Lending Community Remains ‘Cautiously Optimistic’ in Approach to Underwriting Deals
Commercial and multifamily mortgage loan originations during the first quarter of this year were flat overall compared with the same period in 2015, reports the Mortgage Bankers Association (MBA).
The MBA’s Survey of Commercial/Multifamily Mortgage Bankers Originations also shows that the first quarter saw a 44 percent year-over year increase in the dollar volume of loans for retail properties and an 18 percent increase for office properties.
Meanwhile, the dollar volume of loans for the hotel and multifamily sectors — two of the hottest property types among investors in recent years — rose only 3 percent and 2 percent respectively during the first quarter.
On the flip side, the dollar volume of loans for healthcare and industrial properties during the first quarter plunged 57 percent and 56 percent, respectively.
“In the aggregate, commercial real estate borrowing and lending started 2016 in a similarly strong fashion to 2015,” says Jamie Woodwell, MBA’s vice president of commercial real estate research.
“Borrowing backed by retail, office, hotel and multifamily properties picked up, as did lending by banks. Disruptions in the broader capital markets pushed originations for commercial mortgage-backed securities (CMBS) down. Across property types and investor types, changes in regulation and broader market conditions could have an impact on originations during the remainder of the year,” adds Woodwell.
To gain more insight into the lending climate for commercial real estate, REBusinessOnline reached out to some of the most experienced mortgage bankers and direct lenders. Questions were e-mailed to six industry experts, who sent us their answers in writing.
The Q&A participants included: Dennis Bernard, founder and president, Bernard Financial Group; Sue Blumberg, managing director, senior vice president of the Chicago regional office at NorthMarq Capital; John Hofmann, senior mortgage banker, KeyBank Real Estate Capital Markets; Charles Krawitz, chief operating officer, NorthPoint Capital Funding; Joshua Rosen, senior vice president and team leader for originations, Capital One Multifamily Finance; and Matt Snyder, vice president, Mesa West Capital. What follows are their edited responses.
REBusinessOnline: What is your company’s specialty in the commercial real estate lending arena? Do you have a sweet spot in terms of loan size?
Dennis Bernard: We are Michigan’s largest commercial mortgage banking firm, acting as an intermediary for over $1 billion in all forms of commercial mortgages in Michigan and the Midwest. We place loans anywhere between $1 million and $150 million on a regular basis with life companies, CMBS lenders, private equity, agencies, banks and bridge lenders.
Sue Blumberg: NorthMarq Capital, the largest privately owned mortgage banking firm in the United States, provides sources of debt and equity on all property types. We work directly with Freddie Mac Program Plus, Fannie Mae DUS program and FHA, as well as a correspondent to 50 life insurance companies, numerous banks and financial institutions. In addition, we have servicing and production relationships with 12 CMBS lenders.
Our annual production exceeds $12 billion. The average loan size is $12 million. We service 5,700 loans, carrying a servicing portfolio balance of more than $47 billion. More than 50 percent of the loans originated in the last three years have been multifamily, evenly split between life company lenders and the agencies. About two-thirds of our loans are refinances.
John Hofmann: KeyBank Real Estate Capital provides acquisition, construction and interim financing, permanent mortgages, commercial real estate loan servicing, investment banking, and cash management services for virtually all types of income- producing commercial real estate. By pairing our balance sheet with our capital markets products such as Fannie Mae, Freddie Mac, FHA, CMBS, mezzanine financing and insurance company distribution capabilities, we separate ourselves from most national mortgage banking platforms.
We originate debt across a broad spectrum of loan sizes and asset classes. In 2015, the bank originated over $30 billion of capital within the commercial real estate sector, making Key one of the most active lenders in commercial real estate. Key also has a very large balance sheet with approximately $16.5 billion of commitments.
Charles Krawitz: NorthPoint Capital Funding is part of the NorthPoint Capital Group, a Midwest commercial mortgage banking operation specializing in originating loans for, and making loans to, commercial real estate owners as a correspondent for life insurance companies and as a FHA licensed MAP lender. Since its formation in 1998, NorthPoint Capital has built a servicing portfolio of nearly $500 million.
While NorthPoint Capital Group historically has funded larger transactions, NorthPoint Capital Funding primarily focuses on financing transactions below $20 million in metro Chicago and surrounding Midwest markets. NorthPoint Capital Funding’s sweet spot is to provide long-term, fixed-rate loans at highly attractive rates to borrowers who have traditionally financed their properties with local banks and are unaware that 10-, 15- and 20-year fixed terms are available.
Joshua Rosen: Capital One’s Commercial Real Estate Group specializes in financing commercial real estate through our balance sheet as well as agency sources. In the Midwest, Capital One is primarily involved in financing healthcare real estate via our healthcare real estate team and our multifamily finance team, the latter of which I’m a member.
The healthcare real estate team provides customized financing solutions to healthcare investors, operators and developers for medical properties and seniors housing and care facilities with numerous products such as first mortgages, interim financing and acquisition financing.
Our business is predominately driven by existing assets — in the form of either a refinance or acquisition. We will entertain construction financing, but on a very limited basis and only if we are extremely comfortable with the deal metrics.
Matt Snyder: Mesa West Capital is a balance sheet, bridge lender that provides three- to five-year, floating-rate first mortgages on transitional properties. Our minimum loan size is $20 million, and we can do loans as large as $300 million. Our average loan size is between $50 million and $75 million. Approximately 75 percent of our business is acquisition financing versus 25 percent refinancing.
REBO: Which property types are you most bullish or bearish on today?
In my role as part of the seniors housing and healthcare practice, I’m most interested in the skilled nursing space. It’s a specialized asset class, and unusual in that most of the value is driven by the operations of the facility as opposed to the actual real estate. Our team is very experienced in knowing how to underwrite and quantify that value.
Hofmann: We believe our sponsors can find value in all property types and markets. Through this business model, we’re less worried about focusing on certain properties and more focused on finding the right operator. When you focus on strong owner/operators, you can create value across many markets and property types.
Bernard: Like the rest of the known planet, we have been very bullish on all forms of multifamily lending, whether it be new construction, refinancing, market-rate apartments, manufactured housing communities or seniors housing. We also remain bullish on any financing in the City of Detroit, where we have placed over $700 million in the last 27 months.
We are still very positive on the Michigan industrial market, which is very tight and not overbuilt at all. Good infill retail remains strong and positive. We do have some concerns about suburban office in tertiary locations and weaker submarkets, and hotels remain on our “be careful of” list.
Blumberg: As a company, we are bullish on multifamily. Continued demographic changes point to continued rental housing in all age groups — from young adults through empty nesters. There is no sign homeownership will be trending up anytime soon. Both suburban and urban apartments are enjoying steady rent increases and high occupancies.
The industrial market is booming, with distribution centers in the Midwest expanding and becoming very desirable investments due to the increase in online shopping that drives faster delivery expectations.
The office sector has strengthened and become more diverse. New office development has been limited as large tenants downsize space, and medium- and small-size tenants expand to backfill those vacancies caused by departures. Rents have held steady with slight increases.
The only property type of concern is in retail, although there are pockets of retail real estate that have single-digit vacancy.
Snyder: At this part of the cycle, I wouldn’t say we are bullish on any asset class in particular, but we do think well located, newer vintage multifamily will continue to perform well. At the same time, I wouldn’t say we are bearish on any particular asset, but we are treading carefully when we look at hotels as it’s difficult to underwrite growth in revenue per available room, especially in markets where we see lots of new supply coming on line.
Krawitz: As a correspondent for multiple life insurance companies, we seek to lend on assets that have well-diversified tenancies. Clearly, multifamily is preferred in this regard, but our lenders have a penchant for retail centers, industrial properties and office buildings.
Characteristically, the more tenants the better. Stable operating performance and long tenant tenures at readily replaceable rent levels typically trump concerns associated with shorter lease terms.
We are bullish on industrial buildings as they appear to be the beneficiaries of a shift in buying habits and are prospering at the expense of traditional brick-and-mortar retail centers. Conversely, we are bearish on retail properties that are highly dependent on big-box tenants who are either nearing the end of their primary lease terms or operating subject to a relatively short-term option.
REBO: Which Midwestern markets are the most attractive, or provide the best opportunities for your company?
Snyder: We have been active in Chicago, specifically the West Loop, which has undergone a tremendous transformation in the past several years. Since the downturn, we’ve seen a migration of companies from the suburbs to downtown, which has strengthened the office and multifamily sectors. We’re also seeing Chicago becoming a growing tech market, which further diversifies the market’s tenant base. Since opening our new office last year, we have originated more than $600 million in short-term debt for the acquisition and/or recapitalization of a variety of commercial, industrial and multifamily assets in the Chicagoland area including the John Hancock Center, and 1K Fulton, which is home to Google’s regional headquarters. So, Chicago is certainly a market where we will remain active.
Bernard: In our 25 years of business, I never thought I would have the chance to write that the City of Detroit is by far our most attractive market for ownership and development. The city and its leaders are making all the right moves, and business and population are following. But like any market, you have to be market knowledgeable and not just dive in. We are seeing many out-of-towners take some undue risk in that they want to be a part of Detroit’s rebirth. Detroit is experiencing growth in office, retail, multifamily and even industrial.
Blumberg: NorthMarq is very active in all markets. Chicago is thriving with office, multifamily and industrial values at all-time highs. Detroit is the only challenging market, but other markets in Michigan are doing just fine. Minneapolis is steadily growing, specifically in the downtown area. Omaha has seen redevelopment in the downtown as well. Markets in Ohio are steady with growth in pockets such as downtown Columbus.
Rosen: As strange as this sounds, despite all the uncertainty regarding the Illinois state budget and other statewide issues, we love Chicago. It’s a big city with Midwestern operators that are fantastic to work with. And it doesn’t hurt that it’s a huge per capita market for skilled nursing facilities.
REBO: Apartments have been the darling of the lending community in recent years. Do you anticipate that trend to continue for the foreseeable future, or are lenders starting to tap the brakes on apartment lending?
Snyder: We don’t foresee the rent growth that some markets have experienced over the past five years continuing. That’s especially the case in Chicago where there is a new project announced each month. So, at some point we will move past equilibrium and supply will outpace demand. It hasn’t happened yet, but the next 12 to 18 months will be interesting. In general, lenders are aware of the new supply pipelines and are pulling back leverage to developers.
Hofmann: We track the apartment supply coming to market closely and still feel positive about the sector as an asset class. We have a strong multifamily franchise, particularly given Key’s presence with Fannie Mae as well as Freddie Mac and FHA. We will continue to be very active in the multifamily sector and see continued growth and opportunity.
Krawitz: While there are some indications that the tepid wage inflation may tap the brakes on the ability of landlords to push through rental increases, apartments are squarely
fulfilling the housing needs of millennials and baby boomers alike. Lenders will continue to keep multifamily at the top of their lists, albeit with more discretion than in the past.
With jobs migrating to the urban core, the suburbs may find that demand is ebbing, making construction money harder to come by. Paradoxically, urban markets, despite strong absorption figures, are also likely to experience a pullback in construction lending as the inventory explosions of the past few years get digested and operating projections are given time to prove out.
Blumberg: Multifamily has shown incredible resilience due to the demographics and trends in rental housing. Homeownership has been on the decline, especially for first-time buyers and new households. This trend is predicted to continue for three to five years. New construction has been steady as absorption continues to outperform expectations. Rents are steadily increasing and vacancies are at a minimum.
The financing of new construction remains challenging with equity requirements increasing, which will keep supply in check. Loan leverage is being watched carefully as low interest rates are putting pressure on debt-service coverage ratios (minimum 1.25). This will be the determining factor.
Bernard: Multifamily remains strong. As of this writing, lenders are remaining somewhat prudent in their lending capacity and underwriting. We are seeing loan metrics not get overly stretched. Lenders are competing more on rate, which helps in the long run since low rates on debt cure all kinds of market and operating evils. Our concern would be if greed kicks in, which it usually does, and loan-to-values go up and debt yield requirements go down.
REBO: The leading economic indicators are mixed. The Bureau of Labor Statistics reports a net gain of only 38,000 nonfarm payroll jobs in May. But U.S. consumer spending recorded its biggest increase in nearly seven years in April and housing prices are rising. What’s your outlook for the commercial real estate lending market over the next year?
Rosen: These mixed signals don’t really affect the type of healthcare lending that I specialize in. That’s because healthcare, as a sector, is pretty immune to these types of statistics due to the population it serves. People are going to continue to age and require specialized healthcare.
Bernard: We are going to be okay, which is exactly what this six-year expansion has been — just okay. Lenders will continue to lend on a conservative basis, developers and owners will continue to cry about the lack of aggressiveness, most people will continue to point the blame or credit to whatever recent survey or report fits their political view, and we will continue to slowly amble along.
Krawitz: Despite the schizophrenic nature of our economy, it appears that the current economic expansion has 18 to 24 months left to run. This horizon seems to be on the minds of construction lenders as they look to avoid lending into a project that comes on line just as the economy turns down. Accordingly, not only are construction lenders starting to require higher levels of pre-leasing, tightening the screws on guarantees and implementing other structural safeguards, but they are also being highly selective on the deals that they will entertain.
Term lenders are also starting to show greater selectivity and are scrutinizing tenant lease maturities and market fundamentals in greater detail. Loans are increasingly being sized not on today’s value, but on the lender’s perception of value over the loan term, sometimes upward of 20 years.
REBO: The 10-year Treasury yield stood at 1.48 percent as of June 30 compared with 2.24 percent to start the year. What accounts for this drop in the 10-year yield, and what impact has this trend had on lending activity?
Bernard: Years and years of poor fiscal and economic policy by both the White House and the Federal Reserve accounts for this drop. If you can’t raise rates when the economy is expanding and have policies that include wage, job and economic growth, then you can’t expect to have the economy grow and expand. You need growth and expansion to sustain commercial real estate, so this is going to continue to be a problem in the future.
Hofmann: Downward pressure on the Treasury yield will continue to provide a gap between capitalization rates and interest rates, which is good for commercial real estate. Treasuries are just one piece to an all-in coupon. Credit spreads also play a factor.
We have seen all-in interest rates stay relatively stable as a significant drop in Treasuries can also trigger a widening of spreads. If we see an increase in interest rates, particularly if it is abrupt, it could create some temporary stalls in lending activity as borrowers will try to regroup and look at their total cost of capital in a different Treasury environment. We counsel our clients on having a good mix of floating- and fixed-rate exposure across their portfolios.
Snyder: We have negative rates in Europe and Japan, so that has put downward pressure on the U.S. Treasury yield. Inflation is still low, and in some areas of the economy we are experiencing deflation. Meanwhile, U.S. GDP is slowing. All of the factors combined force investors to a flight to quality, and that flight to quality will keep rates low. As long as the U.S. economy is the best of the worst, it’s hard to see rates moving higher.
Commercial real estate is an attractive asset class as long as rates are low. We are also seeing the flight to quality as strong assets in major markets are trading at all-time highs. Investors are hunting for safe yields, and we’re also seeing investors push into secondary markets looking for yield.
REBO: Have underwriting standards fallen at this point of the real estate cycle, or are lenders still cautious?
Krawitz: Just the opposite. Lenders are concerned that prices may have peaked as indicated by a general slowdown in investment sales activity in the first quarter. In addition, lenders are starting to respond to the new regulatory regimes that were implemented in response to the Great Recession that are just now taking effect.
This regulation has resulted in choppy bond markets as former market makers have all but exited the business due to perceived conflicts of interest. Market liquidity has suffered as proprietary trading has been sidelined in favor of simply executing trades for others.
The upshot has been disjointed pricing as demonstrated by the near collapse of the CMBS marketplace earlier this year. The lack of a consistent buyer and seller of the related bonds has reverberated with other types of lenders who underwrite to “the market.” Accordingly, mezzanine and other lenders are taking a more conservative approach to loan proceeds and digging deeply into a deal’s fundamentals.
Hofmann: We don’t believe that underwriting standards have slipped. If you compare today’s lending environment to the pre-crisis market, the underwriting standards are very different. Banks and capital markets lenders continue to show restraint by lending on existing income and avoiding the pro forma underwriting standards we saw during the previous cycle.
Snyder: Lenders generally realize we are late in the cycle and are being prudent on not providing too much leverage in the system. We are seeing lenders pull back (some of it is because of regulatory standards) on construction loans, so it feels different than 2006 and 2007 when there was much more leverage in the system.
Blumberg: Underwriting has been cautiously optimistic. Borrowers with experience and liquidity are getting preferential treatment. Proven track records are worth a lot to any lender. Equity in a deal is important as lenders want to make sure the borrower is invested in the property. These low interest rates help maximize proceeds to a borrower, but values and debt coverage limits keep the loans reasonable.
REBO: What keeps you up at night?
Rosen: The healthcare space is a lumpy business, and we’ve been experiencing a boom for quite some time. But rates can’t stay this low forever, so those thoughts can impact my sleep. That and Netflix. Lots of Netflix.
Hofmann: We feel that the market is functioning well, as lenders and borrowers have shown discipline in taking on leverage. I do, however, worry about temporary dislocations in the capital markets as we enter the wave of loan maturities in the coming years.
The market needs a functioning capital markets to get through these refinancings, and a liquidity crunch could create some distress. As a bank, we feel well poised to provide our clients with liquidity via our balance sheet in volatile times, but not everyone will be able to use bank debt to pay off a maturing CMBS loan.
— By Matt Valley. This Q&A originally appeared in the July issue of Heartland Real Estate Business.