Walker & Dunlop: Excess Capital Makes for Competitive Lending Environment
The third quarter of 2020 was the beginning of a significant rebound for capital markets in commercial real estate. After banks and other lenders slowed their activity during the pandemic, lenders and equity investors regained their momentum — particularly in multifamily and industrial — a trend that has continued through the third quarter of 2021. It’s a good time to be a borrower, explains Mark Strauss, managing director of capital markets, and Rob Quarton, senior director of capital markets, with Walker & Dunlop’s Irvine, California, office.
Vigorous Lending Markets
Currently, Quarton explains, “Banks are really competitive. Debt funds are also aggressive — their funding mechanisms, like collateralized loan obligations (CLOs), have come back strong. Further, insurance companies are under allocated to real estate, which increases their annual volume targets and desire to win more business. Consumers have been purchasing more life insurance policies and insurance in general post pandemic, which provides dry powder for insurance companies to invest. In general, lending markets are very robust today, with ample options for lenders up and down the capital stack.”
“Lenders have yearly production quotas, and I don’t think any of them hit their quotas last year,” adds Strauss. “This caused an overhang of capital available going into 2021. Borrower participants in the marketplace are reaping the benefit of that additional capital. Add the liquidity that has been created in the market by all the various stimulus programs and the amount of capital available today, whether debt or equity, probably exceeds what was available prepandemic. Lenders are playing catch-up this year, and they’ve got additional money to spend. I think you’ll find at the end of the year that the quantity of transactions and the amount of capital lent or invested are probably going to be ahead of everyone’s projections.”
Increased demand from commercial real estate acquisitions, refinancing and equity placement are fueling activity. Investment in commercial real estate has seen an uptick in interest as investors are looking to diversify and find alternative investments to the stock and bond markets. In terms of equity, Strauss explains, “Real estate has always been one of those alternative investment vehicles, and liquidity is driving demand.”
Much of the demand Strauss sees is for industrial properties and all types of housing, including single-family residential, single-family build for rent, multifamily, affordable housing and 55-plus. “Across the board in the housing market, you’ve seen tremendous growth and demand,” explains Strauss. The demand for housing has remained strong across all types of multifamily, except in the senior care market, where Strauss anticipates improvement over time with the continued rollout of vaccines.
Banks are a leading participant to supply capital to the commercial real estate industry during this lending resurgence. Particularly, regional banks have been active with all types of borrowers from blue chip national companies to more regional firms.
“On the debt side, macro-market wise, we’ve seen a resurgence from the banks,” says Quarton. “They have a ton of deposits in their coffers from the federal stimulus and liquidity injected into the financial system. This situation is making banks more assertive to close more business. The ratio of bank deposits to loans is at record high levels, which is forcing them to lend more money to generate more interest income to offset the capital drag on deposits. To evidence the competitive environment, construction loan quotes for multifamily are receiving multiple quotes at sub 3.0 percent rate with 65 percent loan-to-cost (LTC) leverage and varying recourse options. The best debt terms are flowing to top quality sponsors, however, there has been an improvement in loan terms and pricing to most other borrower with good credit profiles and track records.”
Larger money-center banks were the first to withdraw and protect their capital during the uncertainty of the pandemic, but they have followed the example of regional banks and fully returned to the market.
Strauss notes that the marketplace has become much more aggressive in its desire to put capital to work, especially in the world of construction loans. “For senior construction loans, we have witnessed a greater number of participants willing to ‘lean in’ to the underwriting on projects — they’re willing to look not only at current rent, but where future rent may be. Market participants are also willing to lean into leverage levels. A year ago, you may have been confined to a 55 percent or 60 percent loan-to-cost ratio. Those loan-to-cost ratios are now at 65 percent and we’ve seen some creep towards 70. A full recourse construction loan a year ago could potentially be a 15 to 25 percent recourse loan today. We’ve seen compression in the difference between non-recourse construction lenders and recourse construction lenders. About a year ago, on the bank side, you may have had a 100 to 150 basis point differential between a non-recourse lender and a recourse lender. Today, that differential is approaching 50 basis points.”
As the supply chain and related pricing start to normalize, some of the conditions previously imposed by construction lenders are lifting. Strauss elaborates, “Many of the construction lenders were requiring a significant buyout of the subcontracts and construction materials to minimize variability of pricing when completing a project. That approach goes hand-in-hand with lenders trying to get a guaranteed maximum price contract from a contractor to decrease the risk of dramatic price increases during the construction phase of the project. We have now found a little bit of tension between having subcontracts and materials bought out at loan closing, versus waiting until those goods or services are needed on the job site as the supply chain is beginning to normalize. Some of the costs of materials and labor are beginning to come down. Many of the developers and contractors are hesitant to buyout much of their materials too early in the process because of the of the current premiums. There is some tug of war between lenders and developers for the required buyout covenant at loan closing.”
Competition Reflected in Loan Structure
Quarton explains that the structuring of covenants has become much more competitive, specifically in the guarantor financial requirements that a borrower needs to provide to satisfy a lender, like net worth and liquidity. “We’re seeing more banks willing to accept an entity versus a warm body individual. Loan pricing is hitting a resistance frontier where it’s harder to go much further, so the structural elements on the fringe are starting to bend and improve.”
Economic indicators are signaling a positive lending climate for the next 12 months: strong rent growth, higher leverage ratios on debt, strong interest from equity players, bullish real estate attitudes and a reopening economy (including the return of even some hard-hit property types like leisure, hotels and offices). These all indicate “a good environment to invest in real estate and capitalize real estate for the next 12 months and into 2022,” says Quarton. However, the rise of coronavirus variants like the Delta variant, which could further disrupt the economy, is a consideration Quarton flags for future growth.
One caution from Strauss, “The one thing that gives me pause is when secondary markets and even some tertiary markets begin to trade at the same cap rates as primary markets. When you start seeing the risk premium between markets compresses or flatten, it’s possible you’re getting somewhere close to the top of the market. There’s a scarcity of product with an abundance of equity capital and the availability of cheap financing. We are beginning to see pricing equilibrate across marketplaces.”