As seen in the Colorado Real Estate Journal May 3, 2023.
The debt markets continue to get more challenging to navigate. Interest rate hikes and macroeconomic factors affect each lending source differently, resulting in an inefficient and confusing debt marketplace. This impacts the entirety of the industry, as debt is associated with almost every single commercial real estate property. The majority of commercial real estate professionals have other things to do during the week than keep tabs on the lending appetite and underwriting metrics for hundreds of lenders. Then there’s us. The lucky ones. Mortgage bankers.
Here’s one mortgage banker’s perspective on what’s going on in the lending space:
- BanksIt’s no secret that the banking system is facing many challenges currently. The Fed’s increase in short-term interest rates directly affects the banks’ cost of capital (another rate hike anticipated next week), resulting in proportionate increases passed through to the borrower. In addition to higher rates, many banks are facing a liquidity challenge, which is why many are emphasizing deposit relationships more than they have historically. The recent bank failures have highlighted the gravity of failed liquidity management, pushing banks to be more conservative to reassure their depositor base.The liquidity crunch is occurring for a variety of reasons, including cash reserve requirements and lack of payoffs. Banks are required to hold cash on their balance sheet for potential loan losses. The amount of cash required to be held is a function of the riskiness of their loan portfolio. Banks’ loan portfolios have been increasing in risk because (1) commercial real estate values have declined, resulting in higher loans to value and (2) interest rate hikes have caused many more debt-service coverage loan covenants to be busted. If banks are reserving more cash, it limits the available dollars they have to lend out. Further exacerbating the issue is low commercial real estate transaction volume. Fewer sales lead to fewer payoffs, resulting in more loan dollars sitting on lenders’ books rather than being recycled and redeployed into new projects.
- Credit UnionsCredit unions seem to be gaining market share in this environment and are actively quoting and closing new business. For the most part, they have an abundance of deposits and are capitalizing on the opportunity to finance more high-quality real estate. Perhaps the most desirable aspect of a credit union loan to borrowers right now is the prepayment flexibility; the majority of credit union loans are open to prepayment throughout the entire loan term. This would allow the “declining interest rate” speculators to capitalize on the opportunity by refinancing without penalty when the time comes. Credit union fixed-rate loans are pricing in the 6.25% to 6.75% range, with a partial to full personal guaranty required. Twenty-five-year amortizations are standard, but 30-year amortizations are available in select circumstances. Maximum LTV is 70%, with guarantor strength being a critical factor to leverage and comfortability.
- Agencies (Fannie and Freddie)Agencies are currently financing about 75%-80% of all multifamily loan volume. They are active, liquid, and generally the most competitive on terms. They are quoting five, seven and 10-year loans and with spreads currently in the 225-250 spread range over the Treasury, yielding all-in rates in the mid-to-high 5s. They are also able to offer preferential pricing for properties that qualify for their energy-efficient or affordable loan programs, resulting in a 25-45 basis point decrease in interest rate and coupons in the low- to mid-5s. They can typically offer 60%-65% leverage, 30-year amortization and several years of interest-only.
- Insurance CompaniesInsurance companies are one of the most liquid and reliable lending sources in the current environment, particularly for non-multifamily properties. This is largely driven by their source of funds coming from insurance premiums rather than the financial system. Insurance companies are more “business as usual,” meaning they continue to collect premiums and have investment allocations to put to work, with typically 10%-15% slated for commercial mortgages. They remain consistent in their low risk tolerance and selective approach, but can offer some of the lowest fixed rates in the market for desired mortgages. Spreads are in the 165-240 range over the Treasury rates, typically fluctuating in tandem with corporate bond spreads. The lower end of spreads is yielding coupons in the low 5s, chasing conservative multifamily, industrial and self storage loans. Unanchored retail and office loans are commanding the highest spreads. In today’s environment, life companies generally top out at 60% LTV, with the majority quoting between 50% and 60% LTV. Loan terms can be as short as three or five years, and typically there is an option to decrease the yield maintenance prepayment structure for a 10-25 bps premium in the rate. Interest rates can be locked 60 to 90 days prior to closing, minimizing interest rate risk while the acquisition or refinance is underway.
- Debt FundsDebt funds have an abundance of capital to place, but the current cost has made it difficult for them to execute. Interest rate hikes have increased the cost to borrow on their warehouse lines, which is the most common financing mechanism used by debt funds. Debt funds’ typical two- to three-year loans are floating rate, with pricing in the SOFR 300-500 range, yielding all-in coupons of 8%-10% for cash flowing, light-value-add bridge loans. A rate cap is generally required as well.Debt funds previously underwrote to stabilized DSCR, but with 8%-10% interest rates, that’s become a lot more limiting. Consequently, many have shifted to underwriting to a stabilized debt yield or permanent loan exit scenario instead and funding an interest reserve for the entirety of the bridge loan term. Even still, permanent loan exit tests use higher interest rates and cap rates compared to 12-24 months ago, so the high LTCs you’re used to seeing from debt funds are significantly scaled back. Historically this has been one of the advantages to a debt fund execution and makes the cost harder to justify.
- CMBSCMBS originations are down significantly year over year. CMBS rates are higher than others’ in the market by roughly 75-100 bps; as of mid-April, they were quoting all-in rates in the high 6s. Spreads widened significantly following three securitizations in April. These were the first securitizations after the banking crisis and accounted for added market risk. Further, given the rapid increase in rates, there are fewer borrowers wanting to lock into something where the only way out is defeasance. All that being said, CMBS lenders are quoting five-, seven- and 10-year terms and are still a good source for slightly higher leverage (65% LTV) on a full-term interest-only basis.