Great read on different capital markets

[Darryl Dahlen]

I received this from one of my lenders and thought that it was too good not to share. As someone who primarily funds loans from CMBS, agency, and insurance companies I think this info is on point.

Despite turbulent capital markets, roiling from weakness in China and a downward spiral in oil and stock prices, borrowers at the onset of 2016 have an abundant array of attractive financing options available for acquiring or refinancing multifamily properties. However, due to recent volatility, astute investors should take a thoughtful approach to navigating the field of potential lenders. While the same lending alternatives are available since the economic recovery gained traction in 2012 – Fannie Mae, Freddie Mac, conduit lenders, banks and thrifts, and life insurance companies – each lender offers distinct advantages/disadvantages as it relates to loan structures, interest rates, closing costs, servicing, and their responses to the whims of the market.

From a general market perspective, there are still plenty of reasons for commercial real estate investors to be optimistic. Treasury yields are currently near all-time lows, interest rate spreads for most lenders remain at favorable levels, and underwriting guidelines continue to moderate due to an ever expanding supply of active lenders in the market. Employment and housing sectors have improved in the past year as U.S. unemployment dipped below 5% for the first time in many years. Barron’s recently reported that despite the turbulent markets, it expects the U.S. economy to avoid recession and grow at a 3% pace in 2016. Additionally, while a precipitous fall in oil prices has had a negative impact on “oil patch” locations, it has effectively increased the spending power of the American consumer.

While there are still concerns regarding the overall health of the economy, the current real estate lending environment remains active and strong as a whole. According to the Mortgage Bankers Association (MBA), the fourth quarter of 2015 was the fourth highest quarter for lending volume on record. The following graph and subsequent discussion below provide an overview of the current lending environment and alternatives we anticipate in the coming months for the multifamily lending market.

SOURCE: MBA, Federal Reserve Board of Governors, Wells Fargo Securities, LLC, Intex Solutions, Inc., and FDIC

Government-sponsoredenterprises(GSEs) – Fannie Mae and Freddie Mac

Fannie Mae (FNMA) and Freddie Mac (Freddie) continue to maintain a dominant market share among multifamily lenders and both have proven to be reliable sources of financing through numerous market cycles including the last prolonged recession. They have the directive from their regulator, the Federal Housing Finance Agency (FHFA), to enhance the flow of credit to multifamily properties nationwide. Since going into conservatorship in 2008, FNMA and Freddie have returned to the government approximately $247 billion, which is $60 billion more than the $187 billion spent on the bailout.

FNMA loans are obtained through Delegated Underwriting& Servicing (DUS) lenders who are authorized to underwrite, process, close, and service loans for FNMA. Freddie loans are accessed through a network of correspondent lenders, called Seller/Servicers, who perform a similar role as FNMA’s DUS lenders. Since FNMA DUS lenders share risk with FNMA, more decisions are delegated to DUS lenders compared to Freddie Seller/Servicers. In both cases, lenders must qualify to become designated GSE lenders by demonstrating financial strength, underwriting expertise, loan servicing experience, and capacity to generate and handle meaningful loan origination volume.

GSEs offer very attractive terms for multifamily properties nationwide, including various fixed and floating rate loan terms, early rate-lock options, and future supplemental loans. According to the Mortgage Bankers Association (MBA), GSE loans currently comprise approximately 43% of the $1.02 trillion of outstanding multifamily mortgage debt in the U.S. While the FHFA has placed annual volume caps on the GESs for some multifamily loans such as market rate apartments, certain types of affordable and small multifamily properties were excluded from these caps in 2015 and again in 2016. In 2015, FNMA booked $42.3B and Freddie booked $47.3B in overall new financing.

FNMA and Freddie typically price uncapped loans more aggressively when compared to capped business but both sectors are priced competitively in comparison to other lending platforms described below. FNMA and Freddie loans are non-recourse and typically allow borrowers to apply for a FNMA or Freddie “supplemental” loan (2nd trust deed) after the first year of the initial loan term, which is a feature that distinguishes the GSEs from CMBS lenders whose standard programs prohibit secondary financing. Both FNMA and Freddie have an excellent track record in multifamily lending and we expect them to remain very active lending in 2016 and beyond.

Banks and thrifts

Banks and thrifts experienced the greatest growth in multifamily lending volume in the past year, and now hold approximately 32% of outstanding multifamily mortgage debt according to the MBA. Improved bank balance sheets along with favorable tailwinds of rising property values have resulted in banks and thrifts expanding loan origination efforts since the market recovery in 2012. In addition, bank deposits have increased, providing additional funds to lend.

Bank lending is usually limited geographically to the footprint of the bank’s retail network as many banks prefer to lend only to those borrowers to whom they can provide additional banking services. Pricing for loans is often affected by the deposit relationship and other banking services being provided, and banks usually retain and service the loans they originate. Furthermore, since banks typically require a personal guarantee, their underwriting focuses not only on the property fundamentals, but often even more intensely on the financial strength and credit history of the individual providing the personal guarantee.

Closing costs are often lower than other lending alternatives and rates remain competitive, but there are some reports that banks have begun widening their interest rate spreads in response to the fallout in the CMBS market. Interest only options are typically not available through banks except on very low leverage transactions and smaller banks often encounter size limitations on loans to one borrower. There are also substantial differences in bank lending programs across the country for multifamily properties. What you are quoted by one bank in one particular region of the country may be entirely different than what another bank is quoting in a different area for similar quality/size multifamily properties.

“CMBS” (conduit) lenders

Commercial Mortgage Backed Securities (CMBS), or conduit, lenders originate and pool loans that are sold in the capital markets. CMBS loans first gained popularity in the 1990s filling a void in traditional lending that resulted from the S&L crisis and the prolonged lending downturn that followed. The CMBS and securitization market provides lenders with liquidity by enabling them to sell their loans and distribute risk across a large pool of investors with different appetites for risk/returns. However, CMBS interest rate spreads respond instantaneously to fluctuations in the market with rates rising when investor sentiment turns to a “risk off’ mentality. As such, CMBS rates today are relatively high, with most full leverage loans in the 5.0% range as of this writing, when compared to other lending alternatives.

CMBS loans are non-recourse, allowing sponsors to keep contingent liabilities off of their books and typically feature 10-year balloon payments with a 30 year amortization (full-term or partial interest-only may be available for quality properties and/or low leverage transactions). For some, the benefits of conduit loans are offset by complex loan documents, high closing costs, market-based pricing that is subject to change prior to loan closing due to adverse market conditions, and loan servicing that is oftentimes handled by a party other than the originating lender.

CMBS activity has picked up since its reemergence in 2012, but CMBS lenders have recently found multifamily loans to be difficult to win due to other available lending alternatives. Multifamily properties are highly desired among conduit lenders who need a diverse mix of property types for their loan pools, but CMBS loans currently account for only approximately 7% of outstanding multifamily debt according to the MBA. In order to win multifamily business, CMBS lenders often have to compete on the basis of higher leverage or be willing to finance lower quality properties or borrowers with average credit.

Most industry pundits anticipated that CMBS lending volume in 2016 would increase. However, in January 2016, instability and an aversion to risk in the capital markets, coupled with Dodd-Frank “risk share” legislation that adversely affects CMBS bond investors’ returns, resulted in a precipitous widening of CMBS spreads. Some lenders shuttered their CMBS lending units altogether or reduced staff to those focusing on balance sheet bridge loans in order to maintain the perception of being “in business” and ready when CMBS demand increases. Today, year-over-year lending volume for CMBS is down (January 2016 CMBS lending volume was $2.67B compared to $3.77B the prior year) and we expect CMBS lending to continue to struggle through 2016.

Still, a CMBS loan may be an option including lower quality multifamily properties at high leverage levels. If you ultimately choose to move forward with a CMBS lender, it is important to choose one that has demonstrated its dedication and capacity to staying in the CMBS market for the long haul. Ideally, an investor should choose a CMBS lender that can also offer balance sheet or bridge loans besides CMBS just in case a back-up option is needed.

Life insurance companies (Lifecos)

Life insurance companies have an ongoing need to invest money in long-term, fixed-rate investments, which include commercial real estate loans with defined maturities. Lifecos are portfolio lenders so they tend to not be immediately impacted by the day-to-day fluctuations of the capital markets, but they do respond throughout the year to market conditions, and individual lifecos can become less competitive later in the year as they fill their annual lending allocations. As such, lifeco pricing today is attractive, but the lending profile for most lifecos remains focused on high quality multifamily properties in larger markets with financially strong and experienced borrowers.

Lifecos also generally pursue larger loan sizes ($5 million or more) at lower leverage levels than can usually be achieved with GSEs, CMBS lenders, or banks. Some Lifecos will work directly with borrowers, particularly on larger transactions, but most of their loans are generated through networks of mortgage bankers who may also service the loans they originate. In addition to originating loans directly to borrowers, Lifecos are also active investors in the bonds sold by CMBS lenders. Lifecos now account for almost 6% of outstanding multifamily debt according to the MBA.

Lifecos tend to have a pricing advantage for loans with fixed-rate terms in excess of 10 years, and can offer the ability for borrowers to lock in the interest rate at the time of application. Longer term money is also available with fully amortizing terms up to 30 years. Lifecos have maintained their spreads for the most part in the 1st quarter of this year. That trend may not continue if the hardships in CMBS and capital markets persist as they will have the ability to increase spreads in response to the absence of competition. Lifecos recently have had a reported 75 to 100 basis point gap in pricing on comparable CMBS debt, which puts them in pole position to win most deals where they compete head-to-head with conduit lenders. However, lifecos tend to be more active early in the year as they have full allocations of money to invest. Borrowers should expect lifecos to hit their allocation targets earlier in 2016 due to the absence of attractive CMBS debt.

In summary, financing is readily available for multifamily properties in most markets, and lenders will continue to compete heavily for higher-quality properties and borrowers. While recent disruptions in the capital markets have increased the cost of capital for investors in some areas, notably CMBS, inexpensive capital is still widely available across multiple platforms. Regardless of which lending platform you choose to pursue, always be sure to work with a lender who has a fundamental understanding of the multifamily sector as well as a track record of closing loans in both up and down markets.