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Towards the end of 2019, BH LLC secured a high-leverage, $12-million senior loan on two retail-and-residential buildings in Manhattan’s East Village. At one of the properties, Momofuku Noodle Bar serves as the anchor tenant and is secured in a long-term lease; however, aside from the restaurant tenant, the investment is a value-add play for the company. Fortunately, BH’s finance partners were understanding of the investment. Infinity Real Estate teamed up with BridgeInvest to provide the capital for BH’s $14-million acquisition.
“We understand the upside that the borrower is trying to capture through the value-add program and see a clear path for the borrower to do so, and we’re comfortable providing financing through this lens,” says David Berg, partner at Infinity Real Estate.
Lenders, such as Infinity Real Estate and BridgeInvest, are one part of commercial real estate’s robust capital markets ecosystem, however, they play a particular role that is increasingly coming into play as the real estate cycle matures. Often, value-add deals have a low in-place cash flow or a business plan that intends to alter the cash flow, which in many cases makes traditional lenders that focus on debt-yield and coverage ratios reluctant to move forward with a deal. As a result, alternative lenders, such as Infinity, have found a niche in providing higher leverage to borrowers to execute on a renovation or repositioning investment strategy.
This is not to say BH Properties couldn’t have financed the deal through more traditional companies. But then again, why should it have gone the traditional route? The capital markets remain robust as a maturing cycle has led to more debt vehicles entering the market, spurred on by low interest rates and favorable real estate fundamentals. Every major capital source increased their holdings of commercial real estate debt during the third quarter of 2019, with Fannie Mae, Freddie Mac and FHA leading the way, according to the Mortgage Bankers Association. The only note of slight dismay is that equity is becoming more pointed and focused in its investments.
A FLOURISHING DEBT MARKET
The debt market has been driving CRE financing for several years now, with providers flocking to offer new platforms. Alternative lenders, many of which were traditionally private equity players, have been launching debt funds and issuing loan products that banks and even large insurance companies cannot keep pace with.
The key question for 2020 is will this largeness continue.
Some believe there could be a pullback from the debt side this year. “Recent years have seen a continued increase in the amount of debt fund financing available to borrowers, but there are indications that this could actually somewhat slow in 2020,” says Jeff Lee, president of Capital One Multifamily Finance. “A lot of funds started raising capital 12 to 18 months ago, and there are not a lot of new players being formed today.”
While Lee expects most lenders to grow in areas of good returns, an uncertain economic outlook could push others to pullback. “Some banks have begun tightening credit standards [especially with the general sentiment that a recession could be near] and we have seen some balance sheet players somewhat on the sidelines,” says Lee.
But as of right now, that scenario is nowhere in sight. Commercial and multifamily mortgage bankers are expected to close a record $683 billion in loans backed by income-producing properties in 2020; a 9% increase from 2019’s anticipated record volume of $628 billion, according to MBA.
Total multifamily lending alone, which includes loans executed by small and midsize banks not captured in the overall total, is forecast to rise 9% to $395 billion in 2020, surpassing last year’s expected record total of $364 billion.
Indeed, for the first half of 2019, debt funds represented a larger share of the commercial mortgage markets than life insurance companies, according to Real Capital Analytics. Specifically, it is within the riskier investment styles where debt funds have been more competitive, allowing them to capture more market share than insurance company lenders this year, the data noted.
One effect of the active debt market is its calming influence on prices. “Rather than test the waters in the sale of an asset, investors can refinance assets in the current market,” RCA notes in a post about its findings. The firm reports that the value of refinancings represented 42% of the capital flowing into commercial real estate in the first half of 2019, versus a 38% share for the acquisition of assets.
The conduit markets are flourishing as well. Domestic, private-label CMBS issuance totaled $96.7 billion last year, topping 2018’s volume by 27.1%—the heaviest year of issuance since the Great Financial Crisis, according to Trepp. The fourth quarter alone posted $38.5 billion of issuance, or 40% of the year’s total.
Right now, there are few signs that this could change, although it is far too soon to determine if 2020 will top last year’s record. In a research note, Trepp points out that the practice of securitizing loans has remained quite profitable, with margins regularly topping 2% and often exceeding 5%.
“As long as the products [are] there, the CMBS or conduit space for single assets, will be very attractive for borrowers,” Gerard Sansosti, executive managing director and debt and loan sales platform leader for JLL, says.
CAUTION IN THE EQUITY SPACE
In general, Sansosti feels positive about the year ahead. For the equity market specifically, however, he senses hesitancy. “The equity market over the last couple years has been a little more cautious,” he says.
Paul M. Fried, executive managing director and head of equity capital markets for Greystone Co., agrees, stating that equity “remains risk-concerned” and will continue to migrate away from the commercial sectors perceived as having the most risk.
“It will stay along the same avenues that it did last year with lots of [investment] in multifamily and urban office and it will be careful around hotel and retail,” Fried says. “And, of course, it will have an enormous appetite for industrial.”
With the exception of student housing, which is seeing some issues with rising delinquencies, according to Trepp, the residential space is still enjoying a lot of investor interest. “There’s still a ton of money looking at being in the multifamily space,” says Doug Root, co-founder and managing partner at Blackfin Real Estate Investors. “I’m not seeing any signs of it slowing down.”
Hilary Provinse, executive vice president and head of mortgage banking for Berkadia, sees equity players seeking out a specific story behind the deals which they pursue, such as class-A apartments on the West Coast.
“Every equity capital group has their own niche and they really are interested in the story of each deal,” Provinse says. “Equity is remaining very disciplined and they’re not loosening their return criteria.”
As equity takes a harder look at its potential investments, there has also been a consolidation of investors, fund allocators and sponsors since the financial crisis. In a low-return environment, these existing equity providers are bringing out large, value-add funds to increase yield.
“The groups that are responsible for the bulk of the equity capital, such as pension funds and other fund investors, have continued to consolidate the number of managers,” Fried says. “Those managers continue to get bigger. While we see more money flow into the equity side of the business, the number of equity channels hasn’t really increased dramatically.”
Ryan M. Haase, director of capital markets for Franklin Street, says there were once dozens of new capital providers entering the market.
“Lately, we have seen that trend falling off, but we have seen many current providers expanding into alternative products to find yield or increase production,” he says.
BRIDGING THE GAP
In fact, equity providers on the hunt for increased yield have been flocking to the bridge lending space. “We’ve seen more equity players convert to debt players,” Sansosti says. “They believe that the yield on a piece of debt is more attractive than the yield on equity.”
These groups aren’t limited to a few structures; they are offering a wide array of products. “These funds are doing bridge, mezzanine or preferred equity structures. Some are originating whole loans and selling the A piece, retaining what is essentially a manufactured B piece,” Stoffers says. “Those are all different ways that these funds are investing.”
However, it is not just equity players moving into the bridge lending space. “Those people [coming into the bridge space] really cover the gambit, including a number of insurance companies that have gone out and raised funds that are now in the bridge lending space,” Sansosti says.
Fried has observed an ever-increasing list of “money flowing into the markets, looking for some way to attach itself to real estate in a debt-type framework” from a number of sources. “You just see that debt providers continue to innovate to try to find that investment,” he says. “Traditional senior lending is giving away to an ever-growing group of quality [mezzanine debt].”
These funds have reduced the need for equity.
“Because underlying interest rates are low, the amount of liquidity and the mezzanine preferred equity space is plentiful,” Sansosti says. “That has driven down the yields on debt and reduced the need for pure joint-venture equity.”
While these options may force borrowers to be more creative as they work through new loan structures, they also come with a lot of benefits, including competitive pricing. “Cheap debt will continue, and there will be lowered return expectations for equity as intense competition for the attractive risk-adjusted returns of real estate [with resulting all-time high asset valuation] continues,” Haase says.
The key is finding the right provider. “There are lots of different niche players out there,” Provinse says. “You just have to know who to go to for what type of deal.”
UNCERTAINTY AT FANNIE MAE AND FREDDIE MAC
While different groups have morphed from equity providers to lenders, one source of debt still remains constant. The GSEs, Fannie Mae and Freddie Mac, are still the backbone of the residential market, but there were some hiccups in 2019.
“The most acute point in time was late summer, where they hadn’t gotten their new scorecard [which sets their issuance goals],” Provinse says. “So, they both pulled back and we had a big liquidity crunch in the market in August for all sectors of multifamily, though the conduits jumped back in and we saw more activity there.”
In early September, FHFA provided guidance that reversed the credit crunch almost immediately, according to Provinse. “We all felt like we got a reprieve for 2020 when the regulator released the scorecard allowing them [Fannie and Freddie] to essentially do $100 billion of business over five quarters, which takes them through the end of the election year,” Provinse says.
While Lee agrees that the two agencies will still be a reliable source of multifamily debt in 2020, he believes the door may open for other providers. “The agencies will continue to help maintain a robust multifamily debt market given the increased caps,” he says. “But there may be a further shift in their volume towards mission-driven business, leaving more room for non-agencies in the class-A financing space.”
As this activity plays out, Lee believes that the agencies will place more of a focus on return metrics to ensure they are able to provide an adequate return on capital in the event of privatization. Others agree. “The fact that [the agencies are] being allowed to retain earnings is a positive for their path toward recovery and potential release down the road,” Stoffers says.
While privatization is in the works, some people still remain skeptical that it will happen. “We’ve heard it before [and it hasn’t happened],” Sansosti says. “And depending on what happens in the election, that could change really quickly. I’m still a believer that the jury is still out.”
If privatization does eventually come, Haase predicts that the lending market will become more competitive. “Without government guarantees, bonds should trade wider, making the GSE’s cost of capital higher, resulting in higher rates to the borrower and consumer, effectively leveling the multifamily lending playing field,” he says.
With the affordability crisis worsening, Sansosti contends that privatization could be counterproductive. “I personally believe that there has to be some government support for Freddie and Fannie because I think privatizing it completely would be a mistake, particularly for affordable housing,” he says.
Due to the agencies role in maintaining affordability in the housing market, Eric Bolton, CEO of MAA, the nation’s largest apartment owner on the NMHC Top 50, is confident that the agencies will remain in some form.
“The agencies play such a critical role in the housing industry,” Bolton says. “The housing industry is such a key component of the broader economy that I just don’t see anything happening, certainly from a negative perspective [with either organization].”
CAPITAL LINES UP FOR AFFORDABLE HOUSING
Even with Freddie Mac and Fannie Mae in the picture, affordability is a worsening problem in the US.
While in its early stages, money is lining up to try to address the issue. “We’re definitely seeing many more targeted, socially conscious funds that aren’t your traditional big “A” affordable in the past,” Provinse says. “It’s not just tax credit or Section 8 kind of subsidized deals, but these funds are targeting more of a workforce housing component.”
Greystone is now a participant in the affordable space, having bought America First Multifamily Investors, or ATAX, in August. ATAX provides real estate developers with construction and permanent financing of affordable, student and senior housing properties through the direct purchase of tax-exempt and taxable bonds. Its Greystone Affordable Development group is a development and transaction management group focused on meeting the challenges associated with the recapitalization, rehabilitation and preservation of affordable housing.
Beyond his firm’s work, Fried predicts even more capital providers will target affordable housing in the future, as firms become increasingly comfortable with affordable housing.
“This was a fairly small community of capital participants a number of years ago,” he says. “That clearly has broadened and it has broadened for the same reason that debt and equity appetites have expanded on a whole host of asset classes. It is money looking for a reasonable place to park itself where it can get some kind of decent return for the foreseeable future.”
These funds often have longer hold times, which can hedge their risks. “While they have lower yields, they’re saying they have much less volatility and downside risks,” Provinse says.