CREJ - Multifamily Properties Quarterly - January 2015
The Colorado Real Estate Journal sat down with real estate capital veteran Steve Bye of NorthMarq Capital and asked him to comment on the trends in the multifamily lending arena and his thoughts about 2015. CREJ: How would you assess the current environment for apartment financing? Bye: To quickly summarize, borrowers are in the best of all worlds. There are no practical limits on the availability of capital from multiple lending sources. U.S. Treasury or London Interbank Offered Rate index rates are near all-time low points and, on top of that, risk spreads have continued to compress. CREJ: Discuss the type of lenders who are most active. Bye: Most of the apartment loans that we are arranging are through the apartment agencies Freddie Mac and the Fannie Mae Delegated Underwriting and Servicing platform through our affiliate, Amerisphere. However, we have also closed a number of permanent loans with life insurance companies. Our Denver office originated a few commercial mortgage-backed security apartment loans in 2014, although these were the exceptions. We were less active in 2014 with Federal Housing Administration originations compared to 2013 and 2012. CREJ: Why are the agency lenders so attractive to borrowers? Bye: Many of the agency loans are focused on financing property acquisitions. Although the agencies have strict underwriting guidelines, they are receptive to the lower cap rates and are comfortable lending up to 80 percent of the purchase price. In addition, they are more likely to offer interest-only payments. They can also provide 30-year amortization schedules for older properties. Another significant attraction is the ability of the agencies to provide supplemental loans, executed in a very streamlined manner. Agency loans are typically subject to defeasance prepayment requirements, which makes it a cumbersome process, although it could result in a discounted payoff in the event of a high interest rate environment in the future. CREJ: You mentioned insurance company lenders. How does that sector approach apartment lending? Bye: First of all, there are at least three dozen insurance company lenders, so there is a wide array of underwriting and risked-based variables that will distinguish one lender from the next. From my perspective, life companies are nimble and can provide a menu of special features that a borrower may covet, as well as the ability to close a loan in as little as 30 days. However, regardless of the purchase price or an appraisal, many life companies use internal underwriting standards based on minimum cap rates or debt yield thresholds, resulting in lower leverage levels. For example, these disciplines may result in a loan amount that is 65 percent of an actual purchase price, even though it may be 75 percent of their internal value. Life companies are less likely to offer interest-only payments or 30-year amortization, unless the property is newer construction. CREJ: Then why would a borrower pursue a life company lender? Bye: They may be able to offer spreads of 25 to 35 basis points lower than the agencies, especially when the loan term is shorter than 10 years. Alternatively, they can provide fixed-rate terms of up to 25 to 30 years, while the agencies are limited to a maximum of a 10-year duration. Life companies can offer flexible prepayment options, such as fixed penalties or even par prepayment over the last few years of the term. Life companies normally hold their loans to maturity, and therefore, are more accessible in order to deal with issues over the life of the loan. However, companies offering internal supplemental loan increases are very rare, although secondary financing is often permitted. Funded reserves for replacements are seldom required, as opposed to the agencies and CMBS standards. CREJ: You also mentioned commercial mortgage-backed securities and FHA. What are those options? Bye: CMBS loans would best align with older properties or those located in a tertiary location, where higher leverage and a nonrecourse repayment are important to a borrower. For example, we recently arranged a loan on a new apartment project in Casper, Wyoming, where the agencies and life companies were too restrictive on their underwriting parameters. We closed CMBS loans on properties located in cities in Ohio and Michigan, where the local economies are less vibrant, as well as in smaller communities like the oil field areas, where the economy is less diversified. There are exceptions to this general rule, as evidenced with several agency loans that our office closed in Midland-Odessa, Texas, and in Breckenridge, Colorado. FHA was a more active refinance option in 2009-2012, when capital was less abundant. The lengthy timeframe required to process a Housing and Urban Development loan creates challenges for most owners, and certainly for those operating under an acquisition deadline. Nonetheless, the 223(f) program offers a compelling loan-to-value ratio of up to 83 percent and amortization period and fixed-rate term of 35 years. The prepayment structure is somewhat flexible, because the step-down penalty phases out after nine years. Although I have not addressed construction lending, FHA’s 221(d)(4) construction/ permanent 40-year program remains an attractive vehicle, notwithstanding the long process. Apartment financing question and answer Financial Market Steve Bye Executive vice president, senior managing director, NorthMarq Capital, Centennial January 2015 — Multifamily Properties Quarterly — Page 11 CREJ: Can you talk about interest rates for these various loan options? Bye: Let’s start with the agencies and use an example of maximum leverage of 75 to 80 percent with a minimum 1.25 debt coverage for a 10-year term. The spread will be about 175 basis points on top of a current U.S. Treasury yield of 2 percent, resulting in an all-end rate of 3.75 percent. Applying a 30-year amortization schedule reflects an annual debt constant of 0.0556. A 65 percent loan to value would price out at a 3.6 percent rate. A life company lender is likely to be more competitive under a 65 to 70 percent leverage situation. The spread would be 125 basis points with a rate of 3.25 percent. For a five-year term at 65 percent LTV, the life company rate would be about 3 percent compared to agency pricing of approximately 3.25 percent. As I mentioned earlier, these examples illustrate a 25 to 30 basis point differential between agency and life companies. CMBS lenders price over the swap rate, currently around 2.1 percent for a 10-year term, the most efficient duration. Spreads for the highest leverage loans are in a range of 190 to 200 basis points, establishing the all-end rate spectrum of 4 percent with an annual debt service constant of 0.0575 with a 30-year amortization schedule. The FHA 233(f) program would reflect a rate of about 3.75 percent, including the mortgage insurance premium. With the longer 35-year amortization, the annual constant is 5.14 percent. CREJ: Other than fixed rates, what else is available? Bye: A few life companies offer London Inter-Bank Offered Rates-based lending programs and most banks also use the 30-day or 90-day LIBOR index. Freddie Mac offers a unique convertible float-to-fix program. Again, spreads are based on a riskadjusted formula, so all-end pricing could be anywhere between 2 to 3.5 percent, as LIBOR rates hover near a quarter of a percent. There are myriad unregulated, nonrecourse bridge lenders, such as real estate investment trusts and private funds, offering LIBOR-based floating rates between 4.5 and 5.5 percent for value-add opportunities. CREJ: If you were a borrower, how would you approach the financing puzzle? Bye: It obviously depends on whether you are a long-term holder or an opportunistic shorter-term owner, which I’ll define as a trader. A longterm owner might consider a term longer than 10 years, given the unique point in time we are in relative to the capital markets. A trader will certainly want an attractive rate, but will require flexible prepayment options in a stable or falling interest-rate environment. Given a threat of a much higher interest-rate environment, a trader might consider a long-term fixed-rate loan that a buyer could assume. In any case, an astute owner should explore all lending options, especially the agencies, as well as a long list of insurance companies, or CMBS if applicable. There are many variables to consider and the market should be cleared to evaluate the optimum loan to best match the borrower’s priorities. This list may also include banks. CREJ: You only briefly mentioned banks earlier. What trade-offs can they offer? Bye: A few banks can offer a fixed-rate term as long as 10 years, and some can offer ultimate prepayment flexibility without a swap contract. Banks can also offer a lower cost of execution and require less property documentation, compared to the other lenders. CREJ: That seems like an excellent option. Why would someone look elsewhere? Bye: First, banks typically require personal loan guarantees, unless the loan is 65 percent loan to value or less. Some borrowers don’t mind guarantees, although the agencies, life companies, CMBS and FHA do not require repayment guarantees. Second, banks normally underwrite the sponsor’s financial picture more than the real estate. They have ongoing debt service, loan to value and sponsor financial covenants, a violation of which may trigger a repayment or a re-margining of the loan. Borrowers from the other conventional apartment lenders do not have this risk after the loan has closed. Third, interest-rate levels for banks are normally higher than the other lending groups, especially for terms longer than five years. Lastly, the banking industry is more regulated than any other type of lender sector and new governmental legislation could result in the implementation of new standards at any time. CREJ: My last question pertains to interest rates. What do you see happening in 2015? Bye: As Yogi Berra once said, predictions are hard to make, especially when you’re talking about the future. Nonetheless, I’ll take a shot, but please understand that this is my opinion only and does represent an official position from NorthMarq. It’s hard to imagine the Federal Reserve raising short-term rates when the economy is still recovering, because they don’t want to make the same mistake that occurred in 1935, when rate hikes sent the economy into a deeper depression after a shortterm recovery. The elimination of quantitative easing has not resulted in a jump in rates, despite what was predicted in early 2014. The longerdated bonds are being absorbed by a flight to safety in the U.S., where positive interest rates are still available. With a tilt toward a deflation in some economic sectors, or at least a disinflationary trend, this suggests that the U.S. Treasury rates should remain in the same range that has existed over the past six months and possibly fall even further in late 2015. Volatility will be continuing, however, as just recently, we saw an increase of 25 basis points in the 10-year Treasury yield. The counter balance to lower Treasury yields is the behavior of credit risk spreads, which are currently reflecting a stable environment. I certainly do not want to convey any “doomsday” scenario, although “black swan” events are always in play. For example, the probability of sovereign debt defaults and currency devaluations seem higher now and a domino effect on capital markets, magnified by the derivative industry, could cause spreads to gap out quickly, as was the case in 1998. There are many other concerns, but let’s keep our fingers crossed that they do not materialize.