“You can check out anytime you like, but you can never leave.”—The Eagles
Equating lenders to various tranches of a commercial mortgage-backed securities pool, the hard-money lenders are the C, or unrated, slice—and the life insurance companies are the AAA tranche. It is likely hyperbole to discuss the impact of another potential meltdown of the capital markets on life insurance lenders. As one originator recently told me, “Insurance companies are unwilling to sacrifice credit quality, and they will not increase their lending volume simply because there is more demand for their product.” Therefore, any comments about eroding credit quality or lending bubbles do not directly apply to the life companies. But any credit risk officer would quickly agree that we cannot just put our heads in the sand since—as we saw in the last crisis—when the subprime loans default, it affects the entire capital stack.
Currently, insurance lenders have a huge competitive advantage on CMBS. During the peak of the securitized commercial real estate debt market in 2006, the interest rate coupon of the two groups was essentially the same. In fact, since the CMBS lenders had essentially the same spreads as the life companies, CMBS briefly became preferable because they would generate higher loan proceeds.
Today, a typical life company quote is 160 to 170 basis points over swaps, approximately 100 to 130 basis points below CMBS pricing. The latter have no choice as the AAA tranche has widened out to 150 basis points over swaps and the junior tranches have widened substantially too. The real estate lending world has become bifurcated with the top quality deals going to the insurance companies and the CMBS and other lenders getting the remainder.
For non-multifamily deals, insurance lenders should always be the first call. What are their preferences? Class A office buildings in gateway markets and grocery-anchored shopping centers with strong sales. The life companies are far less active when it comes to Class B properties and markets that are susceptible to economic slumps, such as Houston. Many of them also cautiously underwrite deals in markets that are experiencing massive development, such as Los Angeles and Miami. Hospitality loans from the life companies are reserved only for top-tier hotels.
Insurance lenders now hold $362.7 billion of commercial real estate loans, according to Federal Reserve data. This is a 12.7 percent market share for non-multifamily and a 5.3 percent market share for multifamily (the disparity due to Freddie Mac and Fannie Mae). The top 30 insurers wrote $59.1 billion of real estate loans in 2015, according to Trepp. The biggest players in 2016 are MetLife, Prudential, Northwestern Mutual, Pacific Life, Mass Mutual, New York Life Insurance Company, Principal Financial Group and TIAA-CREF.
MetLife remains the largest of them all, having originated more than $12 billion in each of the last two years. And with $230 billion of maturing CMBS in 2016 and 2017—which is more than the combined amount from 2010 to 2014—the life companies could increase their market share substantially if they wanted.
However, insurance lenders have historically shown that they won’t stretch to win deals and they won’t lend on tertiary or transitory assets. With Reg AB II now being imposed on issuers of CMBS, those lenders have little room to maneuver. Meanwhile, banks are feeling the pressure to hold more reserves against their $1.77 trillion of commercial real estate loans and are also burdened by their poor performing commercial and industrial loan portfolios. So if the CMBS lenders can’t digest all of the maturities and the life companies won’t budge on their standards at the same time that banks are already showing limitations due to increased regulation, how can all of the borrowers refinance these loans?
Opportunity funds and other alternative lenders will have to fill the void and the resulting effect will be increasing cap rates.
The recent stock market sell-off was a long time coming. A few bold souls have stated that it could actually have a positive effect on real estate, as investors will eschew stocks for property. But if the contagion effect overflows into real estate, few will be spared. The ones who will be the beneficiaries will be those with the dry powder to pick up bargains, owners with little or no leverage, and insurance companies who will simply keep doing their thing—writing conservative loans on high quality assets.
Dan E. Gorczycki is a senior director with Avison Young, where he specializes in acquisition financing, construction financing and joint venture equity, with strong life insurance company relationships.