Kristian Lichtenfels
Associate director, HFF, Denver
The state of the United States commercial real estate economy is stable and in our post-Brexit vote world stability is preferred over nearly all alternatives. Investors and lenders continue to key in on real estate as a larger and larger percentage of their portfolio. This increased appetite for CRE investments has provided a deep bench of lenders and buyers. Borrowers are now benefiting from dropping interest rates and a flurry of liquidity. The confusion caused by prolonged market growth in CRE and global volatility has resulted in a wide variance from one lender to the next.
International economic uncertainty has yet again provided a flight to safety in the U.S. Treasury bond markets. As bond buyers increase their demand for U.S. Treasury, the 10-year UST yield has dropped below 1.5 percent, a level not seen since 2012 (1.43 percent 7/25/2012), and a level never seen previous to that. Most fixed-rate commercial real estate lenders price their borrowing rates off of the correlating UST. This renewed demand for UST bonds is resulting in, yet again, record-low borrowing rates. Furthermore, the international economic uncertainty is also leading many analysts to speculate that the Federal Reserve will not be raising short-term borrowing rates anytime soon. These two factors combined has resulted in a flattening of the yield curve, meaning the difference between short-term interest rates and long-term interest rates has narrowed significantly. To articulate this, the difference between the 10-year UST and the 1-year UST is narrowed to nearly 1 percent; this is tighter than anything we’ve seen since 2007.
Life company lenders started the year off with an increasing demand for more CRE loans. Most life company lenders have indicated portfolio lending goals that meet or more often exceed last year’s targets. In line with recent trends, life companies started the year off with a bang, issuing the largest percentage of their CRE loan allocations within the first five months of the year, some actually reaching their lending limits before summer. This aggressive start can often result in a void of life company lenders by fourth quarter.
This year, however, we have seen a number of life companies opt to hold onto a portion of their portfolio allocations in the hopes of capturing a slight premium in interest rates on loans closing late in the year. Other portfolio lenders have received an authorization to pursue additional CRE loans over and above original targets, as these lenders try to increase CRE mortgages as a percentage of their overall investment portfolio.
Most recently, the drop in UST yields has resulted in life companies leaning on interest rate floors to maintain a minimum yield for their first-mortgage investments. Today we are seeing a wide range in interest rate floors from 3 to 3.75 percent for the highest-quality 10-year fixed rate mortgages. Life companies have remained consistent in their leverage with maximum loan-to-value ratios typically reaching 65 and 70 percent at slightly higher interest rates and availability for interest only for lower-leverage requests.
This year the commercial mortgage-backed securities market has shown the most volatility within the CRE lending world. At the end of last year, we saw CMBS bond buyers demanding a higher yield for CMBS bonds.”
This year the commercial mortgage-backed securities market has shown the most volatility within the CRE lending world. At the end of last year, we saw CMBS bond buyers demanding a higher yield for CMBS bonds. This had a direct impact in the borrowing rates for those CRE owners trying to close loans between December 2015 and March of this year. Overall borrowing rates for five- and 10-year fixed-rate loans during that period drove up to as high as 5 to 5.25 percent. This resulted in a flight of borrowers from the CMBS markets, as property owners justifiably opted for alternative sources of financing from the likes of banks and life insurance companies. As a result, the supply of bonds dried up in February and March and CMBS bond buyers found themselves with virtually no CMBS bonds to buy.
Since that time, CMBS borrowing rates have settled back down to an equilibrium in the mid-4 percent range for full-leverage, 75 percent loan-to-value, five- and 10-year fixed-rate loans. Despite this recent equilibrium, there is nevertheless the potential for still more near-term volatility in this market.
In December, CMBS lenders will be forced to retain a 5 percent ownership of every pool of CMBS loans they securitize; this is known as “risk retention.” Previously, CMBS lenders simply sold all their loans to end bond buyers. Now that these lenders have to allocate capital to retain a share of their CMBS pools, analysts expect a pricing impact on interest rates by mid-September. Some analysts are anticipating as little as a few basis points, while others think this could reach beyond 0.25 percent in additional interest rate. We do know that, given the overall lower interest rates available within the marketplace, borrowers will not tolerate an average CMBS borrowing rate of 5 percent.
The banks continue to offer liquidity in the market for short-term borrowers of five years or less. Although the banks have drawn down their appetite for construction lending, they are commanding lower leverage and requiring more recourse than we saw even just 12 months ago. A number of banks also are withdrawing from construction lending on speculative projects altogether, as exposure and supply present more of a cautionary tale in their credit committees.
Interest rates are likely to remain very low through the end of the year as the Federal Reserve staves off a rate hike until global volatility subsides. Borrowers today can count on an availability of capital, but volatility both internationally and in the CMBS markets is likely to result in significant variances from one lender to the next. Clarity in the lending world can best be found through a broad reach in the capital markets.
