It doesn’t seem like it, not to me at least, but ten years ago we were in the depths of The Great Recession. On one hand it seems more recent as the difficulty of those times is still very fresh in my mind, but when you look at what is happening in our corner of the real estate world today – massive rent growth, record years, half a dozen cranes downtown at any given time, talks of over-development in multiple disciplines, the internet continuing to cause stress in the retail sector – it seems like an eternity ago.
So where are we today?
I un-scientifically surveyed a number of lenders and they had a lot of similar things to say about the market. Most had strong loan originations in 2017, just as they did in 2016, and 2015 before that. But every lender feels loan volume will be down in 2018 for two major reasons: First being the wave of CMBS maturity refis is over. The CMBS originations stopped dramatically in mid-to-late 2007 and all those loans are, for all intents and purposes, gone. The second reason is rates are the highest they’ve been in several years, so demand for refis will be down. Both of these lead to what was a universally declared a challenge for 2018: The increased competition for fewer loan transactions. Of course, this may be a challenge for lenders, but it may be a benefit for borrowers. Another common theme was rates. Overall, they feel rates will continue to rise. The 10-Year US Treasury, a commonly used index, is at 2.86% as of this writing, up about 50 basis points since late December and it is expected to march past the 3.00% barrier, but how much further is anybody’s guess. As for spreads, the general consensus was that they should remain fairly steady. And lastly, lenders like Denver and the Front Range. While most agree we’re towards the end of the real estate cycle, lenders also agree the fundamentals are still good overall – we are still seeing job, rent and population growth – so we may remain here for some time and they are not drastically changing their underwriting. That’s not to say there won’t be any changes. I think we may see some lenders back off on interest only periods and others may not push leverage as much as they have in the past few years.
What are lenders looking for? What are they avoiding? Let’s break it down by institution type.
Life insurance companies typically provide some of the lowest long-term fixed rates (anywhere from 5 to 25 years fixed) with 10-year spreads ranging from 125 to 200 basis points – however they do underwrite more conservatively as they are looking for lower LTV loans. Many life companies provide non-recourse loans. As for property types, across the board they have a strong appetite for apartments and all types industrial. They may shy away from high leverage requests on new Class A multi-family builds, instead preferring lower leverage loans, even on Class B or C properties. Many life companies still like well-located service-oriented neighborhood retail centers however they will pay extra attention to location, tenancy and rollover. Big box retail will be tougher. They also have moderate to strong appetite for self storage with good history and moderate appetite for office as long as it is well located with good history.
The Agency Lenders (Fannie Mae, Freddie Mac, FHA/HUD) provide high-leverage, low rate non-recourse apartment loans on a construction (FHA) and permanent basis. The adjusts the volume caps every year (2018 cap is $35B each for Fannie and Freddie vs $36.5B each in 2017) but they also build in loopholes to do business outside the cap with affordability calculations, “Green” programs and smaller property programs (such as 5-50 units) that also benefit borrowers via lower rates. All Agency lenders will do as much business as they possibly can. They can be aggressive on new builds, newly renovated projects as well as run of the mill assets with good history. The Agency lenders feel Denver/Front Range is a strong apartment market – due to market fundamentals, job growth, population growth and demographics as well as the constant driver, our climate and lifestyle – and will continue to aggressively pursue loans here. The vast majority of Agency-provided apartment loans are non-recourse, even as small as $1 million loans in some cases.
The CMBS market has traditionally provided high-leverage non-recourse loans on a 10/30 term with some interest only, and while they still do that, this sector of the business has seen some changes. Risk Retention rules (set forth by Dodd-Frank in 2010 effective December 2016 where all CMBS loan originators have to retain a small portion of the loan, a.k.a. keeping “skin in the game”) haven’t caused a large shift in underwriting, but they have created a sense of level-headedness as the we near the end of the cycle and lenders are competing for loans. They don’t get crazy to win deals now knowing they have more at risk. Retained Risk did however cause the number of CMBS loan originators to halve, from about 50 to around 25 lenders today. Another change has been an overall reduction in leverage – whereas before 75% was almost a given, today 70% is more common with price increases as LTV approaches 75%. This was driven by the senior bond buyers, not Risk Retention. In fact, some feel that because of Risk Retention the bond buyers are feeling more secure now and a move back to 75% is a natural progression. We’ll see. Warehouse, self storage and then office are the most desired product types today, however they will continue to be active in hospitality, retail and multi-family, too. The reality is that the Agencies and life companies do most of the high quality multi-family deals leaving story deals to the CMBS lenders. They will also be more cautious when looking at new construction apartment. As for retail, CMBS will continue to be active but will avoid most big box retail, and they will look at the tenant make-up, store sales (when possible), and rent levels to determine the ongoing viability of the center.
Banks and credit unions generally offer loans with shorter fixed-rate periods at higher rates but more prepay flexibility than what life companies, the Agencies and CMBS lenders provide. The appetite for lending on commercial real estate varies from bank to bank today. Some are lending as they have for the past few years, while others are more conservative for any number of reasons including being “lent up”, preferring owner-occupied real estate due to less onerous capital requirements, or other reasons. Banks have stronger desire to do warehouse, apartment and self storage loans and they are more selective on office and retail requests. For these types they will look closer at tenancy, history, and location. Being recourse lenders, in general, borrower strength will play a factor and that may mitigate perceived risks with the real estate.
We are experiencing interesting times. Rates are the highest they’ve been in a few years and they are still creeping up. Retail is going through a transitionary time – again. The real estate market has been hot for several years and some are wondering if there will be a correction coming soon. But on the other hand, fundamentals are good. We have job growth. We have rent growth. We here in Colorado will always have our number one draw – our climate and lifestyle. People want to live here. And there is a lot of capital out there that needs to be deployed. Lenders want to lend. They want to lend in Colorado. All I all I think 2018 should be another good year.
Terrix Financial Corporation