2018 to Be Another Good Year for Borrowers

By Jay Maddox

Despite concerns about the potential impact of rising interest rates and a jittery stock market, the good news is that CRE lenders have abundant capital allocations and aggressive origination targets for 2018. This was the sentiment a group of my colleagues from Avison Young’s Capital Markets Group had after recently attended the MBA’s CREF/Multifamily Housing Convention & Expo in San Diego. So far, credit spreads have not widened, indicating that lenders are not yet factoring the risk of market volatility into their risk premiums. For very high-quality life insurance company loans, the interest rate spread over the 10-year U.S. Treasury rate can be 1.30 percent or perhaps lower, resulting in an all-in rate in the low 4 percent range.

Most participants expect interest rates to increase this year, with the bellwether 10-year Treasury rate increasing to 3.00 percent and perhaps as high as 3.50 percent. If credit spreads don’t widen, all-in mortgage rates will move up to the mid- to high-4 percent range for premium quality projects.

Abundant Financing for Large Value- Add Projects 

The playing field for short-term bridge, mezzanine and preferred equity for value-added projects seems to be ever increasing, with some life companies getting into the bridge market offering short-term fixed rates at attractive pricing levels. The focus is on $25 million-plus projects, leaving smaller projects that comprise the bulk of the market with fewer options. While there are some niche private equity funds and family offices that will write smaller equity checks, and some have inter-creditor agreements in place with lenders, this market segment is very fragmented and difficult to access.

New Construction Financing Remains Challenging

Money center banks have been selective with construction loans, in many cases offering them only to existing, valued customers. This is due in part to regulations such as HVCRE, which is currently being modified in Congress. However, their smaller regional and community bank counterparts have been increasingly active. Loan funds, mortgage REITs, and, in some cases, life companies have stepped in to help fill the demand for construction financing, offering greater flexibility and higher proceeds than banks, albeit at higher rates. 

Permanent Lenders Increasingly Aggressive

A number of life companies and mortgage REITs now offer borrowers the ability to lock in a fixed forward interest rate—in some cases as much as a year in advance. Additionally, the competition for high-quality multifamily projects has heated up to the point that these lenders will fund up to 65 percent loan to value upon completion of construction, with a future funding at stabilization.

Lenders’ Underwriting May Be More Conservative

Several lenders suggested that they may need to adjust their underwriting assumptions on premium multifamily projects, especially in below 4 percent cap rate markets like San Francisco, Los Angeles and New York. Increasing interest rates coupled with borrowers’ aggressive rent growth forecasts and historically low going-in cap rates may not be sustainable.  Lenders’ exit debt yield and loan constant are very likely to increase, and cash flow underwriting may be more conservative. Today’s 8 percent exit debt yield on a multifamily project is likely to be 8.50 percent or 9.00 percent. 

Commercial real estate lenders are in general optimistic about 2018 and most have similar or greater allocations than 2017 for virtually all levels of the capital stack. However, with the abundance of capital chasing quality projects, history tells us that some lenders will over-reach, especially when facing intense competition against pressures to increase originations. No doubt mistakes will be made.