“How low can it go?”
That was the question on everybody’s minds for most of 2010, as interest rates reached historic lows. Cap rates for Class A apartments compressed in concert as investors jumped off the sidelines and threw down the gauntlet.
Meanwhile, the limbo stick just kept dropping. Behind the dip, of course, was the spiraling 10-year Treasury, which started the year at 3.85 percent, but wiggled down to 2.4 percent in October, which meant borrowers were locking in 10-year rates with the agencies in the low-4 percent range—a level unheard of, even in the heyday.
As a result, the acquisition activity came rolling in at year’s end in a flurry: Consider that Freddie Mac closed $3.6 billion in multifamily loans through the first six months of the year, but by the fourth quarter, it was closing $2 billion per month.
“At some point, people will look back and say, ‘We’ll never see those rates again,’” says Mike May, who leads the multifamily division of McLean, Va.-based Freddie Mac.
Unfortunately, the gathering momentum may only be temporary. In less than a month, interest rates shot up nearly 60 basis points (bps). The 10-year Treasury went past 3 percent again in early December, sending all-in rates past 5 percent and throwing a cloud over transaction velocity and cap rate compression as the apartment industry headed into 2011.
“We all knew rates would rise. The question has always been: When?” says Don King, head of agency production for Boston-based CWCapital. “When there’s a dramatic upward movement in rates, you will get a fairly dramatic slowdown in transactions. And it’s particularly painful while the market is changing.”
Despite the rise in rates, experts say underwriting will be more borrower-friendly in 2011, thanks in large part to the return of competition from life insurance companies, mortgage REITs, banks, alternative lenders, even bridge and mezz financiers. And the simultaneous decline in the dominance of Fannie Mae, Freddie Mac, and the Federal Housing Administration will only shift the pendulum of power between lenders and borrowers even further.
“We’ve gone from a lender’s market back to a neutral market,” says Mark Wilsmann, managing director for New York-based MetLife. “But for core trophy assets in places like Washington, D.C., and New York, the market is very much a borrower’s market again—and very frothy.”
Trickling Down
The acquisition market’s recovery started at the top: Institutional buyers, including REITs such as Equity Residential and Behringer Harvard, looked to core properties with certainty of cash flow. But as those assets were bid up, a trickle-down started to occur as investors searched for higher returns elsewhere in late 2010.
Loosen Up the reins
Finding capital for a value-add/acquisition-rehab deal has been a tough task this year.
Many multifamily lenders are still shell-shocked from the acq-rehab boom seen at the height of the last upturn. Many of their balance sheets are weighed down by ambitious value-add plays that never delivered the expected results.
But as fundamentals continue to improve in many markets, more lenders are growing comfortable with the idea of underwriting rent growth. “More people are talking about it now because there is finally some debt available for it,” says Bill Hughes, managing director of Encino, Calif.-based Marcus & Millichap Capital Corp. “Six months ago, no one had enough confidence in the marketplace to take the risk of a property stabilizing. Now there are a number of different financial institutions, typically private funds, that will provide that kind of financing.”
While the GSEs clearly dominate the debt market, they’ve shied away from the repositioning market. The GSEs’ acquisition-rehab programs have basically been put on the shelf as they continue to furiously process deals for stabilized assets. This means that most of the acq-rehab business being discussed now is on a small scale—bringing a B-plus asset up to an A-minus, for instance. The rehabs that change the nature of a property—bringing a Class C to a Class B, for instance—have a much more difficult time finding financing.
“We won’t make that loan; we’re not going to speculate on that type of transformation,” says Mike May, senior vice president at McLean, Va.-based Freddie Mac. “In fact, some of our largest problem assets are exactly that.”
Yet, many private-sector lenders are growing more confident with the ability to get a pop in rents through rehab, particularly as bridge loans become more available. Active providers today include Ladder Capital, BB&T Real Estate Funding, Starwood Capital, GE Capital, Canyon Johnson, and A10 Capital—and all of them have seen a shift in their focus heading into 2011. “Bridge programs have been around, but now we’re seeing bridge product move into the arena of value-add,” Hughes says.
“The market wants a little more yield than those trophy buildings allow, so it’s migrating to deals with a trickier rent roll, or buildings that aren’t as nice,” says Mike Kavanau, a senior managing director for Holliday Fenoglio Fowler’s (HFF) Chicago office. “And then it migrates further down, until you get people going full bore on B and C properties.”
Like most trends, the story started on the coasts. Cap rate compression was soon after being felt in secondary markets such as Nashville, Tenn., and Chapel Hill, N.C., where Class A deals traded in the sub-6 percent range in 2010. But the compression that characterized 2010 isn’t expected to continue. Industry watchers say the suddenly rising interest rate environment of the fourth quarter of 2010, combined with the availability of more product in most markets, will put upward pressure on cap rates in 2011.
“Debt really does, in a lot of circumstances, control pricing on the cap rate side,” Kavanau says. “If you have sustained upward moving interest rates for a period of time, cap rates follow as a general rule.”
What’s more, for much of 2010, there was a scarcity premium baked into many cap rates. An abundance of equity looking to invest, combined with a lack of quality assets in the marketplace, made buyers willing to pay a premium for the best assets. But as more deals come to market, the more likely that premium is to go away. In fact, there will likely be no scarcity premium in 2011. “Cap rate compression has pretty much run its course,” Wilsmann says. “Values will be higher in 2011 because of improvements in NOI and not because cap rates are tighter.”
In particular, as 2010 drew to a close, speculation abounded that it was indeed cheaper to build than buy in some markets. And with so many buyers acquiring higher-end assets (Class A and A-minus) at or below replacement value, many wonder how long that dynamic will last. “The natural progression is that competition is going to drive deals above replacement cost,” says William Ross, an executive vice president at Minneapolis-based Northmarq Capital. “As effective rents start to push up, you’re going to start to drive prices up above replacement costs, and some buyers are going to be more reluctant to play.”
Opening the Portfolio
Still, forging ahead with very little reluctance this year will be the GSEs, which will continue to win the lion’s share of acquisition loans. That doesn’t mean, though, that competition can’t give them a run for their money in 2011.
Take life insurance companies. In 2010, a number of large providers, including MetLife, Prudential, New York Life, Northwestern Mutual, Principal, and Nationwide, re-engaged the market. These portfolio lenders were mostly winning large, low-leverage deals in major metros, finding the most success on transactions that fell outside of the GSE purview—pre-stabilized assets, for instance, or deals in markets where concessions were rapidly burning off. “The agency underwriting is more backward-looking so in those types of circumstances, life companies can be more flexible and offer a better execution,” MetLife’s Wilsmann says. “And life companies can be more user-friendly in terms of documentation and having flexibility to tailor the deal to the borrowers’ needs.”
MetLife led the charge—it was the most active life insurance company in 2010, allocating about $1.6 billion to lend on multifamily assets. And the firm’s appetite will only increase. “We expect to have even more money available in 2011 to lend,” Wilsmann says.
On the other end of the spectrum are the commercial banks, which have been giving the market for five-year loans some competition. Many banks spent the past few years purging troubled real estate assets from their portfolios, and they seem to once again have an appetite for balance-sheet lending.
For example, outside of agency executions, KeyBank Real Estate Capital was quiet for a few years. But it intends to start making some noise in 2011. “We’ve significantly reduced our real estate exposure, and the top of the house says it’s time to start using the balance sheet again,” says Clay Sublett, national production manager and CMBS director for Cleveland-based KeyBank. “We’re in the market on the balance-sheet side to provide financing for acquisition and renovation.”
The company is now offering LIBOR-based bridge loans—a trend that should gather momentum in 2011. Consider that Wells Fargo dusted off its non-recourse bridge loan program in 2010, as did Prudential Mortgage Capital. And Berkadia, Walker & Dunlop, Greystone, and CWCapital all say that they plan to bring bridge loan programs to the market in 2011.
KeyBank is also considering offering five-year, fixed-rate permanent loans off the balance sheet in 2011, a term where many banks are growing more competitive. “If a borrower wants a five-year deal, there’s a good chance a bank may win,” says Will Baker, a vice president at Bethesda, Md.-based Walker & Dunlop. “It may not meet Freddie Mac’s exit test, and Fannie Mae’s underwriting floor might make it prohibitive to do.” Securitization Stabilization
Simultaneously, the CMBS market is getting closer to once again being a viable execution. Berkadia and Walker & Dunlop recently opened their conduit platforms, and several encouraging signs are gathering for the sector. For example, in mid-November, KeyBank closed its first CMBS deal in more than two years, featuring an all-in rate of 5.75 percent. “The CMBS bonds have sold well, which bodes well for the return of the product,” Sublett says. “We’ll continue to see some continued creep of spread, but will it get to the point that CMBS will compete with the agencies? In the near term, probably not.”
Established players such as Goldman Sachs, JPMorgan, Deutsche Bank, Morgan Stanley, and Citibank have also been in the market but aren’t winning many multifamily deals. Yet the sector is growing more creative. Many CMBS lenders maxed out at 70 percent loan-to-value (LTV) in 2010, but by the fourth quarter, some were going up to 75 percent. Some firms, like Bridger Commercial Funding, have added a mezzanine program to their CMBS platforms, offering to go up to 85 percent LTV for multifamily properties.
“Not only are we seeing CMBS lenders be more active, but they’re starting to be more aggressive in the marketplace. One of the ways they’re competing is with some additional dollars,” says Bill Hughes, managing director of Encino, Calif.-based Marcus & Millichap Capital Corp. “I believe that CMBS lenders will become much more available next year.” Climbing Up
In 2010, multifamily started to look good to investors again. Buyers believed that the sector’s woes were largely in the past and that both the availability of cheap capital and strong risk-adjusted returns of apartments present a good bet. And this year will be more of the same. “The amount of broker opinions of value and assignments that we’re getting suggests that we’ll have a very good transactional market in 2011,” HFF’s Kavanau says.
The bonanza of deeply discounted distressed deals never really materialized, flummoxing all of those opportunity funds that found themselves returning equity to investors. But there may be a bigger flood of distressed assets this year, particularly as the FDIC continues to work its way through troubled bank holdings.
The FDIC concentrated on stabilizing the largest banks first. But the subsequent pace of smaller bank failures has overwhelmed the FDIC, resulting in delays in closing “zombie” banks, some of which probably should have been shuttered a year ago. KeyBank, along with Midland, have signed up as exclusive servicers for the FDIC, processing the loans that come out of bank foreclosures. “And the FDIC is basically telling us to buckle our seat belts for 2011,” says KeyBank’s Sublett. Continued smaller bank closures are the biggest trend yet to unfold. “These community banks are chock full of B-minus or C-quality multifamily properties,” Sublett says. “So there will be more distress sales next year on the lower quality, smaller assets.”
Overall, 2011 will likely see a rebound in transaction velocity and values. “This growth, although relatively slow, is sustainable and should build from this point forward,” Hughes says. “It seems like we’re at the bottom of the big hill on the roller coaster, and let’s just hope it keeps going up.”
—Additional data compilation by Les Shaver