn’t be generating income for two-and-a-half years or more, O’Hea said. “No one’s smart enough to say [with certainty] whether Treasuries and rates will be higher then. Our thinking was that having the 10-year Treasury at about 4.5 percent presented an incredibly attractive opportunity from a historical perspective,” he added.
The developer had also observed “some evidence that the Fed was then probably two-thirds of the way through its rate-hiking [mode], and there were projections that the 10-year Treasury would probably get to 5 percent or 5.5 percent” within a year or so, O’Hea continued. So locking-in the long-term rate months before construction even got under way “is a lot better than having to wonder what the world will look like when you have to take out your construction debt in three years,” he said.
Added business for portfolio lenders
On the other side of the fence, life companies and other traditional portfolio-type lenders see the fixed-forward structure as a solid opportunity to drum up much-coveted permanent multifamily lending business – while also earning a pretty decent premium over long-term rates during the interest-only construction period, Cannon said.
Life companies are particularly well represented among the select group of primarily portfolio-type lenders now fine-tuning the forward construction/permanent programs for market-rate developers, according to Peter Norrie, vice president at Cohen Financial. There’s also some indication that commercial and investment banking companies with loan warehousing capacity are starting to fund these deals, with an eye toward securitizations of the permanent mortgage after roll-over and stabilization, said Norrie. In some cases, particularly for exceptionally large developments such as Reserve @ 4S Ranch, portfolio lenders might partner with a traditional construction lender contributing a portion of the debt on a short-term basis.
In addition to Babson, Norrie and other experts identified Northwestern Mutual Life, Allstate Investments, MetLife, Principal Financial, Teachers Insurance & Annuity Association (TIAA) and AEGON as some of the major insurers offering fixed-forward programs. Although 10-year maturities and 30-year amortization schedules are pretty much standard terms, programs can vary with respect to rate calculations, closing costs and fees, loan-to-value cost ratios, roll-over schedules, interest/operating-deficit reserve requirements, recourse/ security provisions, extended interest-only periods, and other elements.
As for the forward-commitment premium, a lender will likely look to lock in a coupon rate equating to 1.5 to 2 basis points over its base stabilized rate for each month between the rate-lock and the expected forward funding, according to Mike Kavanau, senior managing director with Holliday Fenoglio Fowler (HFF). Lenders also typically factor in a grace period of three months to finalize documentation and allow work to get under way.
For example, if the lender’s likely rate for a comparable stabilized community is 100 basis points over the 10-year Treasury, and the project’s certificate of occupancy is expected 18 months later, the coupon rate would probably be somewhere between 122 and 130 basis points over the 10-year rate.
Depending on the program, the financing might roll over from construction to permanent at completion, or at stabilized occupancy, or when the development reaches an income-based valuation hurdle. If the financing rolls over at completion, lenders might require additional interim security such as continued recourse or a back-up letter of credit. Some programs include a so-called earn-out element, allowing the permanent debt amount to increase following lease-up based on income performance, but typically subject to a pre-set maximum.
A standard fixed-forward structure would have the construction-period debt covering up to 80 percent of cost, with the lender adjusting the loan amount to 80 percent loan-to-value at rollover or stabilization. But in some cases where a proven developer has arranged an equity commitment to take out 20 percent or more of the construction period debt at roll-over, a life company (possibly partnering with a construction lender) may be willing to fund close to 100 percent of a project’s cost. As is the case with Sares-Regis’ Reserve @ 4S Ranch development, the construction-lender funding that’s intended to be taken out by the equity infusion might be quoted on a floating-rate basis.
In one deal done with an expected equity infusion, GMAC/Capmark and TIAA partnered to provide more than $104 million toward development of Habitat Co.’s 420-unit Grand Kingsbury high-rise in Chicago’s North River district. The construction-period debt amounts to more than 98 percent of development costs, with GE Asset Management committed to infusing about $30.45 million in equity to take out GMAC’s short-term facility at rollover.
Given where long-term rates have moved since Habitat locked in the rate late last year, the fixed-forward execution has proven quite attractive at this point, Kavanau said. By mid-June the 10-year Treasury rate had already nearly caught up with Habitat’s coupon rate – and Grand Kingsbury isn’t scheduled for occupancy until next year, he added. “You look at where both the 10-year Treasury and LIBOR [the London Interbank Offered Rate] have moved since then, and they’re pretty happy they did it.”
Once GE contributes the cash at completion, TIAA will hold a $71.5 million permanent loan that works well for its portfolio. The lenders also required a letter of credit equating to 12 months of debt service. But the expectation is that the LTV ratio will end up in the safe “low-60s” loan-to-value vicinity at or shortly after stabilization, Kavanau said.
Sares-Regis’ financing package for Reserve @ 4S Ranch covers 100 percent of the development’s cost, thanks to a $49 million equity commitment from an institutional investment fund managed by BlackRock Realty (effectively taking out Bank of America’s short-term floating debt). The deal also includes an earn-out component allowing for permanent debt from MassMutual potentially amounting to as much as 90 percent of the construction cost.
The loan is scheduled to roll over from construction to permanent mode concurrent with the equity infusion, 40 months after initial funding. So if Sares-Regis manages to complete the Reserve project in just 30 months, the ownership entity can “sit on” the 100 percent financing under an interest-only schedule for much of a year, O’Hea said.
If at rollover, the project isn’t stabilized according to a pre-set income-based formula, the developer has another 12 months under an interest-only schedule (but subject to a letter of credit) to maximize the permanent proceeds through the earn-out. Any additional debt beyond MassMutual’s initial $80 million would be priced at the prevailing market rate, according to O’Hea.
With long-term fixed rates up about another 50 basis points since the Reserve’s lock-in date, O’Hea wouldn’t hesitate to consider another fixed-forward deal. “If I had another project under consideration today and wanted to commit to long-term financing, it would still be a pretty attractive strategy today with the 10-year Treasury at 5 percent.