By John Bray Managing Director
Primary Capital, Atlanta
jbray@primarycapital.com

Lack of transaction volume is the order of the day from both refinancing and acquisition standpoints. The majority of multifamily sales that have taken place thus far in 2009 have been distressed sales by lenders or special servicers. For instance, Atlanta has had only 14 non-distressed investment sales close through October of this year, a significant drop from over a hundred market rate sales, totaling $1.5 billion, for the same period last year. Similarly, Charlotte had only one apartment deal, which was a distressed sale, closed this year.

The bottom line is that the only market rate sellers are REITs and pension funds which are disposing older assets to bolster their cash positions. The primary buyers of those deals have been private groups with either family/friends or “country club” equity, which typically have lower yield requirements. Institutional equity has been on the sidelines this year and is likely to remain there for the near term.

There has been no motivation for the private owners to sell as their lenders are allowing them to exercise extension options for minimal fees and are not requiring them to right-size maturing loans. The owners are content to keep their short term, interest-only loans in place at extremely low floating rates, partly because they have few other options available. Both lenders and borrower are hoping that time will bail them both out of the deteriorating economic conditions.

In all likelihood, this will be a failed strategy as the commercial real estate decline is starting to gain steam and is probably far from bottoming out. The real estate industry is dependent on low interest rates and leveraged capital. There are few banks funding new construction projects and those that have capacity are only funding deals with strong repeat borrowers at much lower loan-to-value “LTV” ratios than in the recent past. This liquidity crunch is further compounded by the need for additional equity investments to bridge refinance gaps for maturing CMBS, banks, and life company loans.

Despite all the negative news in the media, there are three bright spots in the multifamily sector: Freddie Mac, Fannie Mae, and Housing and Urban Development (“HUD”). These capital providers have continued to quote and close competitive loan products through one of the most turbulent economic periods in history. Although both Freddie and Fannie have been in conservatorship for the past 12 months, neither has missed a beat in supplying the much needed liquidity to apartment owners and developers.

All three lenders are still providing 75-80% leverage, with HUD going up to 85% LTV, at below market spreads. Without these market-makers, the apartment sector would likely be in a tailspin as cap rates would certainly be north of 8% on the Class A’s and B’s and there would be virtually no liquidity for the deals rolling out of construction loans or for the large pool of maturing loans.

Currently, life companies are not a good option for most private owners as they are not going above 55-60% leverage at coupon rates ranging from 7.5% to 8%. This compares to Freddie Mac’s Capital Markets Execution (“CME”) product that will go up to 80% leverage, on acquisitions, at 5.5% to 5.75% coupon rates. Freddie Mac is also offering interest only for two to three years on 10-year term loans. It even provides interest only for the entire term on loans with less than 70% LTV. Freddie’s CME product is the way of the future as it allows them to continue to originate loans while reducing their balance sheet exposure as required by the Congress. Freddie’s recent securitization of approximately a billion dollar in multifamily loans was a huge success and was well received by the capital markets. This product continues to evolve as borrowers are now able to choose a yield maintenance prepayment option versus defeasance in exchange for additional spreads. The inflexible exit structures were a major shortcoming of this product, which Freddie Mac has now improved upon.

Although the fixed rates offered by the agencies are very appealing, Freddie Mac’s Capped Adjustable Rate Mortgage (“ARM”) product gives borrowers the best of everything. The borrowers get to take advantage of the historically low floating rates, while having built-in interest rate protection and a flexible exit. Freddie Mac is also offering this product with both seven and ten-year terms. Depending on the stepped down exit structure you choose, the spreads on a seven-year Capped ARM with a maximum note rate of 7.75% could be below 300 basis points (“bps”). To further enhance this product, it has recently begun offering 75-90 day spread lock options along with the existing 60 and 120 day options. Cutting the spreadlock period from 120 to 90 days will save the borrower between 4-8 basis points.

With the current 30-day Freddie Mac Reference Note trading at 12bps, the coupon rate today on a seven-year Capped ARM would be in the 3.30%, which is incredible considering that there is little or no competition. Most industry experts and economic gurus agree that interest rates will rise in the near future and that borrowers should not assume these low floating rates to remain low for the entire duration of the loan term. However, one can assume that interest rates will only start to climb when the economy is on the mend. An improving economy, combined with a reduction in new supply, should translate into higher rental rates offsetting the projected higher cost of capital. As the economy recovers and other lenders re-enter the market, we should see more buyers return in earnest. Those with Capped ARM loans will have the flexibility to sell their assets with reduced and defined exit fees versus being subjected to pricey yield maintenance or defeasance prepayments.

We are recommending our clients to be proactive with respect to managing their loan maturities over the next two to three years. We believe that the permanent debt markets will maintain the tightened underwriting criteria over this time frame as loan defaults and foreclosures increase. These events will likely translate to higher interest rates and lower leverage loan structures. This scenario is likely to happen with the billions of dollars of CMBS paper maturing in the next three years in conjunction with the declining value trends resulting from illiquid debt markets.

What we know right now is that Freddie Mac, Fannie Mae, and HUD are still in business and offering incredibly competitive loan terms. We also know that difficult times are likely to continue in the commercial real estate industry for some time. It makes sense if borrowers take advantage of the current favorable situation and mitigate their risks of having to refinance later in a potentially much more difficult financing environment. The higher interest rates and prepayment penalties that borrowers may have to pay now could pale in comparison to the checks that may have to be written to cover future refinance gaps.