Lenders Press Forward, but Outlook for CMBS Remains Reserved
Commercial real estate lenders are growing more confident, or at least more inclined to resume risk-taking. Bucking headwinds from the weaker economy and job market, underwriting standards for loans on well-positioned assets eased in the second quarter and through the summer. Competition to fund high quality borrowers showed increasing spillovers from the febrile apartment sector, with a small but growing number of development projects and cash-out refinancings registering alongside new office, retail and hotel mortgages.
From the vantage points of operating, investment, and lending, apartments continue to set the high bar. Long-term fixed-rate financing for stabilized apartments fell to a national average of 4.0 percent in the second quarter, the lowest on record. For larger and higher quality assets, rates lower. In New York and Washington DC, in particular, the prevailing notion that lending spreads are in line with historically supportable levels is being tested. As risk-free rates skirt bottom, we should expect a far-sighted market to offset with wider cushions. For some lenders, competitive pressures from peers and from the sector-dominant agencies are clouding the long view and limiting risk-based pricing power.
Short-term risk metrics reflect the apartment sector’s strong cash flow momentum. Even as debt yields inched lower, the combination of cash flow gains and lower rates allowed debt service coverage to improve slightly in the second quarter. But more comfortable measures of term risk belie the elevated maturity risk embedded in the most aggressively priced loans. Too many loans in the second quarter assumed a “new normal” in the interest rate environment while also affording a healthy uptick in cash flow growth.
Baseline projections for interest rates anticipate ten-year treasury yields in the vicinity of 4.5 to 5 percent when today’s new permanent financings mature. In a moderate economic growth scenario where the economy expands below its potential rate, that is a reasonable working assumption. Even though treasury yields have generally been falling for more than three decades, they were fairly steady at just below 5 percent in the years leading up to the financial crisis. However difficult to imagine today, higher rates will be even more difficult to digest at refinancing, in particular for the rising count of apartment loans with up-front interest-only periods.
The lender landscape is not as sparsely populated as it was a few years ago. Banks with healthier balance sheets and even healthier regulatory relationships are continuing to support their legacy borrowers’ needs and are slowly engaging new business. Underwriting standards suggest that banks are betting the economy will strengthen, though bets are being hedged on the rising tide lifting value-add assets. Life companies are dominating opportunities to fund large loans for public REITs and other liquid borrowers. The agencies are ceding some share of apartment lending but have seen the absolute volume of their apartment lending programs hold steady or increase.