Multifamily Agency Lending in the time of COVID

[Chris Davis]

This is my day job, and it's been both horrifying and interesting watching our healthy capital markets gradually deteriorate into a Michael Lewis financial disaster book.  Thought it might be interesting to share war stories, from whatever perspective anyone happens to have (i.e. lender/sponsor/attorney/vendor etc).

In terms of actual  market impact, here's what I've seen:

- New debt service reserve requirements at closing (killer for a lot of acquisitions that need max leverage)

- Apprehensive lenders, due to loss sharing and/or buyback requirements.  Haircutting transactions above and beyond whatever restrictions are put in place by the GSE's.

- Decreasing appetite for cash out refinances, high leverage, interest-only, and peculiar deals (scattered site, low liquidity, nonlocal sponsors)

- Mixed-use deals having their retail income underwritten at $0 unless big national credit tenants.

- Falling collections at properties playing hell with deals in process.  If your collections drop the month before closing, usually the Agencies are going to want to go even farther to "catch the falling knife" and you get whacked on debt service coverage ratio.

- Subsidized deals are king right now, nothing like having tenants that don't have jobs to lose, so HAP contracts or Section 8 voucher transactions or anything like that are largely immune to the current sturm und drang.

In terms of actual horror stories:

- Big sponsor with lots of workforce housing that included many undocumented immigrants who can't collect unemployment, most of whom work retail or domestic services and none of whom are working now. Reported something like 8% collections in April (i.e. 92% collections loss). On a CMBS loan so no forbearance, nightmare scenario.

- Fannie/Freddie announced loan forbearance for existing borrowers but the process is a bit clumsy, which has led to some downright irate exchanges between sponsors and servicing folks.

- People being eaten alive by hard money shops turned loan-to-own operations when their GSE takeout financing falls apart and they run up against hard maturities.

What's everyone else seeing out there?

[Joshua Ferrari]

I've seen a lot happen in the market & fully expect that it will take a while for the dust to settle. Meanwhile, I'm sure there will be more lucrative opportunities out there for savvy investors, then there have been in the past decade. It's just going to be much harder to get them closed. As always "Cash is King" moving forward. 

- All the uncertainty creates great challenges in pricing assets and debt options. Forecasting property revenues has become next to impossible, and no asset class is unsusceptible from the current environment. However, the capital markets are still showing movement. Sales and debt financing deals are getting done. The market continues to function, although at a significantly reduced level.

- U.S. Economy is falling. No one wants to catch the falling knife, but there’s room for optimism. Recent forecasts have shown an 18% decline in Q2 GDP. Full-year 2020 GDP is expected to be negative 1.9%. The U.S. economy is expected to start bouncing back in Q3 and continue its rebound all the way into the following year, 2021. The 2021 GDP is currently forecasted at over 5%. CBRE’s particular view is much closer to a “V” recovery than the views seen from many other Wall Street and big bank economists.

- The global response to COVID-19 and the resulting economic contraction has been huge. Response in the U.S. has been just as great or greater with roughly $6 trillion in stimulus. The $6 trillion will go far in filling the tremendous economic loss suffered in Q1 and Q2.

- There’s some optimism also on the “how long will it last” question - both the coronavirus itself and the severe restriction of many industries. Estimates ranges from Treasury Secretary Mnuchin’s 10 to 12 weeks to New York Governor Cuomo’s “4, 6, 9 months.” The timeline is likely to come closer to the shorter end, provided the measures put in place are successful. China is beginning to bounce back. Italy’s infection rate has begun to improve.

- With all the fiscal stimulus going into the economy, will we move into a possible inflationary environment? In 2021, the U.S. will likely have slightly more inflation, but nothing like the 1970s. The broad, long-term forces, such as aging U.S. population, that have been keeping inflation down over the past decade are still in play and should outweigh the inflationary influences of the stimulus.

- REITs multifamily data shows unfavorable changes in the coming market. REITs' real-time data provides us a window on the multifamily market. The perspective is timely, but not favorable. From the market peak in mid-February to March 23rd, apartment REIT stocks fell 40% which is on par with all REITs, so multifamily is in the middle of the sector. There's been a huge loss of value through the implied apartment cap rate. In mid-February it was 4.8%. Today it is 6.9%. Similarly, the implied value per unit has fallen from $390,000 to $275,000. Now, this is REIT specific, and it's extremely hard to analyze the A/B/C/D class assets for a non-institutional buyer. So moving forward, cap rates are unknown. However, I can see there being roughly a .5% increase on the buy side IF this pandemic dies off, before the end of June.

- Market fundamentals are beginning to be challenged. Near-term expectations of property T-1’s include higher residential retention (definitely a positive), but lower increases on rents for renewals. Numbers are showing closer to flat than the previous 3% to 5%. New leasing activity has dropped. Market performance at the A-class should be able to weather the economic uncertainty surprisingly better given that most residents are in better financial condition during this downturn. Strong demand for workforce housing leading up to the current period should give the B & C-class sector the ability to rapidly reach high occupancy levels again when jobs return. Bottom line is that if borrowing costs are escalating and revenue collections are being challenged, that means values are being stressed (dropped). But, market performance and value are market-by-market and asset-by-asset so that’s not to say all multifamily will be drastically affected.

- Higher risk metros include those with large energy and tourism sectors. In the REIT landscape, Washington, D.C. and Boston (among other markets) should perform better over the near quarter, due to ability of government and tech sectors to weather the economic downturn better than other markets. Houston, Orlando and Orange County, CA will likely be worse off due to the large restrictions in tourism and energy. Markets with higher supply also may be worse due to much lower overall leasing activity. New Orleans and Las Vegas are additional markets with higher risk due to tourism declines, as well as other energy-related metros. Atlanta and Dallas/Ft. Worth should possibly be added to the "at more risk" list, given their huge air travel hubs which serve as economic machines for the metros.

- Senior housing, assisted living facilities, nursing homes, and student housing are of great concern moving forward. Both student housing and senior housing have begun to see a decline in future growth: Since mid-February to March 23rd, seniors housing and student housing REITs were both down 55%, compared to 40% for conventional multifamily. Uncertainty around student housing performance comes from lack of confidence that colleges will all be back to normal operations in the fall. Senior housing performance is more on the demand side. Occupancy rates are expected to fall due to increased risk of infection. One silver lining is that the capital moving away from these products creates more opportunity for those still active in the space. This includes all sectors here, multifamily, senior housing, & student housing.

- Debt capital. We’ve hit a time in the market where we need to be a little more creative in our deal structure.

Banks - Banks are still lending but are being very selective and are definitely favoring relationship borrowers. Current underwriting includes increased borrower scrutiny. Banks have either implemented floors or raised spreads recently but remain competitive.

Life Companies - Most lifecos are taking a pause and not quoting new business given the recent spread widening in investment grade corporate bonds. Lifecos are all using interest rate floors, but they are not sure where to set the floors.

Agencies are wide open - Both Fannie Mae and Freddie Mac are focused on liquidity and stability. They remain open for business, continuing to quote, rate-lock and close deals. In fact, they both have had high levels of business in the past month. Deals with the greatest certainty on rents and asset performance over the near term will get the most focus by the agencies. Typically your lower unit numbered B & C class assets. Fannie Mae and Freddie Mac are generally less enthusiastic about pre-stab, value-add, student and other deals where income is in the future. Cash-out refinances are also challenging, assets in markets that are or will get hit harder by this recession. But they have still been lending in these markets. Sometimes higher reserves are required for what they perceive as higher-risk loans. Non-standard loan requests also will be less favored. Rate-lock policies have evolved due to increased uncertainties on timelines for inspections, closings, etc. Deals are getting rate-locked now much closer to closing dates. I've seen an investor have his interest rate increased THE day of closing. Causing some serious reconsideration on the debt structure.

- Credit markets are beginning to tighten up. The credit/lending markets overall and the multifamily mortgage markets specifically have deteriorated. The markets are in a volatile state. What began as a minor liquidity challenge has turned into a major liquidity and credit issue. Broad rate indices provide a sense of the dramatic changes in the credit markets. 10-year Treasuries were 1.88% at the beginning of 2020 and 0.84% as of March 23rd. In same period, one-month LIBOR fell from 1.73% to 0.93%. The Federal Reserve has issued two 50-bps rate cuts to the Federal Funds rate. The target is now 0% to 0.25%. Debt financing costs have risen, although they are coming off record-setting lows. Credit loans have widened dramatically for all product types and forms of lenders (Lower LTVs). Interest rates are higher. Mortgage rates are higher, causing stress to prospective borrowers, as loan proceeds are reduced. With potential increases in DCRs in the future. Nevertheless, some deals are still happening. I know three investors here locally in Mobile, AL, with two multifamily assets each, under contract, with no sign of cancellation, only delays. Typically, challenges in getting deals closed include the logistics of inspections, getting third-party reports and recordation. What has been remarkable in the past few weeks, is how well the groups (buyers, sellers, lenders, vendors, etc.) have worked together to find solutions. Flexibility and patience around normally rigid rules have been tremendous.

- Tougher market for construction and value-add financing. Banks are very, very selective in quoting construction loans or bridge loans. However, they’ve shown a little more lenience on longer construction/bridge loans than the shorter term 6-12 month loans. By and large, financing for value-add deals are off the table. Underwriting of post-renovation rents is extremely difficult to determine. New renovations have came to a screeching halt.

- Deals are still happening, but the investment sector has changed significantly. Nearly all assets that went to market prior to March 11th have continued to be marketed with sellers taking a “wait and see” approach on how buyers will price assets. Transactions that were well along in the due diligence and/or closing process are proceeding towards closing. Buyers and sellers are working together to complete the transactions. Usually more time is being granted to the buyers to overcome logistical challenges of inspections, etc. In a couple of closed transactions last week, there was a price adjustment prior to closing; however, in those instances the seller was very motivated for liquidity to solve other issues. Deals where the buyers had a locked rate at the lower mortgages than currently in the market are also likely to complete the deals. Most of the deals that were in very early stages of marketing at the beginning of the coronavirus period are being pulled and moved to the sidelines. A recent survey found that about 90% of the offerings expected to hit the market in the last two weeks have been delayed. Marketing strategies have changed. Many assets still going to market are being shown to a select group of investors, rather than the more typical broad marketing approach used in the pre-coronavirus period.

- Private capital, especially 1031 buyers, dominate current investor sectors. Private capital represents over 85% of recent bids. The biggest capital source still in the market is the 1031 buyer. Institutional capital has fallen to only about 10% of bidders while public REIT investor interest has completely evaporated. While a lot of investor capital has gone to the sidelines for the near term, investment capital for multifamily assets is not disappearing. When we return to a stabilized environment, there will be lots of debt and equity.

- Due diligence process creates challenges, but virtual tours provide some solutions. The normal flow of property tours, due diligence, closing processes and more are all being disrupted by social distancing policies, travel bans and other complications from COVID-19. Technology is helping overcome some of the challenges, with virtual tours leading the way. Virtual tours are not just a “here and now” solution, they are here for the longer term. Other challenges exist like recordation offices being closed, tours of occupied units, etc. But patience, creativity and technology continue to help find solutions. That said, more time for due diligence is being asked, and granted, for most deals.

Summary

Multifamily real estate has seen some tremendous changes in the past few weeks and will continue to evolve as we push through this crisis in our economy. Long-term investors are showing persistence and agility in the pursuit of multifamily assets, probably at lower-than-market value. Deals are in the starter stages of being more lucrative now than in the previous decade. What’s still to be seen is the floor of the market. No one wants to catch the falling knife and have their asset drastically decrease in value, so major precautions are being enforced. My company is full speed ahead for the coming transitions and changes in the market and fully intends to bring cash flowing assets to our investors so we can ride the upcoming wave to the top of the economic cycle. Attention to detail is key and consistency of the same will bring about the most lucrative opportunities being capitalized on.