The Federal Reserve met during the second week of June, and as expected, the nation’s central bank opted to raise short-term interest rates for the second time this year. In short order, this means that borrowing costs for banks are going up, which means that increased borrowing costs for consumers will follow close behind.
At least one more rate hike is anticipated to occur before year’s end as part of the Fed’s stated goal of increasing the federal funds rate from its current range of 1.75 percent to 2 percent to 2.5 percent by year’s end. In addition, the Fed has pledged to continue its rate hikes through 2019 and potentially into 2020 as it pursues a tighter monetary policy.
The capital markets behind commercial real estate in Texas have long seen these rate hikes coming — necessary measures to choke off inflation brought on by tax cuts, a ballooning stock market, an 18-year low unemployment rate and near-3-percent annual growth in GDP (2.9 percent in the first quarter).
Some borrowers have been able to refinance existing debt and lock in favorable rates in advance of the Fed’s hikes. Those who didn’t, perhaps because their loans were too far removed from maturity or because their loan-to-value (LTV) ratios were high enough to float their cash flows, are hustling to do so now.
In the rush to outmaneuver the Fed, borrowers are increasingly looking to CMBS and life company financing as vehicles for retaining as much of their cash flows as possible.
Playing A Long Game
While each loan structure has its drawbacks, CMBS and life company loans generally allow borrowers to lock in fixed interest rates for relatively long periods of time, both of which are top priorities in this market.
Ryan Watson, Q10 KDH
“Borrowers’ appetite for longer fixed rates has undoubtedly increased,” says Ryan Watson, vice president at Houston-based mortgage banking firm Q10 KDH. “Many are looking for a minimum of 10 years with fixed-rate financing, with some opting for 15 or 20 years fixed.”
The emphasis on locking in rates for the long term suggests that borrowers view the current interest rate environment as somewhat volatile. In addition, property values in Texas have appreciated significantly during the current cycle, but underwriting standards haven’t really changed. This combination typically leads to an all-around lower-leverage lending environment.
“Regardless of whether you’re using CMBS, a life company or agency debt, lenders still have to underwrite based on cash flows going into the deal,” says Brandon Brown, managing partner at Houston-based LMI Capital. “If cash flows haven’t changed much but values have, then proceeds start to be more driven by debt coverage ratios than anything else.”
Brandon Brown, LMI Capital
Brown adds that opting for longer terms tends to increase the number of interest-only periods for the borrower. Not only does having more interest-only periods increase borrowers’ basic yield, it grants them more flexibility with their repayment options. This flexibility in turns frees up additional cash flows for capital investment in the property or to pay off pre-existing debt.
Without question, capital markets are littered with high-profile, established borrowers that don’t need and won’t consider CMBS loans. But in Texas, the tremendous amount of capital seeking placement in commercial real estate and the surging volume of development have ensured that there are enough borrowers out there to generate demand for virtually all product types.
Fixed-Rate Fever
It bears mentioning that even with the hikes, interest rates still remain historically low. Yet borrowers still are still hedging their bets by locking in fixed rates.
“We can tell that borrowers are interested in moving out of floating-rate deals into fixed-rate deals,” says John Morran, founder and principal of Austin-based mortgage banking firm Texas Realty Capital. “The [interest rate] yield curve is relatively flat right now, and that’s prompting borrowers to look for longer-term fixes.”
John Morran, Texas Realty Capital
Morran, whose firm works extensively with life companies, adds that these lenders tend to price their loans very aggressively in exchange for providing less leverage. In addition, deals with life companies come with a greater certainty of execution.
“Life companies will give you a rate lock that’s good for 60 to 90 days when you sign the application,” says Morran. “They don’t usually change the terms of the deal regardless of what happens in the capital markets, which can be a real plus.”
In addition, life companies tend to function more like contracts for professional athletes, laden with incentives and bonus features that can be unlocked if certain performance metrics are met. All of these traits represent the trade-offs that come with settling for lower leverage.
LMI Capital recently closed a CMBS loan for this 215-unit multifamily asset in Houston. CMBS is increasingly appealing to borrowers in the current interest rate environment.
Life companies have in general scaled back their productions of retail loans in the e-commerce era. But sponsors targeting retail deals are drawn to the stability of life company loans, especially when gambling on a sector as shaky as retail. HFF recently secured acquisition financing for Tanglewood Court, a 125,500-square-foot retail center in Houston, through a national life company. The sponsor was American Realty Advisors.
Borrowers can also secure fixed-rate financing with CMBS loans. Although they typically carry higher spreads compared to life company loans, CMBS deals can give cash-strapped borrowers the hefty leverage they need to complete pricier projects and acquisitions. In addition, CMBS loans offer more long-term financing options.
“Smart investors are looking for ways to protect their cash flows from the rate hikes,” says Charles Williams, founder and managing member of Dallas-based Pioneer Realty Capital. “CMBS is not necessarily the only way to do this, but it’s an especially attractive option for large portfolio owners.”
Charles Williams, Pioneer Realty Capital
Williams notes that CMBS loans have their cons, including less favorable pricing and more reporting and compliance work. But they work well not only for investors with large portfolios, but also for borrowers whose properties have not yet stabilized or are in shaky sectors, like retail. Nearly a third of all retail deals in today’s market involve CMBS loans, according to recent data from Berkadia.
The growth of CMBS loans as vehicles for financing retail properties, as well as for locking in fixed interest rates for lengthy terms, is paying dividends to the capital markets in general. Financial data and analytics firm Trepp LLC recently reported that the delinquency rate on CMBS loans clocked in at 4.12 percent in May, a decline of 24 basis points from April and the lowest monthly rate recorded since the Financial Crisis of 2008.
While a move toward fixed-rate financing is prevailing, it’s not a one-size-fits-all solution. Patrick Ramsier, senior vice president of regional bank LegacyTexas, has seen some borrowers buck the trend despite knowing rate hikes were imminent.
“The nature of demand for refinancings has changed in response to the rate hikes,” says Ramsier. “Some borrowers are willing to take floating-rate risk despite the short-term increases, perhaps because of the flattening-forward LIBOR curve.”
Second-Half Outlook
Despite the rate hikes, the capital markets landscape is still very borrower-friendly, especially in high-growth states like Texas.
The 10-year Treasury yield recently topped 3 percent for the first time in four years. Congress has approved legislation to roll back key provisions of Dodd-Frank, which theoretically should enable smaller banks to up their lending volumes.
In addition, debt funds, while tending to favor short-term, floating-rate financing, have increased their presence in the commercial lending space in recent years. This means that in general, there is more competition among lenders for deals, which favors borrowers.
The real question, at least in terms of policy, centers around how quickly capital markets adjust to the rate hikes. An overcorrection would create an environment wherein the cost of capital exceeds economic growth. The Fed also has the option of accelerating short-term rate hikes if it feels the economy is running too hot.
Jim Neil, Churchill Capital
“If long-term rates start to move noticeably, it will have a major impact on the volume and velocity of deal activity,” says Jim Neil, CEO and co-founder of Dallas-based Churchill Capital. “But to the extent that rates stay where they are, we could see economic expansion for another 12 to 24 months.”
Furthermore, valuations of certain assets, particularly industrial and multifamily product in high-growth markets, need to cool off a bit in order to give buyers a chance to catch up to sellers. An increase in interest rates is not going to help achieve that goal, particularly if exacerbated by soaring property values.
“People are still willing to do deals in the current interest rate climate because they can sell their properties on the back end at a high value,” says Neil. “Cap rates have remained low because long-term interest rates have remained low and people still have a favorable view of the economy.”
— By Taylor Williams. This article first appeared in the July 2018 issue of Texas Real Estate Business magazine.