Financing student housing might not be as bad as you might think. While the capital markets are in flux, purpose-built student housing has some of the strongest fundamentals in commercial real estate going for it. Robust pre-leasing, very healthy occupancy and rental rate increases are making the asset class attractive to lenders. The problem: getting today’s terms to pencil on some projects.
“Borrowers should be prepared for lower leverage, higher pricing and fewer options to choose from when seeking financing,” says Timothy Bradley, founder of TSB Capital Advisors and principal of TSB Realty. “We are still getting deals done, but leverage has come down 5 percent to 10 percent on average while pricing has increased significantly over the second half of the year. Groups with long-standing institutional lending relationships are leaning on those sources heavily, but many banks are looking for ancillary business as a prerequisite to lend in this environment.”
Loan Pricing
For student housing investors who are acquiring properties, figuring out how much the loan is going to cost hasn’t been easy this year. Because of constant changes in the Treasury rate, pricing has been hard to nail down. What may be in place at contract may not be the term as closing draws near.
“Spreads have gapped out more on student housing compared to conventional multifamily, making underwriting more challenging to pencil, and the depth of lenders is thinner compared to 2021,” says Dan Dooley, managing director of investments at Coastal Ridge. “Sizing metrics are much more conservative, which has translated into lower proceeds. On top this, the volatility in the base rates has made it more difficult to ensure pricing holds through the transactional process.”
Lenders are adamant that the student housing market is healthy, but the capital markets where the issues lie.
“It is more difficult to price loans in the current environment,” says John Petersen, vice president, mortgage banking, with KeyBank Real Estate Capital. “However this is not as much a function of student housing in particular but the debt market overall. The Treasury movement, which can be 20 to 30 basis points daily, has been the larger driver here compared to spreads. Spreads have mostly been flat, but have increased incrementally month over month.”
Pricing can be especially difficult for larger transactions, says Bradley. “In general, pricing and the lack of liquidity in the current financing markets have made it difficult to find debt pricing that works for acquisitions, particularly for transactions above $100 million,” he says. “There is more liquidity and, in some instances, more attractive pricing for sub-$100 million deals, but only marginally so.”
Many owners are seeking refinancings on properties with strong fundamentals — and likely a lot of equity — and haven’t had trouble, as long as their corporate financials are sound. New York City-based Vesper Holdings recently refinanced two student housing properties in its portfolio, says co-CEO Isaac Sitt. The company acquired one of the assets about 18 months ago and increased the NOI since acquisition.
“The refi was part of a buyout of our institutional partner where we replaced expensive floating rate bridge financing with less expensive 10-year floating rate debt,” says Sitt.
In another property in Ann Arbor, Michigan, Vesper refinancing a strong performing asset that it has owned for a long time. The fixed-rate debt had two years remaining, but Vesper chose to replace it with a 10-year floating-rate loan that will generate cash to fund major upgrades. Both loans were refinanced with Freddie Mac.
So despite the challenges, deals are getting done.
“Overall, inflation, rising interest rates and the resulting capital markets disruptions have not done anyone in commercial real estate any favors, but we’ve still been able to get deals done due to the overwhelmingly strong fundamentals of the student housing space,” says Bradley. “Because of the massive rent increases we’re seeing in many Power 5 student housing markets, we’ve gotten a number of lenders comfortable with sizing based on pre-leasing rent rolls for the 2023-2024 academic year. While that doesn’t help with pricing, it can help offset some of the hit to the leverage and proceeds that higher pricing has caused.”
Who’s Lending
While there are options for capital out there, it is not a matter of who is lending, but who can come closest to the the terms the sponsor needs to make a transaction make sound business sense. Many lenders say because acquisition volume is down, loans are readily available and taking less time to process because they have capacity.
“There are participants in all the main lender food groups — agencies, banks, life insurance companies, debt funds, etc., but some have definitely moved to the sidelines,” says Bill Lewittes, managing director and head of loan originations for Kayne Anderson Real Estate. “In general, spreads — and the indexes — have widened, and loan-to-value ratios have narrowed, but we are focused on finding the best solution for each potential borrower in the current environment.”
Finding that solution means that lenders and their agents have to find products — and solutions — that will work for a transaction.
“Select banks are still placing debt, but we have also seen the agencies become active and competitive,” says Dooley. “All-in financing rates are higher than year one and sometimes year two yields, whereas in 2021, investments were leverage positive immediately, so we would say the terms today are certainly less advantageous for the borrower.”
“Banks are being more focused,” says Marty Kearney, director of commercial real estate with BMO Harris Bank. “Lending is a little more difficult. It’s harder to get the same leverage as six months ago, because the rising interest rates are constraining leverage on a debt service coverage ratio basis.” Because those figures mean a lot to the overall profitability of a project, borrowers are focusing a lot on the terms they get. And because the asset itself is being scrutinized, lenders are focusing on sponsors who they know can transact.
“Most lenders are focused on supporting their top relationships and safest opportunities,” says Melissa Frawley, managing director, real estate banking, at Wells Fargo. “If you have not accessed the debt markets in the past six to nine months, financing terms have changed pretty dramatically, especially as the base floating rates have risen almost 400 basis points.”
One surprise has been the government sponsored entities (GSEs), Freddie Mac and Fannie Mae, who had a lot of volume in the sector in 2022.
“Fannie and Freddie, despite all the chaos and volatility in 2022, actually had very good years in student housing, more so than was expected,” says Will Baker, senior managing director with Walker & Dunlop. “The agencies have started to regain their role as the primary permanent lender in the student space. Going into 2023, with $75 billion per agency to lend — half mission and half non-mission — that’s a lot of dry powder for the year.”
Griffin Cotter, senior director, production & sales, with Freddie Mac, says the agencies have risen to the fore to support the sector.
“Part of our mission is to provide stability and liquidity to the market, and that is what we will continue to do,” he says. “There are other lending sources besides the agencies, but not as many as there were earlier in the year. Some lenders have either filled their annual allocations or are waiting for markets to calm down before stepping back in to lend. Loan structures aren’t as aggressive as they were earlier in the year, but there are still very good terms available to borrowers.”
Because much of the need is in refinancings, that is where Freddie Mac has seen the most demand, says Cotter.
“The acquisition market has slowed down but there are still deals happening across the country,” adds Cotter. “Most of the refinances we see are maturing refinances rather than discretionary. We have had a great year in multifamily student housing, and the majority of our volume has come in the third and fourth quarters.”
The resurgence of the agencies has been a welcome development for the industry. Their activity slowed in 2021, but has risen back to the front burner in 2022.
“We have been very active in the student housing market this year and found if the owner is a long-term holder, the agency market is open and still providing attractive market terms,” says Lori Coombs, managing director, multifamily capital, at Wells Fargo. “We have recently negotiated agency quotes for top sponsor’s acquisitions at competitive terms for both fixed and floating rate executions.”
With so many deals earmarked for refinancing, some lenders are seeing an uptick in requests for other debt and equity financing.
“We’re seeing loan requests across the spectrum — development, repositioning, value-add, bridge, etc.,” says Lewittes. “Banks and agencies who are still lending, albeit at more conservative levels, are causing us to see a heightened demand for mezzanine and preferred equity as well to get to higher leverage levels.”
Market Adjustment
Still, the student housing sector has been in a quandary when it comes to lending. Unlike other commercial real estate sectors, its fundamentals — including increased NOIs and rents — are extremely strong. Why then, can’t it get better terms on loans?
“It’s an interesting time,” says Lewittes. “Extremely strong operating fundamentals — rent growth and pre-leasing — as well as continued favorable supply/demand imbalance are generating continued investor interest in the space, and cap rates are continuing to be at historic lows. At the same time, we are seeing the wider cost of debt make some deals less economical for some borrowers and sponsors. So far, these tighter terms have not offset robust investor sentiment so the market has yet to adjust. Unless there is some kind of seismic shift in the capital or investment markets, these two factors — cap rates and lending rates — will have to adjust to one another, but for now this does not seem to have started in earnest.”
Talk in the industry is that something has to give. In a rising interest rate environment, that is likely going to be borrowers who are holding out for better terms. The true adjustment, say lenders, is that borrowers have to underwrite deals to terms that aren’t the same as those in 2021 and earlier.
“If rates stay where they are, something will eventually have to give,” says Cotter. “It could be adjustments to cap rates, investors taking lower returns, or both. There is a lot of equity that needs to be deployed, and the weight of equity can slow down the adjustment of cap rates. From my conversations with borrowers, it seems like the adjustment will be a gradual process, and we will find a new normal in the next six to 12 months.”
“We’re in that feeling out period where buyers and sellers are deciding what cap rates are going to be — and there are some large portfolios in the student space being marketed right now that will be a good barometer of where values will shake out headed into the new year,” says Baker.
Cap rates for purpose-built student housing projects have widened since the start of 2022 due the current interest rate environment, says Bradley.
“What we are really focusing on now is the 2023-2024 academic year cap rates,” he says. “There has been an adjustment, but it hasn’t been in lockstep with rate increases — and not enough to overcome negative leverage in year one for deals that require new debt. Part of the reason for this is the extremely strong performance of the sector in the 2022-2023 and 2023-2024 pre-leasing cycles. Buyers and lenders have been able to underwrite tighter in-place yields due to what can be expected — based on signed leases in place — on the top line in the second year.”
The Year Ahead
As borrowers and lenders look ahead, timing becomes critical. The industry generally begins a property marketing blitz in early April ahead of InterFace Student Housing. What will the capital markets look like then — and beyond — to allow transactions to move forward?
Lenders have one strong piece of advice for those seeking financing: don’t wait.
“The best solution is to start looking early,” says Petersen of KeyBank. “Having a dedicated team following the property as the situation develops will allow for a faster execution when it’s ready to go. Lenders are adjusting their metrics frequently, so what works today may not hold true in a matter of weeks.”
While the changes in loan pricing have been difficult for borrowers to get their hands around, many say that it will take some level of understanding of pricing to come to a new normal.
“The market will adjust to new pricing,” says Petersen. “I believe the market is figuring out what the new normal will be through price exploration. With the huge rise in rates since the first quarter of 2022, and uncertainty in the future, I don’t believe pricing will settle until the debt markets do. Beyond rates, it’s impossible to predict the full impact of the Fed’s activities on the overall economy, and what the impact will be on rents.”
The only thing everyone in the market is certain of is that rising interest rates are what what is preventing activity and transactions.
“The biggest unknown is when is the Fed going to stop raising interest rates?” says Kearney. “They’ve been very clear that they will stop when they see inflation coming down. When that happens, the industry can recalibrate and we will see more lending.”
“The market will adjust eventually, but it feels like a later 2023 event,” says Frawley of Wells Fargo. “Investors need to feel confidence before transacting, so once we see more interest rate stability, we will see the adjustment and corresponding sales and starts.”
But the industry’s strong fundamentals are cause for at least some optimism.
“While the capital markets are choppy, student housing fundamentals could not be stronger heading into the 2023-2024 academic year,” says Bradley. “We expect banks’ limited lending capacity and the focus on relationship banking will continue to make financing development deals difficult into the first quarter of 2023. However with record-breaking pre-leasing velocity already for the 2023-2024 academic year, and fewer new deliveries projected annually from 2023-2025, we feel the tailwinds for student housing will propel the sector to a similar pre-leasing success story for the 2024-2025 academic year cycle and will keep lender and investor interest in the student housing space high.”
—Randall Shearin
This article was originally published in the November/December 2022 issue of Student Housing Business magazine.