Despite the U.S. federal funds rate ticking up nearly 100 basis points since last year, the real estate finance sector has continued at a steady clip from a strong 2017. Will the second half of the year hold a candle to the first? Leading lenders and mortgage brokers list the trends they’re watching.
2017 was a banner year for originations: solid fundamentals, increasing property values, low interest rates and plentiful capital. How has 2018 performed so far?
PROVINSE: While we may have expected the market to cool off, given its sensitivity to rising interest rates, the spread compression has not been passed through to the borrowers—for them, 2018 has looked a lot like 2017. Given the borrower financing opportunities and the continued need for debt providers to deploy capital, 2018 has performed quite well.
LEE: Acquisition activity has fallen off slightly with rising rates, (though) not as much as one would have thought. There is still a lot of equity out there. Refinancings have picked up, too, (as) borrowers seek to lock in (rates) before they go any higher.
DUVALL: We’ve had a number of borrowers choose to refinance 12 to 24 months in advance of scheduled maturities in order to beat what they expect to be a continued rise in interest rates. Capital remains plentiful, and competition to invest (that) capital has led to a material decrease in spreads.
SIMON: It’s been a bit of a roller-coaster ride with the yo-yo movements in interest rates, and borrowers have really needed to stay nimble to take advantage of the swings.
PATTON: On an annualized basis, sales transaction activity in the multifamily sector is now 9 percent higher than in 2017. Both our debt and investment sales teams are (outperforming last year’s) pace, and the pipeline is (also) very encouraging. We were concerned with how the rising interest-rate environment would impact (deal flow). However, now that rates have seemingly stabilized, activity has increased significantly. Being ahead of a very strong 2017—even with higher rates—has been surprising in a very positive way.
BURNS: The big run-up in rates at the beginning of the year slowed the market down somewhat. It seemed that sellers were waiting to launch their deals until the dust settled. So although there was plenty of capital in the market, there was little product. As the market has settled into a more stable rate environment, we have seen a marked increase in both acquisition financing and refinancings. The past few months have felt like 2017 again.
What surprised you about the first half of the year?
BURNS: Just the slow start. At the National Multifamily Housing Council meeting in January, the mood was very upbeat, and there was so much capital ready to go. It was surprising that it took a few months for the market to really start moving.
LEE: How well the market absorbed an almost 1 percent increase in interest rates.
SIMON: I think most investors expected rates to rise at some point in the past three years and have been preparing for it. The most surprising thing to me so far this year has been the sheer amount of liquidity in the market, creating competition and driving lender pricing down. That competition has helped offset some of the increases in Treasuries and Libor, but not all the way.
PROVINSE: Given the recent tax reform and its impact on the return on equity of GSEs, we expected (the GSEs) to be able to afford reducing the spread. However, we didn’t expect it to happen so quickly following tax reform. This has led to a favorable environment for borrowers, even with rising interest rates.
DUVALL: There has been pretty intense competition among lenders to put out their allocations. While this was not too surprising, the degree to which lenders have reduced spreads has been.
SIMON: We have also noticed many borrowers utilizing longer-term, fixed-rate financing instead of the shorter, floating-rate loans that were the hot option over the past three years. This is a trend that will continue, especially given how flat the yield curve currently is.
What are the top trends you’re watching for the remainder of 2018?
SIMON: Rising interest rates, continued liquidity creating competition in the markets and creativity in lender programs and structures. It’s still a great time to be a borrower, but it’s important to be proactive and take action when appropriate to mitigate risks.
PATTON: Something we are watching very closely are Treasury rates. Will they hold steady where they are? Or will they need to increase as the Fed continues to raise short-term rates? Currently, the yield curve is flat between short- and long-term instruments. We still need to wait and see what will happen if long-term rates rise and how that will affect cap rates. Will that push (cap rates) up?
LEE: I’m curious to see how long cap rates stay low and disconnected from interest rates. I’ll also be watching what happens when NOIs and returns start flattening and optimistic projections don’t hit.
PROVINSE: We’ve got our eyes on higher spreads and higher interest only. We’re also looking to see how much longer lenders can absorb the (interest rate) increase.
BURNS: I think we (will) continue to watch rent growth slow at the high end of the market. We will continue to see upward pressure on rates unless we stumble into a trade war that (moderates) the current pace of economic growth and inflation. Finally, I think the amount of capital pushing to get deployed will keep (putting) downward pressure on both cap rates and loan spreads.
Which markets or property types stand out?
PATTON: While investment had been down slightly in many primary markets over the last several years, there was an uptick in focus on primary markets in the first quarter: Primary market (transaction) volume accounted for 45.3 percent of total multifamily activity in the first quarter, up from 40.3 percent in 2017.
SIMON: Even with huge development pipelines in most major markets, we are still seeing solid market fundamentals and continued but normalized growth. I think this has directly correlated to the (deep, lasting) demand for multifamily loans by an ever-growing audience of lenders.
BURNS: We have seen a lot of activity push out into more secondary markets, (such as) Sacramento and the Central Valley, as that is where the rent growth has moved, and cap rates are 75 to 150 basis points (higher).
LEE: Value-add (opportunities) seem to be what people are chasing the most across the board. Equity continues to pour into the industry and is creating more new ventures. The demand for properties to buy far outpaces supply.
DUVALL: Affordable units continue to be in very high demand. Not a big surprise that this segment is doing well, as it has been much discussed that our country is experiencing a shortage of affordable housing.
How is the competitive landscape impacting lenders and borrowers?
PATTON: Lenders like Fannie Mae, Freddie Mac and life companies are continuing in their more traditional roles, but their underwriting is now requiring lower leverage on deals. Whereas a few years ago we could (easily) get 75 to 80 percent leverage, now it’s challenging to get 70 percent on high-quality deals with the lowest cap rates. That is forcing some clients to turn to preferred equity structures to capitalize some deals. However, there is great depth in capital sources, as debt funds and banks are aggressively (vying) for business. (These sources offer) viable alternatives for our clients, even for longer-term loan structures.
PROVINSE: Fannie Mae and Freddie Mac are competing aggressively, which is driving much of the spread benefits. We’ve compared the interest-only Fannie, Freddie and CMBS (products) to their historical rates, and they’re looking similar to where they were 11 years ago, (which is) good for the borrower but potentially (unfavorable) for the lenders.
BURNS: The same dynamics that make this a great market for sellers make it a great market for borrowers. There is just such an abundance of capital in the market, and there are multiple lenders for borrowers to access at every point in the capital stack. That competition on the spread side is helping borrowers somewhat offset the rise in Treasury rates.
LEE: As a lender, we’re focused on what differentiates us, which includes access to our balance sheet, as well as our relationships with the agencies.
SIMON: That competition is holding or compressing lender spreads in an environment where widening corporate bonds should be (increasing) lender spreads. The competition and liquidity directly correlate to better loan terms and structures for borrowers, allowing most to remain competitive in a rising interest-rate environment.
DUVALL: Lenders seem to be willing to compete on price. Unlike frothy times in years past, we have not seen a material decline in underwriting standards.
Which lenders have been the most active, and which have pulled back?
SIMON: Banks still have a lot of exposure to multifamily construction loans and are taking a conservative approach to reviewing new loan opportunities.
BURNS: I think construction financing is a little tougher to get at slightly lower leverage points.
DUVALL: Nearly all types of mortgage lenders seem to have been active—life companies, agencies, CMBS, banks, bridge, etc. The agencies still capture the lion’s share of multifamily financing.
SIMON: Liquidity in the market has grown, and insurance companies, banks and debt funds have come out swinging this year and have really made for some fierce competition in the market. Even the construction lending markets have opened back up quite a bit, with significantly more liquidity and competition.
LEE: Banks are more competitive, however, as their loan balances have decreased over the past few years.
What have borrowers needed to bring to the table to get deals done?
DUVALL: A good credit history and (high-quality) property. Lenders clearly like a borrower with a fair amount of experience. Typically, once a borrower gets the first deal with a lender done, they become part of the family, making the second deal easier to complete.
SIMON: Rising rates are causing debt service coverage constraints (and limiting) proceeds available to borrowers who rely on maximum leverage. This has not yet impacted cap rates, so borrowers are needing to bring more equity to the table or get more creative financing to maintain levered yields.
LEE: With more focus on value-add (investments), borrowers have needed more loans that allow them to draw rehab dollars. Also, they’ve needed to work with a lender (that is) able to close the deal faster to rate-lock loans, given the volatility of rates.
What are your most pressing concerns for the rest of the year?
BURNS: The uncertainty of who President Trump appoints to take the place of Mel Watt at the Federal Finance Housing Agency and (how that may impact) Fannie Mae and Freddie Mac.
DUVALL: 10-year Treasury yields, cap rates and the political scene in Washington, D.C. I sleep pretty well at night, but Washington is the wild card that I worry about.
SIMON: The inevitable inverted yield curve as the Fed continues to increase short-term rates has historically been a telltale sign of a recession. Strong market fundamentals and continued lender underwriting discipline certainly put many of my concerns to rest, but many of us have seen this before, and the flashbacks of 10 years ago are hard to forget.
You’ll find more on this topic in the CPE-MHN Mid-Year Update 2018.