Texas Lenders Express Optimism for Second Half
By Taylor Williams
Decreased acquisition activity across virtually all asset classes is among the most visible impacts that COVID-19 has had on commercial real estate, but capital markets professionals say there’s reason to believe deal volume will rebound sharply toward the end of the year.
According to data from Real Capital Analytics (RCA), the total sales volume of commercial properties in the country was approximately $44.7 billion during the second quarter. This figure represents a staggering year-over-year decrease of 68 percent and the lowest quarterly total in more than a decade.
In terms of income streams, some asset classes are faring much better than others. Social distancing mandates and stay-at-home orders, while disastrous for retail and hotel properties, have elevated demand for e-commerce, as well as manufacturing of essential goods and services. The latter trend ensures that for many industrial owners, rent collection is not a major concern.
But current and future economic uncertainty are causing investors across the board to pause new acquisitions.
“We saw a significant decline in demand for acquisition financing when the pandemic began,” says Jeff Erxleben, executive vice president and regional managing director of NorthMarq’s Dallas office. “There were major unknown factors coming in all at once, not the least of which involved the process of completing a transaction. As a result, many deals that were under contract were dropped if significant earnest money was not at stake.”
The combined government actions of banning evictions due to COVID-19-related job losses and disbursing additional stimulus and unemployment funds has allowed most apartment renters to pay rent. The National Multifamily Housing Council found that in June, U.S. owners collected almost 96 percent of their total rents.
“We should see more acquisition activity in the second half of the year, and some of that will be driven by what happens with the next stimulus plan,” says Phil Melton, executive vice president of Bellwether Enterprise’s Dallas office. “There are some sellers that for one reason or another will need to free up cash, so you should see an uptick as people get more comfortable with the overall real estate metrics and how businesses are going to operate.”
The U.S. Senate’s latest plan for extended relief does not include a moratorium on evictions and also reduces the ancillary unemployment benefit from $600 to $200 per week.
Assuming public health concerns are kept in check, Erxleben says his firm feels good about the second half and has already begun to see more inquiries and activity from private investors.
He expects institutional buyers to get back into the game more slowly and for most new multifamily transactions to take the form of refinancing from Fannie Mae and Freddie Mac, as loan terms for these deals have remained competitive. Borrowers are also taking advantage of the agencies’ floating-rate loan products as the 30-day LIBOR rate has bottomed out in recent months. The benchmark short-term rate stood at 0.18 percent in late July, down from 2.27 percent a year ago.
However, even with these deals, overall underwriting standards are becoming more stringent, sources say.
“Fannie and Freddie never left the market, although they are underwriting more conservatively and requiring more debt-service reserves and other bells and whistles that ensure the safety of the loan,” says Tom Fish, managing director of Walker & Dunlop’s Houston office. “But with the government pumping money into the system via the agencies, we’ve seen bigger banks pull back. Regional lenders are using that as an opportunity to be aggressive and capture more business.”
The slowdown in production from big banks presumably stems from their exposure across numerous platforms, including distressed commercial assets via loan modifications and forbearance requests, as well as and various household liabilities like automotive and credit card debt.
Other liquidity concerns derive from commercial lenders like life companies and CMBS groups that have been slow to re-enter the market, notes Tucker Knight, senior managing director of Berkadia’s Houston office. Knight says his firm has seen some life companies be aggressive and others limit their funds to deals for best-in-class assets backed by market-leading sponsors.
CMBS lenders have largely been on the sidelines with a few exceptions, and those that are active are underwriting more conservatively and restricting their loan-to-value (LTV) ratios and cash-out refinances, as well as implementing debt-service reserves that will be held by the lender, Knight says. Most of the capital is focused on multifamily, industrial, self-storage and medical assets. Hospitality financing is basically nonexistent beyond note sales, and lenders are being very selective on retail beyond grocery-anchored product.
“Outside of the agencies and life companies, which have lower leverage points, there’s not a ton of liquidity,” says Knight. “Most of our recent deals have been refinancings, and we’re getting them done, but with a low Treasury yield and the ability to hedge interest-rate risk at historically low levels, we’re optimistic for the second half. Sitting on the sidelines isn’t conducive to how people in this business operate, so they’re trying to find ways to be aggressive and generate momentum in the market.”
Melton sees several reasons why now is a good time to refinance.
“Locking in low-cost financing right now means that borrowers can focus more on their operations because they’ve got their capital in place,” he says. “There’s security in that play, and there’s also value for some borrowers in cashing out given the current sales environment. When they do sell, they can market their property with assumable debt that is attractive to buyers.”
The 10-year Treasury yield stood at a mere 0.61 percent in late July, down about 150 basis points from what was a near-historical low a year ago. Fish of Walker & Dunlop is quick to point out that this paltry rate of return won’t satisfy many investors for long.
“The need for yield has never been more acute than it is now with the 10-year Treasury yield under 70 basis points,” he says. “Everybody is hunkered down, so you should see a bounceback from that toward the end of the year as investors realize they have to get money out the door.”
Low Rates Lift All Boats
Sources agree that, as intended, historically low interest rates are propping the multifamily lending market.
“Lenders are asking for security measures, but some borrowers are willing to put up additional debt-service reserves to lock in a sub-3-percent interest rate and capitalize on this environment,” says Knight. “If you can borrow at a coupon rate of 2.8 percent on a property that’s trading at a 5 percent cap rate, you have more than 200 basis points of positive leverage. That math works on a large scale, and those terms are very appealing to borrowers.”
In addition to requiring more reserves for debt service — six to 12 months of mortgage payments in some cases, depending on leverage — lenders are finding other avenues through which to exercising caution: conservatively underwriting of rent growth, tracking rent collections and being more selective about which types of assets and markets they target.
Before the COVID-19 outbreak, the Federal Reserve had flip-flopped on raising and cutting the federal funds rate before ceding to political pressure to keep them at or near historical lows. This decision, which played out in 2019 and early 2020, prompted a flight from borrowers to lock in fixed-rate, long-term financing. With the economy now facing business closures and higher unemployment, it’s unlikely that the central bank will raise rates again this year.
“It’s a conflicting situation with the rates,” says Fish. “There doesn’t appear to be an immediate threat of them rising, which would steer borrowers more toward floating-rate financing. On the other hand, for the first time in my career, we’re seeing 10-year,
fixed-rate deals in the 2.5 to 3 percent all-in range. Why wouldn’t you want to lock that in?”
“The Fed’s support of credit markets has likely had the biggest impact in terms of staving off the severity of this recession,” adds Erxleben of NorthMarq. “Keeping short-term rates low has kept some liquidity in the market.”
Erxleben adds that his firm has recently seen an uptick in demand for floating-rate financing. While almost all borrowers are drawn to long-term fixed-rate debt that can be locked in at or below 3 percent, floating-rate debt typically carries limited prepayment penalties and thus makes sense for borrowers looking to reposition their current capital stack and sell in the next 12 to 24 months, he says.
But even if overall deal volume and velocity pick back up in the second half, lenders with hefty portfolios of loans on certain property types will still be exposed. Hotel, retail and restaurant properties are the obvious members of this club, though sources say loans on office assets are also carrying greater risk due to the adoption of work-from-home programs.
— This article first appeared in the July 2020 issue of Texas Real Estate Business magazine.