Builders Lean Toward‘Fixed-Forwards’

Multifamily developers entered the holiday season atop the wish lists of many income-property construction lenders. But as commercial banks and other lenders enter the new year facing an “inverted yield curve” requiring higher interest rates on short-term adjustable debt than fixed-rate loans, they’ve generally been forced to reduce the rate spreads they can charge on floating construction loans.

Spreads are tightening on variable-rate construction loans as the short-term London Interbank Offered Rate (LIBOR) indexes have remained in the low 5 percent vicinity while longer-term U.S. Treasury-tied rates have moved back below 4.5 percent, said Michael Melaugh, Trammell Crow Residential’s (TCR) capital markets expert. TCR development ventures today typically see quotes in the range of 150 to 160 basis points over the LIBOR from bank lenders, down from 190 to 200 just a few months back.

As a result, some savvy builders are opting to work with a growing roster of life insurers willing to fund development costs through construction-permanent packages tied to today’s long-term fixed-rate indexes. Life companies struggling to compete amid a frothy permanent lending environment are targeting opportunities to provide long-term mortgages tied to construction facilities.

They’re doing it by offering fixed interest-only financing during the construction period at rates below what developers would likely get from traditional variable-rate construction lenders. These pre-locked programs also eliminate risks that permanent take-out rates will rise during the construction period, although the consensus appears to be that long-term rates aren’t headed upward any time soon.

Indeed, director John Petersen at banker CBRE/Melody sees the gap between long- and short-term rates generating more interest in these so-called “fixed-forward” combinations of construction facilities and permanent mortgages. This emerging structure, which has numerous specific models, provides a single fixed rate covering most or all of the construction debt as well as the post-stabilization permanent financing.

Developers see a fixed-forward as a way to take advantage of the lower fixed-rate benchmark relative to short-term rates while also locking in a take-out debt rate, Petersen said. “The differential in fixed and floating yields means a fixed rate during construction can make a lot of sense for developers,” he added. “So we’re seeing a lot of interest in that structure.”

Pricing entails a premium over current permanent rates for stabilized communities. For instance, if a developer’s venture would likely see a spread of 110 or 115 basis points over the 10-year Treasury for its permanent mortgage upon stabilization, a pre-locked fixed-forward rate would probably be in the range of 140 to 150 basis points over, Petersen said.

In contrast, a seasoned developer might see quotes on a floating-rate construction loan at 130 basis points over LIBOR, which would factor to a starting rate above 6.6 percent based on mid-December rates, said Andy Little, a real estate investment banker with John B. Levy & Co. But a fixed-forward structure tied to the 10-year Treasury may well come in below 6 percent through the construction period and on into the permanent financing.

“If you’re able to fix your rate [at less than 6 percent], that’s going to make sense for a lot of developers today,” Little continued. “So it’s become pretty easy for life companies to sell those programs.”