“I’ve seen more people fail because of liquor and leverage … You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.” —Warren Buffett
Numerous articles are devoted to the CMBS industry and its effect on the larger real estate landscape. With total CMBS lending at $99 billion in 2014, this capital flow has helped buoy the market and keep cap rates low ever since the dark days of 2009. However, it is the life insurance companies that are the rock that large loan deals are built on. Behemoths like Prudential and MetLife individually lend over $4 billion annually, through good times and bad, going back to the 1980s, before CMBS was even a thought.
In 2009, when banks and CMBS lenders ceased lending to all but their largest customers, life company production levels decreased, but only marginally. Sure, they took advantage of the market by implementing tighter underwriting standards (thus lowering LTVs) and were able to increase pricing, but it was still business as usual. There is a distinct subset of borrowers that are against taking out a CMBS loan at any cost due to the inflexibility of the loan documents and how hard (neigh, impossible) it can be to modify a CMBS loan once it’s been originated. Life companies serve the type of borrower that wants more personal service.
Only crusty veterans in this business remember the old days of life company lending. Almost all of them had correspondent lending shops like Dorman and Wilson or L. J. Melody, for example. You couldn’t directly access the life companies without going through a correspondent who acted as a gatekeeper. Interest rates were quoted as a coupon rate, and that rate was valid for the two or so weeks required to negotiate the application, even if the market moved somewhat. While they now quote over the Swap or Treasury Rate like everybody else, they are originating more direct loans (even where they have correspondents) and many more of the life companies are delving into products like mezzanine loans and direct equity.
The one thing that you can still count on from life companies is that they will offer the cheapest interest rate if your asset meets their stringent standards. Case in point: In November 2014, our firm took a $115 million retail center out to the financing market in North Carolina. The loan request was only a 60 percent LTV and since it was a new acquisition, there would be a lot of fresh equity from an institutional buyer. We were thus sanguine about our chances of obtaining a life company loan. However, several of the life companies were supercilious, stating that the submarket was too ancillary for a loan of that size. In the end, two life companies raised their hand and said that they would quote. While the conduit quotes were clustered in the 180-185 basis points over swaps for a 10-year interest-only loan, the life companies were well inside that range. One was even at 150 basis points over swaps while the winning bid was at 135 basis points over swaps (albeit with only five years of interest only).
That lower coupon on the financing was a windfall for the high bidder of the property, which was paying a cap rate with a “6 handle.” The accretive financing meant IRR is well into the mid teens for a Class A core property that is fully leased. The takeaway here? As long as interest rates remain low and your property is “insurance company worthy,” cap rates will remain low.
Loan size is often an issue for some life companies. Giants like MetLife have no qualms about loan size limit, as evidenced by their $290 million loan on the Wells Fargo Center in Denver last month. However, even fairly large life lenders like Principal Financial and Aegon have expressed their intent to limit their exposure to $50 to $75 million per loan. In the gateway cities, that size loan may only get you a medium-size asset. This tendency to limit single asset exposure could buffer the hit to any life insurer’s portfolio in the event that disaster should strike.
But for all their conservatism, a look at the fundamentals beneath a lot of life company lending reveals some chinks in the armor.
One new issue for the life companies is ascertaining what the floor rate should be, or the lowest coupon that they will accept regardless of spread. That floor rate pierced 3.75 percent for 10 years in late 2014 and is now below 3.5 percent. But there is clearly a limit. Historically, life companies match funded real estate loans with Guaranteed Investment Contracts and locked in the spread. Now, most of the funds within real estate companies get lumped together and the obvious risk is a potential sharp spike in interest rates. The life companies would be left balance-sheeting long-term loans in the 3’s while short-term rates could be higher—a recipe for disaster before considering any defaults.
The National Association of Insurance Commissioners recently conducted a study that found that 96 life insurers have more than 10
percent of their cash and invested assets in commercial mortgage loans, and 10 life insurers have more than 20 percent of their assets invested in commercial mortgage loans. Split by product type, 31 percent of the loans are in office buildings and 25 percent are in retail properties so a consumer downturn could have a cascading ripple effect in the next inevitable economic downturn.
Geographic concentration is another potential risk, as 38 percent of total life company originated loans are in the Middle and South Atlantic Region and 26 percent are in the Pacific Region.
To be sure, delinquencies and defaults have declined steadily since 2009. The industry average of only 20.8 percent of loans having over 70 percent LTV is assuredly the main contributor to this fact.
Still, compounding the aforementioned risks, life companies have ramped up their mezzanine and equity programs in an effort to obtain yield. Thus the historically curmudgeonly firms are getting swept up in the competitive market.
What does all this mean for 2015? As long as the market avoids a cataclysmic event, there will be more of the same—blue skies ahead. Of course, what we learned in 2008 was that when the next catastrophe strikes, there will be as yet unforeseen consequences.
Dan E. Gorczycki is a managing director andhead of debt and equity financing for Savills-Studley.