Dekel Capital Managing Director Shlomi Ronen discusses 2017 mid-year trends in real estate financing, including borrowers’ increased demand for alternative lenders keeping the balance between demand and new regulations.
As the first half of the year has come to a close, we look at trends in real estate financing, influencing commercial real estate investment and development.
As a result of the Dodd Frank risk retention rules that were implemented at the end of last year, the number of CMBS lenders has contracted significantly and the impact on the market has been muted due to lackluster borrower demand for CMBS loans.
According to Trepp, only 21 lenders have participated in securitizations this year and the five top lenders accounted for more than 61 percent of the volume. That is a significant drop from 2015, when 38 lenders contributed loans and the top five accounted for 43 percent of the volume. The large banks with balance sheet capacity have emerged as the beneficiaries of the new regulation as a result, because they can retain a risk piece.
Irrespective of this change, borrowers continue to demand CMBS alternative financing, as the CMBS loan origination process continues to be costly with loan terms subject to changes in the bond securitization market. In addition, loan servicers have been slow to document loan assumptions on asset sales, further frustrating borrowers. In the first half of this year we saw a few financing companies roll out fixed-rate loan programs designed to specifically target these issues. By either using their balance sheet or deferring securitization, these “CMBS alternative” lenders are offering a front spread lock on loans and will retain servicing for the life of the loan.
The agencies continue to be the go-to source for multifamily financing. With significant deliveries of Class A properties, we have seen the agencies become more selective and conservative in their underwriting on their “lease-up” programs. In some cases, they are pulling the lease-up program all together over supply concerns. Otherwise, they are aggressively providing both fixed rate and floating rate loans for stabilized properties.
Debt funds have been dominating the non-recourse bridge loan space this year. New capital raised last year has translated into increased competition that has both brought down the cost of bridge debt and loosened underwriting guidelines. In order to differentiate their capital and “win” new business, we are seeing a willingness by the debt funds to take on more construction risk, push leverage, and lend in secondary and tertiary markets; Oftentimes leverage is being increased through the use of internal mezzanine.
Additionally, we are seeing for the first time bridge lenders willing to commit to future funding without charging interest on the hold back amounts.
Construction lending capacity at the banks seems to be better managed this year as a result of tightened underwriting parameters, loan rationing and consequential filtering out of sponsors. We are seeing the upper limit on loan to cost at 70 percent, with most banks maxing out leverage at 65 percent.
The rule of thumb for sponsorship liquidity and net worth requirements used to be 10 percent of the loan amount, with the net worth being equal to the size of the loan. However, as developers take on more construction projects, banks are shifting toward 15 percent liquidity upwards of a 150 percent net worth. Credit spreads on construction loans, however, have flattened–we have not noticed any significant changes in spreads so far this year.
With respect to land financing, some banks are willing to provide pre-development or land development loans, but sponsors are being underwritten to take out construction financing, and only in cases where lenders are also actively trying to win the construction loan.
Product type comparisons show that street-level retail centers with legacy tenants, as well as mid-size and big box centers, are the lowest priority for bank lenders. Industrial properties are in high demand, especially in infill locations in major markets where last mile industrial properties are undersupplied.
Higher Leverage and Prefered Equity
Due to constraints on bank construction debt leverage, mezzanine and preferred equity funds have proliferated in the middle-market commercial real estate space, providing up to 85 percent financing on development and value-add deals.
Various funds are offering a stretch senior product in which they provide the full capitalization, with the senior loan component priced competitively with bank financing and removing one additional capital partner from the equation. These funds are typically non-recourse, which is more appealing to borrowers as they are focused on balance sheet management, given the banks increased focus on contingent liabilities.
This year we have seen JV equity funds shift their focus back to major markets as opposed to searching for higher-yielding investments in secondary or tertiary markets. Funds remain focused on partnering with experienced sponsors, especially as execution risk from a market cycle standpoint has become a greater point focus for them.
The capital markets continue to evolve with seemingly strong liquidity in all segments of the market. Recently proposed changes to banking regulation and pending rate hikes should not materially change the supply of capital in 2017.
Dekel Capital actively sources equity for developers in the industrial, creative office, multi-family space. We advise our clients to get out in front of their deals in terms of timing as the groups that are active are busy, which can affect closing timelines.
This article was originally published in the CPE newsletter 7-19-17.