How Late-Cycle Risks Impact Multifamily Financing

In an exclusive interview, PGIM Real Estate Finance Principal Brian Salyards discusses how competition and volatility are impacting the debt market.
Brian Salyards, PGIM Real Estate Finance
Brian Salyards, PGIM Real Estate Finance

The maturing real estate cycle and a cluster of economic, social and political changes—from the decline in overall multifamily transaction volume to the modified tax code—are all reflected in the financing landscape. “Lenders and owners alike will need to contend with volatility,” Brian Salyards, principal of PGIM Real Estate Finance, told Multi-Housing News. Still, despite the increasing competition for deals, lenders remain diligent, laying the foundation for a debt market capable of absorbing many of the risks associated with the latter part of a cycle.

Salyards explains how the debt market will adjust to rising interest rates, a falloff in CMBS loan maturities and a reduction in Fannie Mae and Freddie Mac’s capped production. In the interview below, he also discusses why the next recession is expected to be different than what the industry experienced a decade ago.

In the past few months, we’ve seen a decline in transaction volume and loan maturities. How will this trend impact the debt market?

Salyards: The recent decline in transaction volume in the multifamily market relates to the volatility in Treasury rates, a changing tax code, a reduction in Fannie and Freddie’s capped production in 2018 and a reduction in loan maturities—particularly in the CMBS space. Lenders have responded with spread compression, offering more interest only and allowing more flexible call protections to win the deals that are transacting. Agency lending caps were reduced to $35 billion each for 2018 versus $36.5 billion in 2017, but Fannie and Freddie originated a record $140 billion combined in 2017 by utilizing uncapped business.

Most predictions for 2018 are calling for flat to slightly lower agency production numbers, so we expect them to both remain competitive in capped and uncapped lending. One potential risk to liquidity comes from life companies that may reduce commercial mortgage allocations should spread compression make public fixed-income alternatives more attractive.

Should we expect to see looser credit standards in 2018? How would this impact the industry in the long term?

Salyards: Strong competition to win deals could lead some lenders to offer looser credit, more interest only and tighter spreads. However, throughout this cycle, lenders have maintained strong credit standards and have not reverted to the pro forma underwriting that was done leading up to the credit crisis. Lenders have also remained diligent in looking at and modeling exit risks in a rising rate environment, meaning when we factor in income and expense growth and interest only and analyze deals at maturity with higher cap rates and higher note rates, the future net operating income is sufficient to repay the remaining loan balance.

Which property types and markets will lenders target in 2018, and why?

Salyards: Multifamily and industrial should continue to see strong demand from both lenders and owners. The primary and secondary markets with strong demographics will remain in favor. Value-add deals should (also) remain in favor, but I’m starting to see signs of borrowers looking for slightly newer—albeit more expensive/lower-yielding—deals due to the premium one needs to pay on a turnaround asset where the outcome carries more risk. Being later in the cycle, buyers are proceeding with caution.

How will the new tariffs on imported solar panels, steel and aluminum be reflected in the financing environment?

Salyards: Tariffs should only have a marginal impact on commercial real estate and debt financing. Higher steel costs will be just one more component in rising construction costs that developers have had to deal with over recent months/years.

Developers are having trouble finding and retaining labor to build product, which, in my opinion, is a far greater concern in the short run. In addition, advancements in engineering technologies have allowed builders to utilize stick construction in lieu of steel. That said, tariffs are inflationary, making products more expensive, thus I do see risks that future inflation will be tackled head on by the Fed and as a result we could see higher interest rates, which eventually cause cap rates to increase and values to fall.

How can lenders navigate the volatility caused by import tariffs, tax reform and rising interest rates and increasing inflation?

Salyards: Lenders and owners alike will need to contend with volatility. Absent stagflation, rising rates and inflation should mean more people are working, earning, buying and renting. To counter this, at some point, if rates widen materially from here, we could see cap rates rise and valuations fall. The lag timing between rising rates and rising cap rates is typically six months or longer, so we are still in the “lag” period.

Timing is everything, though, and in 2018 we’re seeing the Federal Reserve unwinding its balance sheet, which could cause spreads to widen at some point during 2018. Lastly, our sister company PGIM Fixed Income, sees the U.S. 10-year Treasury potentially dropping to 2.5 percent by year-end and sees further tightening from the Fed with three or four rate hikes this year. This is the unfortunate backdrop of risks and opportunities that we’re all having to work through.

What do you expect from the CMBS market going forward?

Salyards: The old risk retention model clearly needed work. Per Morningstar, delinquencies from deals issued from 2005 to 2008 represent 87.2 percent of all delinquencies by balance. Under the new risk model, the CMBS market put up impressive numbers in 2017, which was a positive sign. “The CMBS market found its footing after new risk retention rules were implemented. Total issuance exceeded $83 billion, a 25 percent-plus increase over 2016 levels,” according to PGIM’s 2018 U.S. CRE Permanent Debt Market Outlook.

For 2018, PGIM expects slightly lower CMBS issuance primarily due to the fall-off in CMBS loan maturities. We also saw slowing defeasance volume in 2017 and 2016, which will likely continue into 2018.

What do you think will trigger the next recession, and how will it manifest as compared to what happened 10 years ago?

Salyards: A Fed-induced inverted yield curve is one thing I see that could trigger the next recession. Historically, it has been one of the strongest predictors of a recession. Also, a tight labor market with a 4.1 percent unemployment rate, a 17-year low, an increase in this rate, combined with an inverting yield curve almost assures a recession. The previous recession was deep and painful. This time, I don’t see the financial engineering, synthetic products sold or the massive risks that were being assumed.

I also don’t see the residential market being hit as hard, as lending standards have remained strong, the homeownership rate has risen from its 2016 low of 63 percent and is still below its historical average of around 65 percent, being at 64.2 percent as of January. So, I’d still expect to see falling stock prices, falling real estate values, increases in unemployment and retailers and autos will suffer. The duration and depth of the recession will likely be driven by how much dry powder the Fed can accumulate until it hits.

Image courtesy of PGIM