By Taylor Williams
There is a pronounced imbalance between the amount of capital looking for placement in commercial real estate in Texas and the number of available deals on the market, making it a good time to be a borrower or seller.
In addition to the time-tested fundamentals that have fueled growth in Texas over the last decade — exceptional job and population growth, corporate relocations, a low-regulation business environment — the state has seen elevated capital flows over the last nine months as a leader in reopening and supporting its economy in response to COVID-19.
The fact that the state’s economy never really had a prolonged, major shutdown during the pandemic means that investors have had more reliable data about cash flows and other key metrics for Texas real estate assets than in many other markets. Access to that data has reduced some of the uncertainty that investors despise but which has been rampant over the last 17 months. As a result of these factors, more capital sources are targeting deals in Texas.
“The inflow of capital to Texas from all parts of the country has been tremendous, dating back to the late third and early fourth quarters of last year,” says Corby Chaffin, managing director at Berkadia’s Houston office. “The fact that Texas was among the first states to reopen has been a contributing factor because it instilled confidence in investors who can see data that reflects actual economic activity.”
“In terms of the options borrowers have from a liquidity perspective, the market is as competitive right now as it’s ever been in my career of 20-plus years,” adds Hal Collett, the COO of Colliers Mortgage who’s based in Dallas. “It’s a great time to sell right now, and there are owners who weren’t planning to sell but received such unexpected offers at such low cap rates that they’ve had to consider it.”
With interest rates still at historic lows and investors of all types looking to recoup returns unexpectedly lost to COVID-19, there is tremendous liquidity in the market.
There’s also the simple fact that lenders are for-profit companies with expenses to cover.
As the saying goes for lenders, if “they’re not lending money, they’re not making money,” and they’re losing market share. As a result, sources say, lenders are competing among themselves to finance deals. And when lenders compete, borrowers win.
A Different Market
Sources agree that the current level of liquidity in Texas markets not only exceeds the amount of properties that need financing or are available for sale, but also outstrips the pre-pandemic supply of capital.
Mike Cleaver, managing director at New York City-based bridge lender Emerald Creek Capital, notes that in this regard, the current capital markets landscape is vastly different from the last event that induced a global recession: the Financial Crisis of 2008.
“It’s very different from 2008, when there was no liquidity,” Cleaver says. “The banking industry and the overall attitude toward debt and leverage changed after that. Investors want to avoid being overleveraged when things come to a halt, so they’ve kept more reserves. As a result, when the pandemic hit, many investors were still well-capitalized.”
Michael Johnson, senior director of JLL Capital Markets, points to activity in commercial mortgage-backed securities (CMBS) loan originations as an indicator of investor confidence in the marketplace.
“The volume of CMBS originations is up about 58 percent year-over-year and is on track to surpass the 2019 volume of $96 billion or so,’’ says Johnson, who’s based in Houston. “There’s conviction in the marketplace that there is sufficient data to evaluate which properties are winners and losers. There is also a better understanding in terms of which tenants are going to be resilient and current on payments and see clear paths to rent growth.”
Johnson adds that in addition to CMBS lenders, other debt providers like banks and debt funds are being equally aggressive. He notes that even before the pandemic, lenders were willing to be flexible on leverage ratios, pricing or other requirements for deals they really wanted to win.
But in the current market, Johnson cites debt yield — defined as net operating income divided by loan amount — as the key metric that captures just how aggressive lenders are getting in order to win certain deals. Johnson says that all factors being held equal, lenders have historically wanted to achieve minimum debt yields of 10 percent. Lately, however, they’ve been willing to come down on that number to win deals.
“Lenders don’t want to miss out on deals that they could have had last year and opportunities to deploy capital,” he says. “So it’s been interesting to see lenders compress on debt yields to get competitive, and it’s allowed them to keep up with cap rate compression as well.”
To be sure, COVID-19 unquestionably dealt the U.S. capital markets a unique set of challenges. The pandemic destroyed parity between certain property types and imbued high levels of risk — sometimes perceived, sometimes real — in certain assets, including office, retail and hospitality.
In addition, the pandemic forced many lenders and investors to temporarily sideline themselves and prompted the federal government to hurl trillions of dollars of relief and stimulus money into the economy, setting the stage for an inflationary period. These capital sources are now aggressively looking to recover returns lost to COVID-19.
But there is a positive byproduct of the multiple months of tabled deals, periodic panic selling and hyper-elevated scrutiny that resulted from the pandemic. Up the chain, from consumers to tenants to landlords to lenders, everyone is trying to make up for lost time. For investors, that means capital is plentiful and cheap, and that’s enough to drive deal volume.
According to the latest data from Real Capital Analytics, the total investment sales volume across all U.S. commercial assets in the second quarter was $144.7 billion, a 176 percent increase over that period last year. With the exception of office (92 percent), every asset class saw at least triple-digit growth in its total sales volume between the second quarters of 2020 and 2021.
“It’s been a borrower’s market for the first half of this year,” says Chaffin. “This has resulted in better loan terms — higher proceeds, lower rates, better structure. The acquisitions market is equally competitive, and that’s created larger buyer pools and more competitive offers on properties listed for sale.”
Earlier this year, Berkadia provided a pair of agency acquisition loans totaling $55.2 million for two multifamily properties in the Dallas-Fort Worth (DFW) metroplex. The loans for both the 320-unit Residences at Northgate in Irving ($28.4 million) and the 280-unit Arbor Creek in Lewisville ($26.8 million) were structured with floating interest rates and five years of interest-only payments.
Inflation, Rate Concerns
Chaffin acknowledges that competition for deals is decidedly more pronounced within certain asset classes, most notably multifamily and industrial.
The appeal of industrial in the age of e-commerce is logical and well-documented, and while investors have long been bullish on multifamily, that property type has become even more appealing as the economy enters a period of inflation. To that point, the U.S. Consumer Price Index rose by 5.4 percent between June 2020 and June 2021, its highest 12-month increase in 13 years.
Real estate investment as a whole has traditionally been viewed as an effective hedge against inflation due to its overwhelming tendency to appreciate over lengthy periods of time. But within commercial asset classes specifically, multifamily is perhaps the best hedge.
This is because multifamily tenants — renters — typically sign short-term leases. Multifamily rents are also more easily adjusted from year to year. In retail, office and industrial settings, users are typically locked in to
long-term leases with rent increases that are based on pro-forma inflation expectations rather than real-time data.
“Especially in the multifamily space, investors have adjusted to the fact that we’re already in an inflationary environment, and that’s fueling more capital demand for multifamily product as a hedge,” Chaffin says. “Couple that with the fact that rising construction costs act as an economic barrier to new development, and it creates a bit of a perfect storm that’s driving pricing for existing multifamily product.”
Collett agrees that competition to win new deals is exceptionally intense within the multifamily space. For that reason, his firm is heavily focused on refinancing properties with existing clients that want to take advantage of the historically low interest rate environment.
This spring, PCCP LCC provided a $30 million acquisition loan for Alexan Southside, a 270-unit multifamily community in Houston. Between barriers to new supply arising in the form of elevated construction costs and supply chain disruption, as well as an abundance of capital in the market, multifamily borrowers and owners in Houston have some favorable market conditions going for them, sources say.
“There’s a sense that we’re competing on fees and on how we look at the overall profitability of a transaction, and for large transactions with big sponsors, the winning bid may come down to a few basis points,” he says. “We’ve lost deals to debt funds, bridge lenders and balance sheets lenders, but there’s enough business transacting that we feel like we’re still getting our fair share.”
Sources interviewed for this story say that in general, inflation is not a major concern for their clients, as the devaluing of the national currency has yet to be accompanied by any interest rate hikes. The Federal Reserve announced after its meeting on Wednesday, July 28, that it would continue to hold its target range for short-term interest rates between 0 and 0.25 percent.
Nonetheless, in some shops, there is some concern over these issues. For some borrowers that are heavily leveraged and carry high-quality assets in their portfolios, it only takes a small rate hike for their bottom line to be hit hard. Inflated property values that translate to higher tax bills would further exacerbate this problem.
“Many of our clients are definitely concerned about inflation and the potential of increasing interest rates as a result of it,” says Adam Sasouness, co-founder and managing principal at New York City-based Dwight Capital. “There’s a lot of money in the system right now and not a ton of places to put it. That problem, in conjunction with dirt-cheap rates, is definitely creating a bubble.”
Dwight Capital recently provided a $60 million bridge loan for the refinancing of Residences at Town Square, a 480-unit multifamily community in Amarillo. Sasouness says that funding loans in states like Texas that have less regulation and high population growth is getting much more competitive.
Collett notes that if there is one facet of the capital markets in which inflation is a concern, it lies on the development side. Though lumber prices have cooled lately, costs of it and other construction materials continue to rise above pre-pandemic levels, in many cases due to strained labor supplies and supply chains that drive up costs of producing and distributing the materials. Yet these barriers to supply growth may serve to further boost prices for existing properties, sources point out.
Other Issues
While hard evidence of inflation has only recently begun to surface, other factors have weighed on investors’ minds during the first two quarters. These include the rollout of COVID-19 vaccines, potential changes to the U.S. tax code, the expected expiration of federal unemployment benefits and vacillation in the 10-year Treasury yield, among others.
In terms of public health, investors have recently signaled concerns over the spread of the Delta variant, especially in countries whose manufacturing and supply chain operations are key pieces of the U.S. economic infrastructure. On Monday, July 19, these fears precipitated the largest single-day drop — about 700 points — in the Dow Jones Industrial Average since October 2020.
As of mid-July, about two-thirds of U.S. adults had received at least one dose of the coronavirus vaccine, according to data from the Centers for Disease Control (CDC). The Biden administration previously stated that its goal was to have 70 percent of the American people fully or partially inoculated by Independence Day.
Movement in the 10-year Treasury yield is also very important to some lenders, particularly those that price their loans off the benchmark rate. As of Thursday, July 29, the rate stood at 1.28 percent, up from its sub-1 percent mark that prevailed during the early days of the pandemic, but still considered incredibly low by historic standards.
“Property buyers view the low yield of the 10-year Treasury as a big positive,” says Cleaver. “And since these are still some of the lowest rates the market has experienced, real estate investors have been motivated to act.”
While the low yield of 10-year Treasury bonds reflects a flight by investors to a risk-free security as a hedge against economic turbulence and uncertainty, commercial real estate borrowers stand to receive lower rates and tighter spreads on their loans as a result of the suppressed yield.
Should the benchmark rate begin a steady ascent in the second half as the economy moves deeper into recovery, borrowers will face higher costs of capital, though sources say the short-term fluctuations don’t move the needle much in terms of demand for financing.
In the end, lenders will continue to lend, and investors will continue to invest. For the simple fact of the matter is that with the exception of securities like Treasury bonds and saving accounts that are backed by faith in the financial solvency of the federal government, all investments carry risk. Navigating shifting interest rates and legislative updates from new political regimes is simply part of the job.
In those ways, the current cycle isn’t really different from any other.
— This article originally appeared in the July 2021 issue of Texas Real Estate Business magazine.