Heavy Capital Flow Fuels Deal Velocity
Debt and equity capital for placement in commercial real estate, particularly in the multifamily sector, have never been more plentiful in Texas. With the Federal Reserve recently abandoning and possibly getting set to reverse its interest rate hikes, even more investors and borrowers are coming off the sidelines.
According to the Mortgage Bankers Association (MBA), the national level of commercial mortgage debt outstanding rose by $45.4 billion in the first quarter of 2019, a 1.3 percent increase from the fourth quarter of 2018. Multifamily mortgage debt alone increased by $17.9 billion to $1.4 trillion from the fourth quarter of 2018, also an increase of 1.3 percent.
The uptick in lending is occurring in the face of an ongoing trade war with China and the elevation of the three-month Treasury yield (2.14 percent as of press time) above the two-year Treasury yield (1.74 percent). Economists often view the latter trend, known as an inverted yield curve, as an indicator of recession, a credible possibility given that the U.S. economy is close to a decades-long expansion.
The perceived risk in the marketplace from these factors has steered more investors toward the 10-year Treasury, a traditionally low-risk vehicle for parking funds. This movement has consequently caused the benchmark rate’s yield to decline by more than 100 basis points in 2019, including a temporary drop below 2 percent for the first time since 2016.
“The appreciable decline in the 10-year Treasury has been beneficial to pricing across all sectors,” says Mike McDonald, vice chairman at Cushman & Wakefield. “The ‘silent hand’ of the Fed has provided stability to the market, and that has increased demand for U.S. commercial real estate from both domestic and offshore investors.”
The central bank’s reversal doesn’t incentivize borrowers that are already carrying floating-rate debt, which typically offers more flexibility on prepayment, to transition to fixed-rate financing. But the spread between the federal funds rate of 2.5 percent and the 10-year Treasury rate of 2.16 percent (at the time of this writing) means that short-term debt has become more expensive. As a result, many borrowers see an advantage in refinancing their properties for the longer haul.
Much like a year ago, when the Fed was on a clear path of rate hikes, borrowers are capitalizing on Fed policy to lock in favorable rates.
The capital markets of the United States have been operating in a historically low interest rate environment for the past decade, bringing more investors into the market and allowing them to shop their deals for the best terms. This trend has contributed to lower leverage as borrowers reap savings on the pricing front.
“Right now there’s good opportunity to lock in long-term financing,” says Dana Deason, president of Texas-based Deason Financial Group. “Due to the inversion of the yield curve, shorter-term rates have become anywhere from 100 to 150 basis points more expensive than long-term debt, and we see strong demand from borrowers moving from conventional bank financing to permanent debt markets.”
“Our borrowers have been taking advantage of the low interest rate environment by placing non-recourse, fixed-rate financing on their properties for as long as 30 years,” adds Emily Zarcaro, vice president at Houston-based mortgage banking firm Q10 | KDH. “That being said, we’ve also seen an increase in demand for short-term financing with construction and bridge loans when needed. The increase in financing across the board be it short or long term is reflective of both the abundance of capital and the strength of the Texas commercial real estate markets.”
One of the lending sources Q10 | KDH accesses on behalf of its clients is life companies, which typically allow borrowers to lock in rates during the application phase while also offering lengthy terms, lower closing costs and access to non-recourse financing
Zarcaro adds that many life companies are seeing heightened competition amongst each other. “While life companies may be lending more than in prior years, they are challenged to keep up with increased year-over-year allocations as real estate becomes a more attractive investment vehicle internally, “she says.
Life companies increased their total volume of debt issued by 2.2 percent between the first quarter of 2019 and the fourth quarter of 2018, per the MBA. Borrowers seeking long-term and nonrecourse loans but which need to maximize proceeds can find similar opportunities with CMBS lenders.
Furthermore, says Deason, these borrowers are hustling to get deals done because the transition from short-term to long-term debt grants them longer amortization periods, as well as a greater likelihood of securing nonrecourse financing, albeit at the cost of flexibility on their prepayment schedules or exit strategies.
As such, lenders that specialize in providing permanent debt — government agencies, CMBS, life companies, mortgage REITs — are also seeing opportunities to boost their deal volumes — if they can win the deal.
A Competitive Landscape
Despite the fact that the economy is now checkered with red flags, deals are still getting done. Some real estate finance professionals believe that is attributable to the sheer volume of capital in the market.
Steve Forson, managing director at Dallas-based Churchill Capital, says that the Fed’s reversal of course has caused borrowers to reassess deals that were previously written off over the last 12 months. This heightened demand for funds from borrowers has led to increased competition for both debt and equity placement, another byproduct of the hefty amount of capital at play in the market.
“There’s still so much money chasing deals that while borrowers are incentivized to do more deals because of the rate policy, it can still be hard to get deals done because the volume of capital is offsetting the attractiveness of those lower rates,” says Forson. “Debt providers have to be more creative and find new ways to attract borrowers.”
While every deal is different, borrowers typically have more of their own funds to divest, which means that leverage ratios are generally coming down. In addition, the compression of the two-year Treasury yield means that borrowers can lock down all-in coupon rates that are lower than what they were eight or so months ago.
“While we’ve seen a swing toward floating-rate debt on short-term, bank-related deals, borrowers with longer-term deals are still looking to lock away fixed-rate money while the Treasury yield is low. Long-term fixed rate money is extremely attractive and aggressive right now and all owners that have long–term hold horizons and stable rent rolls should consider locking up these historically low rates today,” says Forson. “The geopolitical factors have to some extent been priced into debt markets, which aren’t as sensitive to these forces as stock markets.”
Brandon Brown, managing partner at Houston-based LMI Capital, which specializes in financing multifamily assets, says that as a result of leverage ratios coming down, deals are becoming tougher to execute in terms of debt service coverage constraints.
“Some borrowers think rates will go down further, and that has translated to more people wanting to get deals done as opposed to eight months ago when the Treasury was much higher,” says Brown. “But a lot of these deals face debt service constraints, which are still a factor of cash flows and taxes. So in many cases we’re scratching and clawing to hold and keep those dollars along the process of the loan.”
Brown notes that the fall in the Treasury yield has helped his firm lock in lower interest rates for borrowers that originally applied for loans earlier in the year. This has helped these borrowers obtain the additional proceeds they seek.
The Fed’s Next Move
Following the Fed’s most recent meeting, held on June 19, the consensus appeared to be that the nation’s central bank would hold rates steady for now while leaving open the possibility of cutting them later in the year.
Political pressure from President Donald Trump to desist from rate hikes and return to quantitative easing — measures that typically increase the amount of money in circulation and stimulate economic growth — has presumably factored into the Fed’s policy shift during the last six to eight months.
“Trump essentially forced the Fed’s hand with all the tariff threats that could have tempered our economic growth,” says Matt Greer, executive managing director at Newmark Knight Frank’s Austin office. “While lower rates help fan our economy’s flame by encouraging borrowing, the fact is that we’re going to be in a low-rate environment for quite a while.”
Greer believes that for multifamily product, Fannie Mae and Freddie Mac remain the pack leaders in terms of providing liquidity. But he also believes that the large amount of capital targeting Texas assets is driving competition and opening more doors for certain types of lenders, most notably life companies and debt funds.
“With the record volumes that the industry is seeing combined with the cap limitations the agencies face, other capital sources are starting to see more opportunities,” says Greer. “Life companies are seeing deals that would normally have gone to agencies. Borrowers’ search for higher proceeds has caused many value-add buyers to turn to debt funds, as they believe that LIBOR is trending down, which will lower their cost of capital during their hold periods.”
Lenders and mortgage brokers generally agree that the Fed moving away from a set-in-stone policy on short-term interest rates is a good thing. The central bank needs to be able to cut rates to stave off the severity of a recession should the economy slip into a bear market. But it must also at times raise rates to choke off inflation from a historically low unemployment rate (3.6 percent as of May) and above-average quarterly GDP growth.
To those ends, a basic “read-and-react” approach to analyzing economic data and adjusting monetary policy is the best course, sources agree.
The Flip Side
Long-term, fixed-rate financing still makes the most sense for deals involving acquisitions or refinancings of stabilized properties. But for distressed properties and assets that are in transitional phases, the government’s see-sawing interest rate policy can have adverse effects.
According to McDonald of Cushman & Wakefield, borrowers have shown a great willingness to accept floating-rate debt on transitional assets in this environment.
“The floating-rate market is both very liquid and very aggressive right now, and is flush with choices via the surging debt fund market in the past 18 months,” he says. “Competition among lenders has driven the ability to negotiate more favorable non-economic terms, such as longer term on floating-rate loans, less onerous cash management and more flexible call protection.”
As CEO of Dallas-based Pioneer Realty Capital, Charles Williams is experiencing these negative impacts of firsthand. With all the competition for both debt and equity placement in the multifamily space, his firm is pivoting to focus on assets like hotels, which banks and debt funds tend to avoid.
Williams says that the Fed’s decision to abandon interest rate hikes eliminated the incentives of his clients to lock in long-term rates as a hedging mechanism. With rates remaining flat or on track to be cut, there’s not much reason to rush into long-term financing. In addition, he says, some borrowers believe the new monetary policy has granted them more time and flexibility to avoid locking in long-term debt.
“One of the biggest challenges lies in the fact that a significant amount of the national real estate debt portfolio is still in transitioning debt or debt from a debt fund,” says Williams. “Capital sources have sensed that the government is afraid of letting interest rates rise to where they need to be, so borrowers in variable-rate programs aren’t motivated to shift to long-term, fixed-rate financing because they think the low interest rate environment is going to continue.”
Williams notes that even within his space, investors are still aggressive in terms of sourcing deals and parting with capital. But rather than hedging against interest-rate volatility, capital sources — be they foreign, institutional or another type — are betting on the imminence of a broader economic downturn by sinking as much of their own capital as possible into deals. With lower leverage requirements, these capital sources are bound to turn to banks and debt funds.
“Banks are very active right now because they like the low-leverage deals,” says Williams. “But with what’s happening with interest rates and investors wanting to put more capital into deals, banks are staying in the game, whereas traditionally they’d be pulling out at this point in the cycle.”
Williams also notes that the number of debt funds available to borrowers has risen significantly during this cycle as more investors have entered the market. As a result of this growth, debt funds are competing with one another, which causes rates to drop and investors to benefit.
“There are so many debt funds out there that interest rates are significantly suppressed,” says Williams. “They’re all chasing some kind of yield, and they’re racing to the bottom.”
—By Taylor Williams. This article first appeared in the July 2019 issue of Texas Real Estate Business magazine.