The players in the multifamily development financing space are mostly the same, but how their pros and cons work out in practice continues to change.
As the sources of multifamily development financing—debt and equity—jostle for business, their strategies and products continue to evolve. These shifts have allowed debt funds to become more prominent capital sources and life insurers to strengthen their share of the market. In the meantime, commercial banks remain the primary source of debt for new multifamily projects.
On the equity side, investors are more inclined to seek a preferred debt position in the capital stack than an equity slot. Meanwhile, falling interest rates, the mutable role of CMBS, Opportunity Zones and the London Interbank Offered Rate phaseout are changing the game for developers looking for financing.
When it comes to debt, commercial banks are recognized as the biggest source of financing for multifamily construction, according to Jay Maddox, principal with Avison Young in Los Angeles. Banks have returned to the main stage of multifamily development lending after pulling back three years ago due to overbuilding concerns. However, debt funds—such as Colony Capital and Square Mile Capital—are becoming more important as they offer more flexibility on terms and, typically, non-recourse loans, in response to which some banks have loosened their lending criteria.
In permanent financing, banks are also primary, along with Fannie Mae, Freddie Mac and the U.S. Department of Housing and Urban Development. Jeff Fastov, senior managing director at Square Mile Capital in New York, agrees with the hierarchy and outlines the fact that government-sponsored enterprises are not focusing on development currently.
In addition, “life insurance companies have become very aggressive” with respect to pricing and the result is that “a multifamily borrower has an increased selection of options now,” Maddox explained.
Alternative lenders like Square Mile, Fastov explains, focus more on the project itself: “We’re just making investments for funds.” The advantages of private players are the higher loan-to-value ratios and the shorter closing periods as opposed to traditional lenders, which thrive by fostering long-term relationships with borrowers.
Kyle McDonough, principal at Tower Capital in Phoenix, confirms that banks continue to prefer developers they already work with. Multifamily development is booming in metro Phoenix, and there’s lots of bank financing, but those banks “are laser-focused on the sponsor and their track record.”
The deal flow is so high that many banks have upped their minimum loan amounts, according to McDonough, who also emphasizes that banks still prefer recourse debt, though this typically burns down as stabilization hurdles—such as debt service coverage ratio thresholds—are met.
Fannie Mae and life insurers both focus on longer-term debt financing. “Fannie Mae’s competition with life insurers is mostly in the low-leverage space. Life insurers tend to focus on multifamily commitments with loan balances of $15 million or higher,” a Fannie Mae spokesperson told Multi-Housing News.
Unlike banks, some life companies offer a participating mortgage. McDonough cites as an example Principal Real Estate Investors’ participating construction permanent program, under which the company provides up to 85 percent of the capital stack for a multifamily or industrial property. The borrower receives at least 51 percent of the property’s cash flow, while retaining more control than in a typical joint venture structure.
In joint ventures and other preferred equity, the private equity funds are the big players. A typical multifamily development would see a joint venture with 65 percent debt and 35 percent developer and equity investor (about 80 to 90 percent from the latter). In a twist, however, through seeking to reduce their risk, many equity investors are leaning toward preferred debt positions instead, according to Maddox. Family offices and high-net-worth individuals are also active on the equity side.
THE CMBS BOOST
CMBS was a big factor in multifamily loans prior to the recession, but now, their pricing is “not competitive regarding most multifamily projects,” Maddox explained. Moreover, they generally present onerous documentation requirements.
However, CMBS activity in the sector is expected to pick up significantly in the last quarter of 2019 as GSEs have slowed down since August, because they started running out of their annual allocations earlier than expected, McDonough says.
The recent interest rate cuts got some attention from borrowers and lenders. Mike McRoberts, a managing director at PGIM, notes that as interest rates come down, it becomes easier to make a deal work, though overall, the economic situation is not especially sensitive to interest rates right now. As a consequence, banks are starting to use floor rates and executives in the business expect this trend to grow.
Opportunity Zones have not yet generated much momentum in the multifamily sector. Even though the industry recognizes the concept as necessary, given the shortage of affordable housing, there are still many questions that need to be answered. Underwriting is one aspect that is more problematic for OZ projects. McRoberts predicts that each specific zone will need one or more “stable anchors” in the form of a multifamily, office or retail project to get things rolling.
“We’re indifferent to them,” Fastov said, because Square Mile’s investors (such as pension funds and sovereign wealth funds) don’t pay taxes anyway. Fastov did express some concern that development decisions based on tax benefits tend to drive values up, and from a lender’s perspective, a higher loan per square foot increases volatility. “You’d rather have a lower loan per square foot, all other things being equal,” he cautioned.
Tower is working on an OZ multifamily project. “It’s extremely sponsorship focused,” McDonough added. Given the rules on OZs, “you’re going to be married to that person for 10 years,” he said.
The looming phaseout of the LIBOR index poses another complication for multifamily development financing. Many loans don’t have the language for alternative indexes, McRoberts points out. “The big institutions are taking this very seriously,” but smaller players could have problems because they’re not prepared.
“The goal is to mimic what LIBOR had done,” Fastov said, aiming to avoid basis risk. “The whole world is working to get this right.”
Though most borrowers are aware of the uncertainty around a LIBOR-indexed transition, many lenders and the GSEs continue to offer LIBOR-indexed multifamily lending products. “The recent flattening in the yield curve has appeared to have more of an impact in moving borrowers away from floating-rate executions [than concern about LIBOR has],” a Fannie Mae spokesperson told MHN.
As to the future, Fannie Mae reports that life insurers’ loan volumes are increasing slightly year-over-year. Fastov predicts that going forward, both debt funds and GSEs will be increasing their market shares.
McDonough expects that multifamily financing overall will remain plentiful. “Everybody’s trying to get it out the door.”