High-Leverage Loans Face Elevated Risk
- May 27, 2020
Among the major real estate asset categories, multifamily is emerging as one of the strongest so far in the midst of the coronavirus crisis. Despite some decline in rent payments, experts are confident that the combination of continued demand and short supply will feed a relatively prompt recovery. That still raises a key question: Will fundamentals be healthy enough for borrowers to secure high-leverage loans?
It has been clear for months that conditions have changed dramatically. Lending for multifamily and commercial properties is unlikely to match the record $600 billion tallied last year by the Mortgage Bankers Association, noted Jamie Woodwell, the organization’s vice president of commercial real estate research, in mid-April. Though loans are still available, spreads have increased and fewer lenders are providing quotes. In an uncertain period, lending trends will hinge on the duration of the recovery and the speed of the economic comeback, Woodwell observed.
Despite the rapid exit of non-bank lenders from the scene, other sources are stepping in to fill the void, even as the impact of the COVID-19 outbreak deepens and affects the economy at large. “There are still some active bridge lenders out there,” said George Smith Partners Principal Shahin Yazdi. “Most of the lower-priced lenders are topping off at 65 percent loan-to-cost, but there are private-money lenders who can get to 75-80 percent LTC.”
The standards for a higher loan-to-value will be familiar to those who have experienced earlier economic slowdowns. “The property itself has to be in a strong metro, and there needs to be a clear indication that rents are below market,” Yazdi added.
Traditional lenders have also stepped back, waiting for more clarity. Meanwhile, “HUD and the agencies are meant to provide liquidity at all times, but especially during times when others have left the market,” noted Brian Salyards, principal at PGIM Real Estate. HUD loans may come with some structure, such as a nine-month debt service reserve. That said, an 85 percent LTV can still be achieved at very attractive rates—slightly below 3 percent plus a mortgage insurance premium on 35-year loans.
As part of their plan to navigate a volatile landscape, Fannie Mae and Freddie Mac have also increased reserve requirements for higher-risk loans, implemented Treasury floors and restricted loan size in some cases. “For the time being, the agencies have pulled back in offering index locks and streamlined early rate locks—two very important interest-rate risk mitigants,” Salyards added.
For acquisition loans or non-cash-out refinances, Freddie and Fannie are still offering up to 80 percent LTV with partial interest-only terms. The financing packages require debt service reserves and involve a heightened focus on collections. “Availability of full leverage in this environment is a testament to why we need the agencies around to meet clients’ needs. I don’t expect this to change in the future,” Salyards said.
However, tighter requirements for borrowers will likely remain the norm until at least the third quarter. Increasing debt coverage ratio agreements and scrutinizing cash flow from properties will temporarily limit loan amounts, but things will change once the economy reopens and rent collections improve. The great unknown, of course, is when the economy will return to full swing.
This time next year
While the leverage point has not changed, the means of covering the debt part of the capital stack has. Today, a borrower needs mezzanine financing, preferred equity or private sources to reach 80 percent, “whereas one year from now, I see the debt funds getting aggressive again and CLO bridge lenders being able to get back up to 85 percent LTC,” Yazdi predicted.
Moreover, full leverage will continue to be available from Fannie Mae and Freddie Mac, which will put no additional structure in place. “Twelve months from now, the economy will be on a better footing and access to debt will be readily available,” Salyards said. “By then, other lenders will have come back to the market, such as debt funds and CMBS.”
USAA Real Estate research shows that the global banking system is healthier today than it was during the Great Recession, but loan losses from the current downturn could be many times larger compared to a decade ago, because of potentially substantial defaults across multiple profit centers. The Federal Reserve’s measures might not be enough to provide the necessary liquidity to the financial system, which could lead to insolvency for some banks.
Borrower discipline will be essential over the next several quarters and will be central to multifamily financing strategies. Salyards advises borrowers to use the best inputs at their disposal, as well as realistic assumptions on rents, rent growth and expenses, and lever only to the point where a deal will be able to maintain cash flow through most economic shocks.
Another risk for multifamily financing could be falling property values. In a worst-case scenario proposed by Trepp, CRE prices could slide as much as 35 percent over the next two years, a trend that would make refinancing extremely difficult.
Trepp’s current best-case scenario projects that the economy will start to rebound by the fourth quarter of 2020. Salyards says he likes the analogy of a checkmark-shaped recovery—a sharp decline followed by slow, steady growth. But he also offers a caveat: “The effects of this on the balance sheet of the U.S. will linger for an undetermined amount of time. The dollars being printed to support the population is on a scale we have not seen before.”