Discipline Tempers Debt Market Flush With Capital

When the current economic expansion passed the 10-year mark on July 1, it became the longest growth cycle in U.S. history. Still, mixed messages continue to plague the economic outlook.

Arguments for optimism include the rising trajectory of GDP growth, which hit a three-year high of 2.9 percent for all of 2018 and was followed by a 3.1 percent reading in the first quarter of 2019. Unemployment is at a 50-year low, and interest rates remain near historical lows.

On June 19, the 10-year Treasury yield briefly fell below 2 percent for the first time since 2016 before closing that same day at 2.03 percent. That figure was down about 85 basis points on a year-over-year basis. Such inexpensive capital tends to fuel investment in residential and commercial real estate, driving up property values. Meanwhile, the Federal Reserve has indicated that it wants to maintain low rates due to mixed signals in the global economy.

Bearish signals include the possibility of an extended tariff war with China that could lead to a hike in consumer prices, disappointing job growth of 75,000 in May, stock market volatility and a flat yield curve creeping toward inversion. The two-year Treasury yield stood at about 1.8 percent as of press time, while the yield on the three-month Treasury bill was nearly 2.13 percent. When short-term Treasuries have higher yields than long-term ones, the situation is a harbinger of recession, say many economists.

The contrasting storylines have failed to spoil the outlook of commercial real estate lenders and intermediaries. As in recent years, debt remains as plentiful as ever, commercial real estate experts declare.

“Even this late in the game, capital continues to come into the market at a very heavy clip, so it’s a great time to be a borrower or a broker,” says Gary Bechtel, president of Money360, a debt fund based in Los Angeles that closed $528 million in loan volume in 2018 and is aiming to originate $800 million this year. “It seems that everyone is putting out a record amount of money.”

Competition Ratchets Up

Indeed, commercial real estate finance companies originated a record $573.9 billion in loans last year, an 8 percent increase over 2017 volume, according to the Mortgage Bankers Association’s 2018 Commercial/Multifamily Origination Summation. (The annual survey tracks totals nationally from participating mortgage finance firms, ranging from local correspondent mortgage bankers to global financial services companies.)

MBA reports that multifamily originations, which totaled $266.4 billion in 2018, accounted for the lion’s share of the volume. In short, lenders remain bullish on apartments as well as industrial and office assets. They’re more discerning when it comes to retail and hotel properties.

Commercial real estate observers are keeping an eye on developments that could disrupt the market, however. Whether the London Interbank Offered Rate’s (LIBOR) scheduled phaseout in 2021 and the transition to a new short-term interest index rate goes smoothly remains unknown, for example.

Efforts to enact rent control in several states and cities, including New York, are a more immediate and worrisome trend (see sidebar on page 23).

Lenders and mortgage brokers are also seeing lending opportunities wane, says Susan Branscome, senior vice president and managing director of NorthMarq’s Cincinnati regional office. Sluggish investment sales are partly to blame, thanks largely to early-year trepidation among buyers after interest rates rose in late 2018. More recently, a price standoff between buyers and sellers has slowed deal volume, adds Branscome.

Sales of office buildings, apartments, retail centers, industrial properties, hotels and development land, for example, totaled nearly $132 billion in the first four months of 2019, down 12 percent from the same period a year earlier, according to Real Capital Analytics. The New York-based research firm tracks property and portfolio sales $2.5 million and above.

Due to peak pricing, investors have reined in their acquisitions of core assets. This has led to lighter loan volumes among life insurance companies and other lenders that tend to favor core real estate, says Christine Haskins, chief investment officer for PGIM Real Estate Finance in Chicago.

Many investors increasingly prefer higher yielding transitional assets, which are typically smaller transactions that appeal primarily to banks and debt funds, she adds. Lackluster refinancing activity is also to blame for lower loan volumes, a consequence of suppressed originations in the dark days of 2009, Haskins and Branscome point out.

Taken together, these market dynamics are catching some lenders off guard, suggests Frank Montalto, a director with Marcus & Millichap Capital Corp. in Chicago. “Many institutions that have had a majority market share with specific lending programs are facing extensive competition and are struggling to deploy capital,” he states.    

From a historical perspective, an abundance of debt and few opportunities have proven to be a dangerous mix. Such conditions sparked the cutthroat competition and loose underwriting that precipitated the 2008 crash. But lenders remain disciplined in this cycle, contend commercial real estate experts.

“Lenders are concerned about the mixed economic signals,” says Branscome.  In April, her office arranged an $8 million, 10-year, fixed-rate loan to refinance an apartment complex in Jeffersonville, Indiana. “There are good signs out there, but we don’t know how long or deep the next recession will be.”

Adds Haskins, “At this stage of the cycle, our investments are more selective but our underwriting approach has not changed.”

Decade of Difference

Lenders’ use of current rental rates and other market fundamentals to underwrite loans continues to differentiate this cycle from the last one. Back then, lenders often underwrote expected rent and value growth in order to juice loan proceeds and win business.

While every deal is different, life insurance companies and banks are generally providing loans for no more than 70 percent of a property’s value — and in many cases, much less. They also are demanding a debt-service coverage ratio (DSCR) of 1.2 to 1.3 or higher.

Those are big improvements over the last cycle, when a variety of lenders routinely granted leverage equaling 75 to 80 percent or more of a property’s value and DSCRs of a “skosh” over 1.0, says Paul Schmidt, vice president of commercial real estate for Associated Bank in Minneapolis. “Underwriting has been pretty conservative all along since coming out of the recession,” Schmidt maintains. “We just aren’t seeing the type of stuff we saw in the last cycle.”

The discipline is reflected in the scarcity of troubled loans. In the first quarter of 2019, banks and thrifts reported an average delinquency rate of 0.48 percent while life insurance companies and the GSEs reported average delinquency rates of 0.07 percent or less, according to MBA. Meanwhile, the delinquency rate for commercial mortgage-backed securities (CMBS) was 2.6 percent in the first quarter. All rates were relatively unchanged from the fourth quarter of 2018, according to the organization.

“The long period of economic expansion doesn’t give us pause due to the fact that underwriting has remained prudent throughout the cycle,” observes Greg Reed, a senior vice president for Capital One Multifamily Finance in Newport Beach, California. “We don’t anticipate this changing in the future.”

No Shortage of Options

Borrowers seeking more aggressive terms can still turn to debt funds or CMBS lenders to avoid recourse or receive more than 80 percent of a property’s value or cost. (Banks are more likely to demand recourse.) But borrowers who go that route will pay more: For a three-year bridge loan, debt funds typically charge 300 to 450 basis points above 30-day LIBOR, which was approximately 2.35 percent in mid-June. For their part, banks charge some 175 to 250 basis points above LIBOR.

Some observers are beginning to see underwriting standards loosen. New debt funds that need to put money out are pushing up leverage amounts and dialing back covenants like DSCR, Bechtel claims. Additionally, a growing number of cash-out refinancings could sabotage lenders if they lack good judgment, says Clark Briner, founder of Dallas-based debt fund Revere Capital.

“If borrowers have non-recourse or light-recourse debt and have already taken out their equity,” he cautions, “what’s their incentive to stick around at the first sign of a downturn?”


Money360 recently provided a three-year, $25.9 million loan to a value-add developer for the renovation of a 174-unit vacant and former Section 8 apartment community in Philadelphia. The non-recourse financing featured 73 percent LTV.

Nevertheless, cash-out deals give property owners a chance to extract some of the value they’ve created, especially given the slide in interest rates this year, argues Dean Giannakopoulos, senior vice president of Marcus & Millichap Capital. In fact, in the intermediary’s Chicago office, refinancings have accounted for 56 percent of business so far in 2019, a significant departure from the last five years when acquisitions made up nearly 80 percent of the business.

“There is still acquisition demand for quality assets,” says Giannakopoulos. But if buyers and sellers are at a standoff on price, then owners can take advantage of a cash-out refinancing to pull equity out of a property rather than accept a lower price, he adds.

Cash-out deals also provide flexibility to sponsors that need strategic capital. In January, Los Angeles-based debt fund Thorofare Capital provided a $7 million, nine-month loan to refinance three assets in San Diego — an office building and two apartment complexes — that the borrower was preparing to market for sale.

The borrower also had an opportunity to buy another apartment asset. Rather than wait weeks or months for a sale to go through, the borrower was able to refinance the three assets to capture the equity and immediately execute the acquisition, says Eddie Prosser, managing director for Thorofare Capital.

Keeping Track

Providing flexibility to borrowers doesn’t mean that lenders are backing off on routine valuation testing or the monitoring of reserves and covenants. For example, Revere Capital requires sponsors to pledge additional collateral or cash to plug the gap when covenants are breached. That might include an initial loan-to-value (LTV) of 65 percent increasing to 68 percent because of vacancy or a drop in rent, explains Briner.

“Those are the types of provisions that allow lenders to catch a falling knife a little sooner,” he adds. “If you don’t have them, you start to have portfolio problems rather than individual loan problems.”

Recent Revere Capital deals include a $25 million, 18-month interest-only loan at 7.99 percent to refinance Brookwood Village, a 411,441-square-foot shopping center in Birmingham, Alabama, that had previously undergone a $20 million renovation.

Rising construction costs can force borrowers into similar situations. Thorofare Capital underwrote tenant improvement (TI) costs at $35 per square foot for an office transaction in Dallas recently. But a rise in material and labor expenses increased TI costs by $5 per square foot, and the borrower had to make up the difference, recalls Prosser. At this point in the expansion, the ability to resolve such problems is a differentiator in origination decisions.

“We weigh our investment decisions on the market, the stability of cash flow, the borrower and how the transaction is structured,” adds Prosser. “But we’re taking an even harder look at borrowers: Were they around last cycle, and how did they perform under duress?”

Value-Add Appetite Grows

Putting borrower experience under a microscope is an especially good business practice today. That’s not only because assets are fully priced in this extra-inning stage of the cycle, but also because sponsors are increasingly chasing riskier but higher yielding value-add strategies.

Hugh Allen, head of commercial real estate for TD Bank’s South division in Charlotte, North Carolina, has come across a significant number of deals in which sponsors are acquiring transitional properties, particularly in Southeast markets that have experienced substantial rent growth.

In some cases, debt funds financing such deals will sell the more conservative portion of the loan to banks and keep the riskier tranche, he says. “Debt funds are creeping more and more into that space and are tending to do deals that require a little more risk than banks have the appetite for,” adds Allen.

That’s no surprise, given the explosion of debt funds over the last decade. According to Preqin, a researcher of alternative asset funds, 102 debt funds with U.S.-based managers raised $70.5 billion in 2018 compared with 40 funds that raised $11.9 billion in 2009.   

As a lender who funds transitional properties, Bechtel is watching the bridge loan and value-add nexus for excessive aggressiveness. Among other deals, Money360 recently provided a three-year, $25.9 million interest-only bridge loan to the owner of a vacant, 174-unit former Section 8 apartment complex in Philadelphia. The non-recourse debt featured a 73 percent LTV, and the borrower will use the loan proceeds for a complete overhaul of the property.

“There is inherent risk that the music stops and that lenders will be caught with an uncompleted transitional project,” Bechtel explains. “But even with that risk, money still continues to pour in.”