Two compelling trends have emerged on the commercial real estate lending and investment front during the first half of 2015.
First, commercial real estate buyers with an abundance of funds and a yearning for yield have poured more capital into the Midwest amid heady prices in major coastal markets.
Second, the increase in spending has transpired in an environment marked by two potential market-disrupting forces: interest rate volatility and temporary anxiety over the role Fannie Mae and Freddie Mac will play in the apartment financing market.
Investment sales of office, industrial, retail, apartment and hotel properties through the first five months of 2015 in the Midwest totaled $19.6 billion, according to New York-based Real Capital Analytics (RCA), which tracks property and portfolio sales of $2.5 million and above.
That $19.6 billion sum has already surpassed the volume of property and portfolio sales in the 10-state region during the first half of 2014 by $3 billion, and it represents 10 percent of national dollar volume year-to-date through May, according to RCA.
Over the past 17 months, capitalization rates in the Midwest have generally remained flat or declined by approximately 30 basis points, reports RCA. The cap rates across the region are still 40 to 120 basis points higher than other parts of the country, however, depending on the property type.
That discrepancy in cap rates has helped attract more institutional investors to the Midwest, including private equity funds, family offices, foreign investors and pension fund advisors, say real estate debt experts.
“I would say investors are increasing their appetite for the type of markets they’ll go into,” says Michael Duggan, vice president for conventional and government-sponsored enterprise (GSE) financing for Berkadia in St. Louis. “Equity dollars over the last few years have been more focused on the coasts, but as those markets have become more competitive, the dollars are certainly spilling into the Midwest.”
Diverse Investor Demand
Duggan anticipates that Berkadia’s St. Louis office will close $300 million in commercial real estate loans in 2015, a nearly $30 million increase over last year. He and other capital markets observers say that apartments, industrial and, to a certain degree, suburban office properties are in demand in the Midwest. Buyers are also seeking seniors housing, student housing and self-storage facilities.
Among other transactions, Berkadia in May arranged $648.2 million in acquisition financing for a buyer of 32 seniors housing properties in 12 states, including Missouri, Texas and California. Berkadia worked with New York-based NorthStar Realty Finance Corp. to provide the 10-year loan, which featured an interest rate of 4.17 percent and a 73.5 percent loan-to-value ratio.
Institutional buyers active in the Heartland include New York-based private equity behemoth Blackstone Group, which recently raised $15.8 billion for a global real estate fund. In early June, Blackstone Group completed its purchase of the 4.5 million square-foot Willis Tower (formerly the Sears Tower) in downtown Chicago for around $1.3 billion.
New York-based private equity firm Blackstone Group this spring bought the
4.5 million-square-foot Willis Tower (formerly Sears Tower) in downtown Chicago for $1.3 billion. Blackstone plans to add more entertainment and retail space and will reconfigure office space to create more common areas and shared amenities.
Earlier this year, Blackstone Group also paid $180 million for the Streets of Woodfield, a 713,260-square-foot retail property in Schaumburg, Ill., and acquired a portfolio of six hotels that included two Marriott flags in the Minneapolis area.
Meanwhile, San Antonio, Texas-based USAA Real Estate Co. in February leased up a 604,000-square-foot speculative warehouse in North Aurora, Ill., that it recently developed with The Opus Group. Last year USAA partnered with Chicago-based real estate investor and developer Golub & Co. to acquire the 30-story Chestnut Place apartment tower in downtown Chicago.
“The Midwest is being discovered by a lot of different owners and capital sources because the returns are higher than elsewhere in the country,” says Charles Krawitz, chief operating officer for mortgage banking firm NorthPoint Capital Group in Chicago. “You’re seeing more of a convergence of cap rates nationally as money searches for yield.”
Volatile Threat
Banks, life insurance companies, GSEs and originators in the commercial mortgage-backed securities (CMBS) market are ratcheting up their lending activity, especially as the first wave of $600 billion in 10-year CMBS loans made from 2005 through 2007 start to mature.
CMBS lenders doled out $41 billion through May, which was $1 billion more than they originated in the first half of 2014, according to the Washington, D.C.-based Commercial Real Estate Finance Council, a trade association for the $3.4 trillion commercial real estate finance industry globally. Similarly, life insurance company loan originations of $11.6 billion during the first quarter of 2015 represented a year-over-year increase of nearly $4 billion.
The strong buyer appetite and the eagerness of lenders to put capital to work persevered through a stormy interest rate period, despite widespread expectations that the Federal Reserve would keep the federal funds interest rate in the 0 to 0.25 percent target range and hold off on raising it at least until later in the year. (Those expectations have since been fulfilled.)
The 10-Year Treasury yield hit a 2015 high of nearly 2.7 percent on June 10, a jump of 80 basis points in a roughly seven-week period. The yield had retreated to around 2.25 percent as of mid-June.
Perceived illiquidity in the Treasury market, the seemingly endless insolvency drama in Greece, and short sellers betting that Treasury prices would drop and yields rise — a strategy advocated earlier this year on CNBC by Janus bond guru Bill Gross — have all been cited for the volatility.
Whatever the reason, the swing in some cases led to contract renegotiations in transactions that lacked a locked-in interest rate, such as CMBS deals, says Daniel Baker, head of the commercial mortgage group for KeyBank Real Estate Capital in Chicago.
“My biggest concern a few months ago was that we were going to have a stare-down between buyers and sellers,” he says, “but we still saw deals close.”
What’s more, ratings agencies and the buyers of riskier bonds — or “B-piece investors” — have largely guarded against underwriting weakness in CMBS deals, commercial real estate observers say.
Still, smaller banks have become more aggressive by offering higher leverage, and CMBS lenders continue to provide interest-only terms at a high rate.
Whereas the environment of low interest rates and copious amounts of capital chasing a limited amount of properties mirrors the run to the last cycle’s summit, the circumstances have yet to incite a prodigious amount of risk among most investors, lenders and equity providers.
“The conditions are ripe for underwriting standards to collapse, but I think you’re seeing rating agencies and B-piece buyers forcing rigor into the process,” says Baker. “Competition is fierce, and there has been some creep (toward looser underwriting), but it’s not dramatic.”
Well-heeled and experienced sponsors can secure financing with a loan-to-value ratio of up to 80 percent for high-quality assets, and mezzanine financing is available for deals in excess of $20 million at interest rates of typically 11 to 13 percent, says Kenneth Martin, a director for commercial real estate capital intermediary HFF in Indianapolis.
But a gulf exists between the loan terms available to deep-pocketed and experienced borrowers versus borrowers with less experience financing run-of-the-mill assets, and occasionally mortgage brokers and loan officers are too optimistic about what they can provide, says Krawitz.
“Some mortgage brokers are out there in this heady, frothy market promising the world because they get wind of a deal done and think that it’s the type of financing anyone can get,” he says. “But they don’t know the back story. You can get it if you have $60 million in cash on deposit with the lender, but it’s not the type of financing broadly offered to the marketplace.”
Apartment Anxiety
The disconnect between the perceived widespread availability of generous loan terms and reality is most apparent in the multifamily category, he adds. That’s hardly a surprise given the high velocity of apartment transactions. Some $3.7 billion in multifamily assets in the Midwest traded hands in the first five months of 2015, an increase of $400 million over the first half of 2014, according to Real Capital Analytics.
Fannie Mae and Freddie Mac still dominate lending activity. The agencies accounted for 39 percent of all multifamily and commercial property originations nationwide in the first quarter of 2015, a year-over-year increase of nine percentage points, according to the Mortgage Bankers Association.
Yet the financing pace set by the GSEs of about $10 billion each in the first quarter put them on pace to hit their respective $30 billion annual caps long before the end of the year. In turn, that led the GSEs to increase rates roughly 35 to 50 basis points to slow lending, which created market anxiety for about 45 days in April and May, says Baker.
In early May, the Federal Housing Finance Agency, which regulates Fannie Mae and Freddie Mac, exempted certain properties from counting against the cap, including affordable housing, manufactured housing and properties with five to 50 units.
“In essence, it has increased Fannie Mae’s and Freddie Mac’s ability to continue to make loans this year,” says Duggan. “We think we’re going to see a nice increase in volume that does not count toward the cap.”
Apartment developers in the major metros of Ohio, Michigan, Minneapolis, Indiana, Wisconsin and Illinois are expected to deliver about 23,000 new units in 2015, an increase of more than 5,000 units over last year, according to the Marcus & Millichap Apartment Research Report for the first quarter of 2015.
Additionally, apartment completions in the Kansas City area of more than 4,000 this year will nearly double last year’s deliveries, according to the 2015 Real Estate Report for Metropolitan Kansas City by Block Real Estate Services.
Citing continued healthy renter demand, debt market specialists for the most part haven’t seen lenders pull back amid concerns of a potential glut. In Indianapolis, developers are adding 3,000 new units this year, up from 2,800 in 2014, according to Marcus & Millichap. But ample time between completions is allowing projects to lease up without too much competition, especially downtown, says Martin.
“We have a fairly robust pipeline if you look at the aggregate,” he adds. “But when you start to break it down, the pacing of the starts is such that we shouldn’t get caught with three big projects coming on line while two others are only halfway through lease-up.”
Conversely, KeyBank has started to pull back on making balance sheet loans in the apartment sector, but it intends to stay active in the student and senior care sectors, says Baker. In February, KeyBank provided $274 million in Freddie Mac financing for seven student-housing properties in six states, including Minnesota and Indiana.
“We’re not trying to time the market, but we feel like multifamily is red hot,” he explains. “We think it’s a good idea to be selective. But senior care and student housing are still very big for us.”
Baker predicts that permanent loan originations held on KeyBank’s balance sheet would total about $7.5 billion this year compared with $5.4 billion in 2014, while bridge and construction financing is expected to stay relatively flat at approximately $3 billion.
Broad Momentum
Beyond apartment properties, demand for hotel and office assets helped drive Midwest sales increases year-to-date through May. Hotel transactions of $2.3 billion are already double the amount recorded in the first half of 2014, and office deals have increased by $1.2 billion to $5.4 billion, according to Real Capital Analytics.
What’s more, industrial transactions of some $3.4 billion through the end of May were on pace to meet or exceed $4 billion in deals completed in the first half of 2014.
While a good chunk of apartment development and investment has occurred in revitalized downtowns in the Midwest, investors are looking to the suburbs for office properties. A joint venture led by Charlotte, N.C.-based Trinity Capital Advisors early this spring paid Duke Realty $1.1 billion for 62 suburban office assets totaling 6.9 million square feet in St. Louis, Raleigh, N.C., Nashville, Tenn., and South Florida. The St. Louis portfolio accounted for a quarter of the deal.
HFF recently arranged an $8.8 million acquisition loan for a joint venture between Minneapolis-based industrial owner Meritex and an institutional investor, which in March purchased MetroAir Building No. 3 in Plainfield, Ind. A life insurance company funded the 10-year, fixed-rate loan. The 248,358-square-foot building is part of the MetroAir Business Park that Horn Properties and McShane Development Co. are developing.
Moreover, strong suburban corridors in Indianapolis and Cincinnati are also attracting office buyers and developers, says Martin.
In February, for example, Eden Prairie, Minn.-based Onward Investors bought the 180,637-square-foot College Park Plaza in the Northwest submarket of Indianapolis for $14.3 million from Griffin Capital Essential Asset REIT.
Industrial assets continue to fetch investor attention, too, Martin adds. HFF recently arranged an $8.8 million loan for a joint venture between Minneapolis-based industrial asset owner Meritex, and an institutional partner in conjunction with the purchase of the 248,336-square-foot MetroAir Business Park Building 3 in Plainfield, Ind.
HFF also arranged $98.8 million in first mortgage debt for Vancouver-based Pure Industrial Real Estate Trust tied to eight properties leased to FedEx, including two in Illinois. The seven-year mortgages feature an interest rate of 3.8 percent.
“A lot of investors that have large positions in other markets are taking a look at the Midwest,” says Martin. “It’s really the full gamut of real estate investors on the industrial side.”
— Joe Gose