February 28, 2019
By Dennis Kaiser
Following NorthMarq’s San Francisco regional office completing $1.42 billion in financing across 50 transactions in 2018, Nate Prouty, the office’s co-managing director, speaks to Connect Media in our latest 3 CRE Q&A to discuss financing trends he observed from those transactions as well as predictions for 2019 based on an equally robust first quarter pipeline.
Q: What are the big trends you are tracking in the finance sector this year?
A: Availability of capital. With respect to the capital markets overall, both life companies and the agencies are expecting stable to rising supply of funds for 2019. Commercial banks, largely due to the perceived late stage in the cycle, continue to curtail their construction activity in 2019. Much of this void has been filled by debt funds. This capital source has been a large source of growth in our origination activity. The CMBS markets, with “loss retention” now fully in place, had another solid year and the number of players seems stable at this point.
One of the biggest trends we’re tracking is the availability of construction financing for projects in the pipeline for 2019. Following a steady trend of annual construction cost increases the last several years due to competition for labor and rising material costs, developers are increasingly having to get more creative in their approach to project financing. While equity investors may be willing to place equity in new projects in core markets at a return on cost below five percent based on optimistic future rent growth expectations, which can often translate into a potentially under-leveraged project using traditional lender exit underwriting. If lenders are not able to underwrite rent growth assumptions in line with historical trends, the resulting loan will fall significantly short in terms of desired leverage—in some cases below 50 percent loan-to-cost (LTC).
Q: How are those factors expected to play out across the commercial real estate industry in 2019?
A: Developers need to get more creative in how they finance their projects. Debt funds, life companies, and mezzanine/preferred equity come in to fill the gap on construction leverage.
Debt funds, with their abundance of capital, are eager to continue to step into the construction lending space, providing higher leverage, non-recourse construction debt for a relatively modest higher yield. In some instances, a debt fund might provide 20-25 percent more leverage than a full recourse bank loan for 200 basis points (bps) more in spread but require only a guaranty of completion from the borrower. Another option to obtain desired leverage on construction while maintaining valuable existing bank relationships is to pair a lower leverage, lower-cost bank senior loan with a higher yield subordinate financing such as mezzanine debt or preferred equity. In those instances, a third party (debt fund, private equity or life company) would provide a non-recourse mezzanine loan or preferred equity investment behind the bank’s senior mortgage, resulting in an attractive blended cost of capital. A third alternative for borrowers is through a handful of life insurance companies providing construction-permanent products. These loans range anywhere from five to 30 years in term, with leverage anywhere from 50 to 90 percent LTC. At the lower range of the leverage spectrum, construction perm loans are often non-recourse in nature with pricing starting around 200 bps over the corresponding U.S. Treasury yield. To achieve 80-90 percent LTC, some form of repayment guaranty is generally expected during construction along, with a higher yield to the lender in the form of higher interest rates and cash flow participation and/or profit participation on the back end.
Q: Do you expect 2019 to be as strong a year as 2018 for loan originations, and why? We’ve seen more owners refinance their properties instead of selling below their asking price. Do you expect this to continue?
A: Based on pipeline activity of new loan originations in just these first two months of 2019 alone, we could expect to exceed last year’s volume by the end of the year. Production for Q1 2019 is already above last year’s pace, and we’re seeing financing activity pick up across the board from new construction starts, value-add and core acquisitions, along with an abundance of refinancings. Refinance activity is certainly picking up as we see a confluence of both cheaper borrowing costs (lower spreads) and lender creativity making the case for longer term holds. For instance, well-heeled borrowers with core assets looking for simply the lowest possible fixed interest rate with more modest cash-out needs may be able to secure a low leverage 10-year fixed rate around four percent today with a life company or agency.
On the other end of the spectrum, as life companies also seek to balance out their portfolios with higher yielding loans they are entertaining “stretch senior” loans or even internal mezzanine tranches that offer leverage approaching levels typically only available through agencies, debt funds or recourse bank loans, allowing for significant cash out as an alternative to a sale. Creative structures such as flexible prepayment, substitution provisions, forward rate locks, and entity-only guarantees are becoming more common in the life company world as they expand their offerings in search of both yield and market share. At least half a dozen life companies are firmly in the bridge lending space now, creating even more competition in an ever-increasingly crowded field—this translates into welcome news for buyers and sellers of value-add properties as there should be ample liquidity for transactions in 2019.
For comments, questions or concerns, please contact Dennis Kaiser