Our Perspective 3/ 3/ 2020

Capital’s supply feels bottomless, putting lenders in hot seat

As our industry settles into a fresh decade, a clear theme has emerged from the capital markets: The supply of capital available for commercial real estate just keeps increasing. This strong appetitive for real estate investment is due to a confluence of factors. The commercial real estate market continues to display strong performance (with extraordinarily low loan delinquencies). At the same time, global yields from alternate investments such as government, corporate and high-yield bonds have continued to face downward pressure. Even in our low cap rate environment, there is a yield premium available to institutions that invest in commercial real estate debt and equity compared to other asset classes.

Accordingly, the general message from institutional investors of all types is that they have more money, not less, to deploy in commercial real estate this year. This has resulted in an incredible amount of capital chasing too few real estate transactions. With a supply of capital that feels practically bottomless, the competitive landscape has intensified, and commercial real estate borrowers are the clear beneficiaries as lenders offer the best terms we have seen during the current (and long-lasting) cycle of economic expansion. The life insurance company lending market, which also is traditionally the most conservative source of capital, provides the best examples of how aggressive lenders have become in the first quarter of 2020.

10-year fixed life company rates dip below three percent
Life insurance companies are widely known for providing the most competitive interest rates available in the marketplace, traditionally because they seek relatively low-risk lending opportunities; however, the interest rates offered by life insurance companies during the first weeks of 2020 are notably low. Long-term (more than 10 years) fixed-rate life insurance capital has officially dipped below 3% for conservative lending opportunities (those with loan to value of 50% or less) on quality assets.

Increased prepayment flexibility
Historically, permanent lenders that offer long-term fixed interest rates often required rigid equations for calculating prepayment penalties, so borrowers have become accustomed to a tradeoff whereby in exchange for securing long-term interest rate certainty, prepayment flexibility is sacrificed. In an effort to win business in 2020, the life insurance company market is offering some of the most flexible prepayment options yet. For example, a few life insurance companies have extended the “open windows” whereby a loan can be paid off without penalty at the end of the loan term to 24 months (whereas six- to 12-month “open” periods previously were considered generous). Additionally, a few life insurance companies are offering completely “open” prepayment terms from Day One of their loan terms in exchange for a 1% origination fee at closing. Another example of increased prepayment flexibility is a life insurance company that is offering a fixed 1% prepayment penalty beginning in the second year of a 10-year loan term (or beginning in the fifth year of a 15-year loan term).

Higher leverage “stretch senior” loans
It is hard enough for lenders to win quality business in 2020, but it is even harder to win lending opportunities on highly coveted property types such as multifamily and industrial. Accordingly, one of the ways life insurance companies are becoming more aggressive is by offering “stretch senior” loan programs, whereby they will lend at significantly higher LTV ratios compared to their historic comfort levels. (The life insurance company market is notorious for seeking 65% LTV or less.) Because these higher-leverage loans still are nonrecourse despite their added risk, life companies want to make sure borrowers have significant “skin in the game,” so they tend to be most aggressive in quoting stretch senior loans for acquisitions (compared to refinances) where no 1031 exchange dollars are being used. This is because they find comfort in “fresh cash” being invested ahead of the life insurance company’s loan. Through these stretch senior programs, life insurance companies are able to lend up to 75% LTV for industrial assets and 80% LTV for multifamily properties.

Balance sheet alternatives to commercial mortgage-backed security
In an effort to deploy more capital, and at slightly higher yields, numerous life insurance companies are investing money in discretionary funds that make commercial real estate loans (separate from the normal loan origination generated through their own in-house personnel). These discretionary funds lend on higher-risk opportunities relative to typical life insurance company lending standards while providing diversification to the participating life companies (since investment funds are pooled and invested across multiple transactions). These discretionary funds are valuable to borrowers because they provide a balance sheet alternative for loan requests with higher-risk profiles that might normally require mortgage-backed security lenders and at interest rates similar to that of typical life company lending. These loans remain on the balance sheet of the discretionary fund lender and the lender retains all major servicing decisions.

Life companies target transitional assets
Life insurance companies have been making nonrecourse bridge loans for transitional assets for several years now in an effort to generate yield premiums; however, they are becoming increasingly competitive in a few notable ways. First, for transitional assets in core locations, life insurance companies have started competing in the debt fund space, lending at significantly higher leverage than previously comfortable, but without the high interest rates required by debt funds. The overall result to borrowers is the availability of debt fund type leverage at life insurance company type pricing. More specifically, in some cases, life insurance companies now are lending up to 75% loan to cost (and up to 80% loan to cost for highly desired property types in core locations) with credit spreads ranging in the 200s over one-month Libor.

Fixed-rate bridge lending is another way life insurance companies are differentiating themselves. Historically, most bridge loans come with floating interest rates (one-month Libor is the usual index), and while borrowers are permitted to buy Libor caps in the bond market to hedge their interest rate risk, the process can be complex. Further, the near-term transition from Libor to the secured overnight financing rate has created uncertainty and discomfort in the market. Borrowers who secure fixed-rate financing eliminate both interest rate risk and the risk surrounding the transition from Libor to SOFR, and some life insurance companies have the ability to offer this alternative.

Overall, borrowers appear poised to be the major beneficiaries of 2020’s present lending environment, but the market has felt even more fluid than usual during the first part of the year. The availability of capital is remarkable, competition among lenders is fierce, and lending options have never been so flexible. Accordingly, borrowers should make sure to discuss their business plans with their capital advisers thoroughly to ensure they select financing options that best enhance their strategies, both near and long term.