Multi-housing debt overview, 2019 outlook

The below is from HFF's annual Multi-Housing Pulse publication, which highlights the equity and debt markets that support transaction volume within the multi-housing industry as well as various regions of the country. The edition features Atlanta, Austin, Boston, Charlotte, Chicago, Dallas-Fort Worth, Denver, Houston, Indianapolis, Inland Empire (Riverside), Los Angeles, Miami, Minneapolis, New Jersey, New York, Orlando, Philadelphia, Phoenix, Portland, Raleigh-Durham, San Antonio, San Diego, San Francisco, Seattle, Tampa and Washington, D.C. Click here to read the full publication.

As 2018 came to a close with markets experiencing volatility, investors are uncertain of what trends are expected to continue into 2019. Volatility is to be expected at this stage in the growth cycle as this cycle is on pace to become the longest in the nation’s history. Despite today’s market uncertainty, the debt markets continue to possess strong and discipline fundamentals along with ample diversified capital. This continues to create healthy competition among lenders and, ultimately, benefit borrowers. Twenty-nineteen should be an interesting year in the debt markets and certainty is that multi-housing remains a preferred asset class among most real estate investors and lenders.

Flattening Yield Curve

The yield curve indication is something investors track closely as it can be related to an impending economic downturn, although recent studies show it isn’t always the best indicator. In January 2018, the spread between a 10-year U.S. Treasury bond and a two-year U.S. Treasury bond was 52 basis points. By mid-December 2018, the same spread had decreased to 16 basis points. The yield curve slowly flattened throughout 2018, which played to the benefit of borrowers. As a result of a flattening yield curve as well as dramatic increases in LIBOR, borrowers took advantage of fixed longer-term loans with minimum premiums over what was historically cheaper shorterterm floating-rate loans. Unsurprisingly, we saw more fixed-rate originations than floating-rate originations in 2018 due to borrowers refinancing out of their floating-rate positions or seeking long-term debt on their acquisitions. We expect this trend to continue throughout 2019 barring a significant increase in the yield-curve spread. 

Widening Corporate Bonds and Increased Interest Rate Volatility Trigger Wider Spreads

Insurance companies, agencies and conduit lenders all price their mortgage spreads relative to the yields they can achieve on alternative investments besides real estate lending. Insurance companies benchmark investment grade corporate bond yields and price their mortgage spreads at an appropriate premium to those yields. At the beginning of 2018, Moody’s AAA and BAA corporate bond yields were 3.52 percent and 4.24 percent, respectively. As of mid-December, Moody’s AAA and BAA corporate bond yields widened out to 4.02 percent and 5.14 percent, respectively, resulting in a respective increase of 50 basis points and 90 basis points. At the beginning of 2018, insurance companies were flush with fresh allocations and the lower yield on corporate bonds resulted in sub-100 basis point spreads on core low leverage multihousing assets. As corporate bond yields trajected upwards and allocations dwindled, so did the insurance companies’ competitive pricing. Similarly, conduit lenders, including Freddie Mac, have widened their pricing as a result of interest rate volatility significantly impacting their buyer-pool of securitized loans. While insurance companies and agencies will yet again have fresh allocations at the beginning of 2019, borrowers must recognize the correlation with corporate bond yields and be cognizant of the potential for continued rising spreads across all lender types as the U.S. economy continues to strengthen. 

Highly Liquid Bridge and Debt Fund Market

Twenty-eighteen saw no signs of the debt fund momentum slowing down. Year-to-date November 2018 saw approximately 34 new funds raised for a combined $20.1 billion, right on top of year-end 2017 numbers of 35 new funds raising a combined $20.2 billion. The sheer volume of capital within the debt fund space has created an intensely competitive pricing environment. In 2018 we saw debt funds pitted against each other with the lender presenting the best economics often awarded the deal. Debt funds became the go-to source of capital in markets where construction delays and slower leasing velocities pushed developer’s stabilization timelines out. This is a trend that is expected to continue and likely grow in 2019 as most markets work through the fury of multi-housing development pipeline coupled with labor shortages and elongated lease-ups. The abundance of capital in the debt fund space coupled with the likely continued rise of LIBOR in 2019 will make the debt fund market ultra-competitive and creative.

Liquidity Returned to the Multi-housing Construction Market

Lenders were extremely cautious to lend on ground-up construction in 2017 due to fulfilled allocations for that product, market and borrower exposure, and conservative underwriting. Alternative lenders saw that opportunity to capture business and obtain additional yield in the marketplace in 2018. Liquidity returned to the construction market in a big way, and the sources of capital for multi-housing construction loans became far more diverse. Debt funds, insurance companies and structured alternatives (mezzanine, preferred equity and participating mortgages) provided a much-needed boost of capital, in addition to the traditional banks, to help alleviate significant bank concentration and exposure. This new diverse and competitive construction market helped restart development in many markets that had slowed, if not stalled out, due to this self-imposed “governor” to development. This diversification and liquidity is expected to continue into 2019; however, lenders remain disciplined in their underwriting assumptions given the late cycle risk and the continued rise of construction costs nationwide. Continued costs creep coupled with flattening of rent growth in many markets will likely continue to taper off development pipelines nationwide.

Agencies Get Creative to Win Business

In 2018, the FHFA decreased the lending cap for Freddie Mac and Fannie Mae from $36.5 billion in 2017 to $35 billion. In November, the FHFA announced the cap will remain at $35 billion for 2019. While this is a contributing factor to the agencies’ production, there are a variety of programs between both agencies that are considered "uncapped." The most well-known uncapped program across both agencies is the Green-Up Advantage program, whereby borrowers are incentivized to spend money on capital expenditures that reduce the property’s water or energy usage. Throughout 2018, the agencies offered a 10 to 30 basis point discount in the spread in exchange for a 25 percent energy or water reduction. In 2019, the agencies will offer roughly the same spread discount, but in exchange for a 30 percent reduction with a minimum 15 percent derived from energy reductions. These changes will make the Green-Up Advantage costlier and more difficult to achieve. Freddie Mac has combated these changes by implementing programs targeting lower-income properties and workforce housing. These programs include a workforce housing or targeted affordable mezzanine program that offer attractive mezzanine financing in exchange for preserving 50 percent of units at a rent threshold that corresponds with the area median income. We expect agencies to continue their creativity in 2019.

Creativity and Competition in 2019

Twenty-eighteen proved to be a great time to be a borrower despite volatility later in the year. That volatility is expected to continue into 2019, which should make for a very interesting time to consume capital. However, volatility allows for creative opportunity and competition will make 2019 another great year in the debt markets. Investors need to stay nimble and take advantage of the options the markets provide.