- Nov 02, 2011
Capital is pouring back into the most active commercial real estate investment markets as lenders are responding to improving property values and rising expectations of future income growth. Banks are loosening lending standards for the first time in close to five years, despite a still-volatile economic recovery, pending legislative changes and looming interest rate hikes.
Lenders and intermediaries are reporting a substantial increase in lending activity. Loan originations increased by 107 percent in the second quarter of 2011 compared with the second quarter of 2010, albeit still substantially down from the $500 billion of commercial and multifamily loans closed in 2007. According to the Mortgage Bankers Association, loan originations reached $108.8 billion in 2010, a 44 percent increase compared with the $82.3 billion of commercial and multifamily loans closed in 2009.
Fueled by cheap money, higher leverage and increased availability of capital, investors are paying stunning prices, often at cap rates of 5 percent for top-tier properties. Intense competition among lending sources is driving up leverage to 75 percent with a 1.20 DSC ratio. Debt yields have dropped below
8 percent for multifamily assets in primary markets, allowing borrowers to encumber their properties with more debt for every dollar of cash flow.
Despite the S&P’s downgrade of U.S. debt and the end of the Federal Reserve’s quantitative easing program, the 10-year Treasury rate dropped in August to one of its lowest points this year. Competitive multifamily rates start at 3.50 percent for a five-year term and 4.50 percent for a 10-year term.
While capital is mainly flowing to trophy assets in top-tier markets, yield-driven investors are beginning to gravitate toward value-add opportunities in smaller metros that are beginning to recover from the recession. The loosening of underwriting standards has opened up the market for properties in transition.
Consider the following example of a value-add transaction. A buyer is seeking financing to purchase an apartment building with ground-floor retail. Several apartments are vacant and in need of renovation. Additionally, rolling retail leases will allow the new owner to capture rent increases. The buyer is hoping for a substantial upside, but for now, the property is not producing sufficient cash flow to service the requested loan amount.
In today’s normalizing capital markets, the buyer will have the following three options that were not available during the past three years. First, the buyer can secure a five-, seven- or 10-year term loan with a competitive fixed-rate for the full loan request. In order to underwrite a below 1.0 DSCR, the lender will have to structure the first year of the term loan as interest-only with a three- to six-month static interest reserve.
Second, the lender can write a term loan with a one-year interest-only period. In lieu of the static interest reserve, the lender would lower the initial loan draw but give the borrower an earn-out after the property is stabilized.
Last but not least, the buyer can first obtain a floating-rate, interest-only loan with a 12- to 24-month term. Once the property is stabilized, the loan would convert to a fixed-rate term loan.
While leading indicators of economic and labor market activity continue to improve, capital will remain available for top-tier assets in stable markets. But as long as the near-term outlook is clouded by uncertainty and the downside risk to the recovery remains a real concern, secondary and tertiary markets will have limited access to capital.
Daniel Hilpert is the managing director of Mortgage Equicap LLC, a New York-based real estate investment banking intermediary.