Filling the Conduit Void

Over the past few months, as commercial real estate lending through Wall Street’s securitization conduits came crashing down with the credit crunch, another critical benefit became abundantly clear to multifamily borrowers. Unlike borrowers in the industrial, hospitality, and other categories, many apartment borrowers can still call on the two federally chartered housing agencies that rank among the top market-rate multifamily lenders—Fannie Mae and Freddie Mac.

As experts participating in Multifamily Trends’ financing roundtable survey in early October explain, the dramatic repricing of credit risk in recent months has clearly increased debt costs for pretty much everyone borrowing against commercial properties. But access to government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac through their loan originations partners around the country has helped soften the financial blow.

Like other income-property pros, many multifamily borrowers are turning more often to portfolio lenders, including commercial banks and life insurance companies. Just as Fannie Mae and Freddie Mac are doing, these relatively conservative institutions are quoting wider apartment interest spreads than the historical lows seen earlier this year.

However, these spreads are not nearly as wide as quotes from hard-hit conduit lenders—who also have become far more conservative when it comes to terms such as loan-to-value ratios (LTVs) amid concerns about dangerously lax credit underwriting. Thus, as the marketplace searches for answers, ULI experts share the following observations about the prevailing multifamily finance environment.

Amid the slowdown in conduit lending, to what extent have you observed that borrowers are migrating to Fannie Mae and Freddie Mac programs?

Bill Hyman: We have seen this migration when borrowers are no longer able to access the conduit market for significantly higher loans compared with loans they can get from Fannie Mae and Freddie Mac. Pricing increases have not been as dramatic in agency programs.

The agencies increased spreads in a measured manner, consistent with their business focus to be in every multifamily market every day. Both agencies grandfathered in existing loans under application that allowed borrowers an opportunity to lock in rates at previously negotiated spreads.

Mitch Kiffe: As the conduits retreated from the market, we have worked hard to fill the gap . . . we held our spread on many, many loans when other lenders were retrading. Our pipeline more than doubled between mid-June through Labor Day; in August alone, we rate-locked more than 200 loans totaling $3.5 billion.

Bruce Cohen: Although some developers have turned to GSEs to fill the liquidity gap amidst the conduit vacuum, the GSEs have not filled the overall capital gap. They’ve maintained their historic levels of leverage, and [their] spreads have probably widened 50 basis points.

Portfolio lenders such as life companies and banks are likewise picking up some of the conduit slack. How have these lenders catered to multifamily borrowers?

Peter Donovan: Life companies have widened out spreads but more in line with the Fannie/Freddie pricing, and have tightened up their underwriting criteria either by lowering LTVs or being more selective on the loans they do.

Hyman: We are seeing banks stick to their precrunch LTV limits [but] their pricing is lower than conduits, and they are giving the agencies a run for their money. Life insurance companies have tended to stick to the 60 percent LTV level.

Kiffe: My observation is that all portfolio lenders have widened their spreads [but] less than conduit lenders, and have tightened their underwriting standards. I spoke with one major life insurance company lender who reported doing a lot of business at 60 to 70 percent LTV levels in the first quarter, but by the third quarter they had plenty of volume at the 60 to 65 percent LTV level.

Todd Everett: With a less competitive market, many portfolio lenders are looking to maintain or improve the quality of their loan portfolios, so they have not been willing to move up the leverage spectrum and are applying a somewhat more conservative view with respect to capitalization rates on valuations.

Cohen: Portfolio lenders have widened spreads [about] 50 basis points and pulled back on LTV limits. Life companies and banks are “cherry-picking” the best deals and clients, and are not trying to fill the gap left by the retreat of other capital market sources.

One implication of the turmoil in the conduit arena is that it is difficult for entrepreneurial borrowers to secure the high-leverage financing that had been available in recent years. How is that affecting competition for available multifamily properties?

Bob Hart: The types of buyers winning deals in today’s credit-crunched debt environment are the all-cash, low-leveraged pension funds, REITs [real estate investment trusts], syndicators, and tenancy in common investors with significant equity [equaling] 35 to 50 percent of value.

Cohen: [Highly leveraged] buyers were not a big factor in the larger core asset market, so their departure has not had much of an effect there. But overall transaction flow is down tremendously in the value-added arena, as leverage buyers can’t make the financing work and sellers are generally unwilling to reduce prices initially.

Hyman: We see many acquisition rehab opportunities where it is difficult to support financing requests at 80 percent of total cost. But borrowers who need only 65 to 70 percent of total cost are able to get their deals done.

Lowered leverage levels suggest increases in demand for secondary financing such as mezzanine debt at a time when many mezzanine lenders are no longer able to finance their investment activities through the collateralized debt obligation (CDO) marketplace. How has this affected pricing/yield rates for mezzanine and equity in the multifamily sector?

Kiffe: It’s clear that the availability of mezzanine and equity financing is far less plentiful than was the case several months ago. If the capital is available, the cost has increased substantially, making some deals uneconomical. Spreads on certain mezzanine strips have increased 300 to 400 basis points in a matter of weeks.

Cohen: Mezzanine lenders are seeking higher yields [because of] the risks they’re taking and the belief that they won’t be able to leverage their investments in the same manner as they have in the recent past.

“Mezz” spreads have widened 300 basis points or more, and [generally] less proceeds are available. And this inability to source junior capital has caused many buyers to drop or reprice potential purchase contracts.

Everett: While mezzanine debt has adjusted in pricing, it’s becoming available again. Institutional capital sources—largely pension funds working through advisers and fund platforms—will likely target material areas of dislocation and excess yield with fresh investment capital. However, the cost of mezzanine debt could still end up 150 to 200 basis points or higher than we were seeing in the early summer.

Some buyers logically are looking to assume attractive existing debt where viable in the current environment. How are they filling the capital gap between their equity and the lower LTV debt they are likely assuming?

Hart: Below-market, assumable-debt financing can help to make a deal happen in today’s environment—notwithstanding the likelihood that this financing can sometimes create a significant equity gap.

In our experience, this has not stopped motivated buyers from “gapping” equity up to the top 40 to 50 percent of the capital stack to make a deal work. We recently experienced that in two southern California multifamily sales and were very pleased with the results.

Donovan: There is no question that there is value today in a recently financed, assumable loan that can no longer be replicated in the market. To the degree there is a gap, it is generally being filled by equity, as lenders are less willing to allow mezz debt behind their loans.

Cohen: Many buyers are trying to [assume] cheaper in-place debt. However, the proceeds needed to fill the gap on the acquisition price have not always been easy to fill. The mezz or preferred equity required to fill the gap is costly, and it’s still hard to source in large quantities.

Hyman: In our experience at Centerline, we have not seen this approach too widely used.However, it is worth noting that one of the key benefits of (GSE) financing is the ability of the buyer to request a supplemental loan from the existing loan servicer in connection with the assumption of an underlying agency loan.

Brad Berton, a freelance writer based in Portland, Oregon, specializes in real estate and development.

Multifamily Trends: November/December 2007
© 2007 ULI–the Urban Land Institute, all rights reserved.