Bright Skies Ahead for CRE Financing
- Aug 01, 2018
Analysts are carefully watching even the slightest variations in the elements that make up the commercial real estate financing environment. Despite changes in tax and trade policies, as well as hikes in interest rates, forecasts remain optimistic regarding their impact on the market. Patrick Ward, founder & president of MetroGroup Realty Finance, cites historical evidence that supports his optimistic view on the future of capital markets. Ward also discusses what it takes to get the most favorable terms for a loan today.
What are the main trends in real estate financing?
Ward: The biggest trend impacting real estate financing this year has been leverage in the CMBS space. In major metropolitan markets, cap rates have compressed as prices have continued to increase. Historically, CMBS underwriting and sizing was still able to get to maximum leverage of 75 percent loan-to-value.
Lower cap rates combined with the slight increase in rates and the premium added to spreads to get to maximum leverage has created a condition where maximum loan-to-values are in the 65 to 67 percent range. This has forced high-leverage buyers into the mezzanine market for the last 8 to 10 percent of the loan amount. These mezzanine pieces are priced in the 9 to 11 percent range and are readily available.
What are the main challenges in commercial lending?
Ward: An issue we commonly see when advising our clients as to their options is recourse versus non-recourse. There are many lenders predominantly within the life insurance company space that are, for the most part, all non-recourse lenders. There are also many lenders, typically banks and credit unions, that are recourse lenders.
Then, there is a group in the middle that are both recourse and non-recourse lenders. The option to offer non-recourse is distinguished by both pricing and loan-to-value. Lenders in the middle category may underwrite a loan request and provide both options: for example, a recourse option in the 70 percent loan-to-value range at a certain interest rate. Then, (there is) an additional non-recourse option at a 60 to 65 percent loan-to-value with a premium of 5 to 15 basis points often attached.
The art here is that the non-recourse ratios typically have some flexibility. Therefore, negotiating the highest possible loan-to-value at the best interest rate is now important. Sophisticated mortgage bankers understand that highlighting the quality of the asset and the borrower’s strength and expertise is now very critical in obtaining the most favorable non-recourse terms.
What can you tell us about the impact of rising interest rates, the tax reform and changes in trade policies on capital markets?
Ward: While it is certainly true that there has been a steady uptick in interest rates, the increase has not been dramatic enough to affect the allocation or availability of capital for real estate. The current 10-year Treasury bill is just under 2.9 percent. In fact, in the past five years, the 10-year Treasury bill was only below 2 percent for a very small duration of time, approximately 7 months. For the most part, it hovered in the 2.2 percent range. Therefore, interest rates are only up approximately 75 basis points on average.
The majority of real estate lenders set their pricing in the range of 1.8 to 2.2 percent over Treasury bills. This puts coupon rates in the 4.7 to 5.1 percent range. This is a range that is still attractive enough that it will not alter the velocity of transactions or, from the capital side, lender allocations. In addition, the majority of maturing loans today typically fall within this range.
We also do not anticipate that the recent tax reform changes will affect the availability or desirability of real estate capital. The preservation of the 1031 tax-deferred exchange program, as well as the favorable treatment of pass-through entities, have not negatively impacted the capital markets.
That said, changes or potential changes by the current administration to trade policies have slightly impacted the capital markets. The biggest impact has been the uncertainty that it has created in the market. There is a looming fear of changing trade agreements and the ongoing concern of the effect of tariffs. As a result, many investors are seeking a flight to safety by investing in U.S. Treasury bills, (placing) downward pressure on interest rates.
What role does technology play in the lending process, and how do you think this will change in the future?
Ward: Technology will continue to evolve and streamline the lending process. We see this in two major ways:
- the process
Lenders have dramatically more tools today than in the past to gather and access information. This includes details such as absorption and occupancy data, demographics, comparable sales and tenant research, all of which are now easily accessible and available. Additionally, lenders are utilizing portals to more effectively track the transaction process, which makes the process available to all involved parties in the transaction and provides real-time updates.
What are your expectations regarding the real estate financing business going forward?
Ward: Our expectations are optimistic. We believe that there will be ample amounts of capital available over the next several years. Interest rates will continue to steadily increase, but not to levels that would upend the industry.
That said, since we started our company in the early 1980s, we have seen three separate and distinct events that challenged the real estate finance industry:
- substantial increase in interest rates
- erosion of values
- lack of capital
In 1981, the 10-year Treasury bill rose to 15.84 percent. The cost of capital obviously brought real estate lending to a halt. In the 1990s, we saw values eroding where lenders left the market to wait and see where values bottomed before reentering the market. In 2007, we saw what started as the subprime residential lending collapse move into an international banking crisis.
Having weathered these economic events, we know our economy and real estate in general are cyclical. However, we do not see any signs that these events could happen again but do believe that in the foreseeable future there will be a market correction. As experienced mortgage bankers, we have to be prepared to adapt and have financing solutions and options for our clients in all environments.
Image courtesy of MetroGroup Realty Finance