Climbing the Capital Hill
Owners and investors face steep obstacles on the path to financing.
Capital availability has improved since the dark beginning of the recession. This year the real estate capital markets came off life support, although they still remain in intensive care. Well-capitalized firms and owners are taking advantage of inexpensive money. Real estate investment trusts have been able to raise funds in both the unsecured and secured debt markets, and although the commercial mortgage-backed securities market has not returned, class A office owners in major markets have been able to refinance assets through securitization programs.
The multifamily market has benefited from a surge of lending activity from the government-sponsored enterprises Fannie Mae and Freddie Mac and the Federal Housing Administration. Many multifamily owners have been able to finance their assets at rates below 4.4 percent, and in the case of FHA/U.S. Department of Housing and Urban Development financings, the rates have been below 4.0 percent with 35-year fully amortizing terms. For new construction of multifamily developments, FHA/HUD has provided owners and developers with construction loans below 5.2 percent for the balance of 2010.
Rumors persist of new lending platforms offering new capital infusion into the commercial real estate market, but the evidence of these ventures is scant. Very few new players have entered the market this year. Instead, 2010 has been more about waking up the old players: banks and insurance companies.
Regrettably, most banks — overwhelmed by regulatory challenges and problem loans — have not returned to commercial lending. In some parts of the country, especially the Northeast and Upper Midwest, banks are lending on some prime office and retail space, as well as on multifamily. But for the most part, bank lending has not been a viable option for owners this year.
Life companies also have been absent for most of 2010. They are producing some loans at very low leverage in certain markets, but no one would really claim they are a significant provider of capital.
Will Capital Flow in 2011?
The first half of 2011 will remain challenging for the commercial real estate market, but not impossible. The Fed will continue to keep rates low through monetary easing or by going back into the market and purchasing securities on the open market. However, the continuation of low rates does not mean that those rates will flow to the commercial real estate market. Someone has to lend the funds.
Banks should make a relative comeback to the commercial mortgage lending game in 2011. Banks are now at a point where they have stopped losing money, so now it is time for them to make money. Bankers will need to lend and they will want to stay local.
For borrowers in small markets, local lending could be the best source of financing. Moving business banking to community banks will help develop relationships. Small commercial real estate owners and investors can forge relationships with local banks and be in a position to benefit from their return to the lending arena.
Life companies also will have a more robust presence in the 2011 market. Traditionally life companies have desired long-term assets to pair up with their long-term liabilities. They retreated from the market during the financial crisis, but they have increased their lending activity in multifamily, and they are players for choice offices in major markets. Look for life companies to be aggressive lenders on multifamily deals with well-capitalized owners. Anecdotally, life insurance companies have complained that the GSEs and the FHA are crowding them out of the multifamily market. This is a sure sign that they are back to lending, but on a selective basis.
Expect Fannie Mae, Freddie Mac, and FHA to do a booming business next year. They are the primary sources for apartment financing, and in the case of FHA, the only source for new construction financing. GSEs and FHA are also the major funding sources for healthcare facilities, including skilled-nursing, assisted-living, and age-restricted independent-living developments. The rates on GSE and FHA deals will continue to be priced off of the 10-year Treasury note. If Treasury yields stay low, GSE/FHA debt should stay low as well.
However, GSE/FHA rates are a function of the combination of the 10-year T-note rate, the 10-year interest rate swap rate, and the risk spread investors want to receive in order to purchase the loan after securitization. For example, an FHA refinance or acquisition rate would be the sum of the 10-year T-note rate (2.38 percent), the 10-year interest rate swap spread (.0988), and the investor spread of 100 basis points, producing a rate of approximately 3.50 percent.
The wild card in this pricing is the investor spread. As more GSE/FHA paper hits the market, investors will want to increase their spreads as a function of supply and demand. They also could increase their spread demands because of asset allocation. Investors can look at the residential mortgage-backed securities market, compare it to the multifamily securitized market, and feel they will get better default protection and more-stabilized returns in the residential MBS market. Investors will see the positive convexity of residential MBS, and they will want a greater spread on the multifamily product to compensate for what they believe will be negative convexity on the GSE/FHA product.
Once investors become a little better informed about the uniform underwriting standards of GSE/FHA loans, their convexity concerns will diminish, and the spreads should drop somewhat. Regardless of where spreads and rates end up, they will remain attractive well into 2011. Multifamily owners should try to refinance as many of their assets as possible to lock in these low rates for the long term.
There is not much hope of the CMBS/conduit market returning this year. That market was built for size and speed, and neither exists currently. Conduits need to warehouse loans in order to aggregate them into securitizations. The origination, closing, and warehousing of conduit loans requires the conduit to have a large lending shelf in order to fund the loans, and a complex hedging operation to manage the inherent interest rate risk as conduit loans move from origination to securitization. The means for a conduit to fund these loans is not available, and when it is found, it is very expensive.
In addition, the hedging cost and the disclosure requirements from the U.S. Securities and Exchange Commission have made the prospect of CMBS/conduit lending in the near-term pretty bleak. Conduit lending may reappear at some point, but it will look very different than the conduits of the go-go years earlier this decade. The loans will have lower leverage, and they will take longer to get to closing. The conduits might fund deals that focus on a property type in one geographic area, such as malls in New England or office space in the San Francisco Bay Area. All of these new restrictions will be leased at higher prices than borrowers were used to circa 2004.
While the commercial real estate capital markets are struggling, the picture is not nearly as bleak as two years ago. By keeping rates low, the current administration, in conjunction with the Federal Reserve, could help prevent the U.S. economy from slipping into another recession. And to help keep rates low, the Federal Reserve will use multiple tools. The principal tool most likely will be another round of quantitative easing, in which the Fed buys fixed-income securities on the open market. With fixed income, rates move inversely to price, so the Fed buying assets will increase the price of bonds, causing the yield (rate) to decrease. The Federal Reserve had success managing rates in the early part of 2010 using QE, and Fed policymakers have announced that they will return to the market for a second round of purchases.
But do low rates alone mean salvation for the commercial real estate market? Clearly not. The salvation will have to come from those looking to invest. Investors seeking yield will have to return to the commercial real estate market as direct lenders or as purchasers of securities backed by real estate. Borrowers looking to take advantage of a return of capital should expect much tighter underwriting standards than were in place earlier this decade.
And don’t expect a tidal wave of lending to hit the commercial real estate market. While the market for multifamily and healthcare lending is robust, it will take at least two years for lenders to return to all asset classes nationwide. In the meantime, owners and investors should continue to communicate and build relationships with all types of lenders in the markets where their assets are located.