Slow and Steady

Capital promises to flow into commercial property this year.

Capital Promises to Flow into Commercial Property This Year

By Keat Foong, Finance Editor

money_flowSlow and steady. Like the proverbial tortoise, the real estate finance market is creeping along and promises to continue to do so this year. Given the prospects for rising interest rates, that is good news.

“There will be more liquidity in the entire capital market stack,” predicted Fred Schmidt, president & COO of Coldwell Banker Commercial. “All players”—namely, CMBS, institutional lenders, banks and private equity—“are looking for increased allocations across the board.”

Indeed, the Mortgage Bankers Association is forecasting continued increases in debt financing for the commercial property sector in 2014. For 2013, the MBA forecasted commercial and multi-family originations volume would rise by 11 percent from $244 billion in 2012. Through the first three quarters of last year, financing was up 14 percent­—roughly matching expectations, noted Jamie Woodwell, vice president in the Research and Economics group at MBA.

At press time, the MBA had not released overall 2013 financing figures, but indications were that the upward trends would be “likely to continue” in 2014, Woodwell told CPE.

The reasons for both greater volume of financing and increased liquidity are multiple: an improving overall economy, better real estate markets and fundamentals, the low-interest-rate environment directing capital to the relatively higher-yielding debt investments, not to mention greater lender confidence. “What we are seeing is strong appetite from lenders” being driven by improved real estate credit performance, returns and fundamentals, said Woodwell.

The major negative development this year is widely expected increases in interest rates as the Fed starts tapering its quantitative easing policies. Gary Tenzer, co-founder & principal of George Smith Partners, said short-term Libor interest rates, which if anything fell slightly this year, are likely to remain low for the next few years, but the longer-term Treasury rates may tick up, though not radically—by 25 to 50 points, perhaps. Andrew Wright, CEO of Franklin Street Capital, said he could see the 10-year Treasury rate crossing the 4 percent level at some point in the third or fourth quarter. As the economy starts to recover and corporate profits improve, Wright said, the Fed can no longer artificially keep money that cheap. Nevertheless, the effects of any rise in interest rates on transactions may be limited, as interest rates are still historically low and NOI continues to increase, compensating as rates rise.

The prognostication for increased capital flows may also be balanced by possible pullback on the part of Fannie Mae and Freddie Mac. Last year, they were mandated by their regulator and conservator, the Federal Housing Finance Agency, to reduce their multi-family financing volume by 10 percent. At press time, it was still an open question whether the FHFA would continue to cut back on their volume for 2014. The agency was still seeking comments from the industry prior to making its decision. Even if the decision is to reduce their financing volumes this year, however, players expect the newly resurgent CMBS market to make up for any drops in their financings. And in any case, part of the rationale for the FHFA to reduce its volume is so that the private market can better compete.

The increased interest rates and possible GSE cutbacks notwithstanding, most of the major investor groups are projected to continue on track to increased financings in 2014. In the first three quarters of last year, CMBS increased by a whopping 44 percent, bank financings by 22 percent and life company financings by 19 percent, according to the MBA. (Indeed, in the second and third quarters of last year, life companies achieved the second-highest levels of financings on record, Woodwell noted.) The only exception to the uptrend last year lay in GSE financing, which declined by 3 percent in the first three quarters compared to the same period in 2012.

The CMBS comeback could prove to be the single-greatest contributor to increased financings this year. CMBS financings made significant headway in 2013, especially in multi-family, when rates and LTVs finally became competitive with Fannie and Freddie’s. Total CMBS securitization this year is widely expected to increase from a projected $87 billion in 2013 to about $100 billion, if not more. (At its peak in 2007, the level of U.S. CMBS securitization totaled some $700 billion.) “No question about it,” declared Bob Barolack, co-COO at Greystone.
Life insurance companies may also increase their financing volumes this year. All indications are that their “appetite for multi-family is only going to grow in 2014,” said Barolak. “Everything we are hearing suggests it will.”
One implication of the greater liquidity is that capital will finally start flowing into the secondary and tertiary markets again—possible good news for the commercial properties that are still having trouble obtaining financing. The transaction market in the core locations “is only so deep,” so as they compete, capital sources will inevitably migrate to the next-lower market tiers and also adjust spreads or leverage and other terms, said Wright.

Secondary markets, such as Las Vegas or Phoenix, that lenders “would not touch” a few years ago are now “hot,” agreed Tenzer. “They are recovering very nicely, and in some sectors the values are very strong.” Financings in tertiary markets, on the other hand, will not be uniformly improved in 2014, instead being more property and market specific, he said.

Another key to the financing market this year is the proliferation of private sources of structured financing, all eagerly seeking deals, and even more players may enter the space. “Capital has returned across the whole spectrum,” said Tenzer. “There is something available for every (transaction) today, one way or other.” Even if a senior loan cannot be obtained at full leverage for construction, for example, structured financing can be put in place to bring the leverage up to 85 percent, said Tenzer. “There are capital solutions to get to higher leverage.”

Despite the liquidity in the commercial property debt market, however, underwriting standards are still—and will remain—disciplined, Schmidt said. Pre-leasing requirements remain in place, and debt service coverage requirements are firm. Wright said leverage is going up and DSC down, but it is still unlikely that DSC ratios will fall from 1.40 to any lower than 1.25 or LTV get any higher than 80 percent anytime soon.

There could be the possibility that the protracted period during which interest rates are held low may be leading to an asset bubble. Tenzer acknowledged there is a risk of such a low interest rate-driven asset inflation. However, while some think multi-family is overpriced because of the low interest rates, others are looking to income growth ahead to be sufficient to compensate for the low cap rates, he said.

“We’ll only know if this is a bubble in the rearview mirror.”
Coldwell Banker’s Schmidt maintains, however, that none of the indicators are “bubble like,” whether for industrial, retail, office or multi-family. Unlike the RTC days of the early 1990s, there is a lot more discipline in the market, he said.

This story appeared in the January issue of Commercial Property Executive magazine.