Colorado Real Estate Journal - May 4, 2016
The real estate industry has enjoyed record low interest rates and bountiful supplies of debt capital over the past decade. As with all good things, now the question on everyone’s mind is, when may this be coming to an end? The feedback or industry whispering is that with this last up cycle, we are nearing or are in the ninth inning. While we feel this is a bit hasty and there is still a significant amount of runway left in this cycle, we are beginning to see some winds of change from a lending point of view. Generally speaking, commercial real estate financing is becoming more selective as lenders are underwriting to more conservative metrics. The following reflects our first- quarter analysis of trends and nuances impacting the commercial debt markets. First, banks have enjoyed a vast resurgence in both capacity and competitive underwriting. However, recent changes in the regulatory environment are now rippling through the industry. As a result of Basel III, many commercial real estate construction and acquisition loans are now classified as “highly volatile commercial real estate.” This designation mandates that bankers increase reserve allocations associated with these types of loans. Not only does this affect the capacity to lend, but it also impacts the desirability of pursuing these loans. Ultimately, Basel III will cause banks to shy away from riskier asset classes. The Dodd-Frank regulations are also contributing to lending hesitancy as banks wade through the new regulations that continue to roll out. On the positive side and despite these regulatory hurdles, we see banks are still remaining active in commercial real estate as ample capital remains. Second, the agencies remain active and competitive. The Federal Housing Finance Agency recently allowed both Freddie Mac and Fannie Mae to increase their lending caps from $31 billion to $35 billion due to continued growth in the multifamily market. The cap will be waived for certain affordable projects or underserved markets. Pricing has been somewhat wider than in the past due to inefficiencies in the market and securitization process. However, this reduces the likelihood that the two agencies will have to restrict deal flow by increasing rates or narrowing their fairways. FHA continues to be a stable resource as it can offer longer term, fully amortizing loans with 35- and 40-year terms. Third, life companies are coming off another record year for funding commercial real estate. The supply of capital that has been allocated for 2016 is estimated to be at least equal to last year’s totals if not slightly more. However, underwriting of certain product types has become more conservative. For instance, some lenders are underwriting hospitality assets based upon 2013 and 2014 historical metrics, ignoring the banner year for this industry in 2015. These lenders are refusing to underwrite at what is perceived to be the top of the market and ultimately restricting the flow of capital to hospitality assets.
. Office buildings are now being carefully underwritten with higher tenant improvement/leasing commission reserves and wider debt yields. With several recent retail bankruptcies and store closings, life companies have become more cautious with what used to be desired anchor stores. Multifamily loans have become harder to source due primarily to the perception of Denver’s market. Insurance companies look at Denver’s larger-than-average pipeline of new construction while ignoring absorption and household formation rates, which continue to exceed supply. There is good news with respect to industrial real estate. Most life insurers are underexposed to industrial real estate, so any nonmarijuana tenanted property tends to be well received. In general, life insurers are slightly easing off the throttle, which is the first sign that this source of funding will be tougher to secure and close. Finally, the commercial mortgage-backed securities market has been dormant for most of 2016. The slowdown was due in part to much higher yield requirements by bond investors. Over the winter, we saw deals getting re-priced at the closing table by 50 basis points or more. Even more troubling was industry experts suggesting that up to 25 percent of the loans in the pools were being kicked out by the “B” piece buyers. Spreads were inordinately blown out and highly volatile. Recent Dodd-Frank regulations also have caused pricing to widen from the norm. CMBS originators now have some personal recourse with respect to complete and correct information that is used by the bond investors. In December of this year, they will all have to contend with a 5 percent risk retention requirement that essentially mandates these lenders have “skin in the game.” There also has been a wave of layoffs in the CMBS sector, further compounding woes. Despite these headaches, CMBS remains a viable source for higher leverage lending though the certainty factor is still a cause for concern. Borrowers will proceed cautiously here. What does all of this portend for the balance of this year? First, it is advisable to enter the debt market earlier versus later. Borrowers should take advantage of a forward rate lock, which costs virtually nothing and capitalizes on current rates and underwriting. Funds are still widely available, but we have seen a slow but steadily narrowing of the fairway from many sources. Second, we do not anticipate any dramatic rises in interest rates, even if the Federal Reserve pushes up rates by 25 basis points. Finally, given the trend toward more conservative underwriting across all lending platforms, borrowers will want to ensure a solid equity stack to mitigate the risks in procuring financing.