Texas capital markets recalibrate in fast-moving waters

Pictured is Radius at Shadow Creek, a 350-unit apartment community in Houston’s southern suburb of Pearland. Earlier this year, Berkadia provided an undisclosed amount of Fannie Mae financing to refinance a portfolio of Houston-area properties that included this one. The borrower was MLG Capital.

By Taylor Williams

The factors and parameters by which commercial lenders and investors underwrite, price and price assets are changing at breakneck speed, creating a capital markets landscape defined by volatility in the second half of the year.

Financial market professionals – as well as regular consumers – seem to agree that interest rate hikes are a necessary evil to avoid record inflation. consumer price index (CPI) rose 8.6% year-over-year in May, according to the latest data available at the time of writing. But a lack of clarity on the magnitude of these future rate hikes is making it increasingly difficult for commercial borrowers to accurately assess the risk in their transactions and project the cash flows of their properties.

The Federal Reserve’s decision to raise the federal funds rate by 75 basis points at its last meeting in June illustrates the impulsiveness and haste with which fiscal policy is crafted. Prior to the release of the May inflation report the previous week, investors had widely expected a
Hike 50 base points. Reports of an even more aggressive rate hike crystallized inflation fears and sent the stock market into a spiral, with the Dow Jones Industrial Average losing more than 1,000 points in 24 hours.

Meanwhile, another long-term investment vehicle and debt pricing instrument, the 10-year Treasury yield, is also showing unusual behavior. Historically, when investors think a recession is imminent, they flock to Treasuries for their risk-free rate of return.

In a near-normal environment, this flight to a safe haven would compress yields. But because the current price of Treasuries is so high due to inflation, yields are actually rising – the benchmark rate stood at 3.21% on June 28, up more than 150 basis points. basis compared to the beginning of the year. The increase in yield is necessary to cover the inflated purchase price of the bond.

In Texas at least, commercial real estate is supported by exceptional employment and population growth that has persisted through the most severe phases of the pandemic and the prolonged period of hyperinflation. But even the strongest asset classes, such as multifamily, are seeing price adjustments as macroeconomic turmoil descends on the worlds of lending and investing.

Underwriting Challenges

The net result of these frantic and unexpected shifts in key economic variables and indicators is, in a nutshell, uncertainty. And rather than trying to navigate what some industry professionals consider one of the toughest financial market environments in decades, some lenders and investors are adopting waiting patterns.

“Lenders are struggling to make underwriting deals accurately right now, especially in terms of exit cap rates,” said Tucker Knight, senior managing director of Berkadia’s Houston office. “This rising interest rate and inflationary environment doesn’t give them the level of comfort or the answers they need to write deals so they can get out of lending. When this happens, the market tends to crash.

“Lenders give loans without recourse and try to reduce them as much as possible, which complicates the equation,” he adds. “Each trade has different return metrics, holdings, exit strategies and metrics, but right now we have multi-family investors buying assets at cap rates below their interest rates assuming that the trajectory of rents will exceed their lending constant. If we really are in the early stages of a financial downturn, that’s a recipe for disaster, because rents aren’t going to keep going up like this, despite the demand for housing.

In Knight’s view, the mentality of the commercial lending community is herd-driven, which means that even among individual stores, the rumor of deals collapsing due to turbulent market conditions could have an effect. domino over the entire sector.

Much of this gun-shy mindset is attributable to lenders’ memories of the 2008 financial crisis, he says. At that time, liquidity evaporated very quickly from the commercial loan markets due to fears of a collapse in subprime mortgages in the single-family housing market – fears that turned out to be well-founded.

Yet many financial market professionals see little to no parallels between a potentially impending downturn and the Great Recession.

“This cycle is not like 2008, as we are emerging from a prolonged period of historically low interest rates, and markets are simply finding a new low,” said Dana Deason, president of Deason Financial Group, a mortgage lender based in Longview, Texas. “Rates were so low for so long that the markets went numb, and everything was working with such a low cost of capital.”

“It looks like we’re going to see further rate increases, so at some point values ​​have to change, and that’s what we should see happen,” Deason continues. “There is still liquidity in the market. Borrowers can still transact; they just have to accept a higher rate. But with the level of uncertainty we have, lenders are going to underwrite more cautiously, which means more fairness in deals, shorter amortizations and higher interest rates.

Deason has also seen examples of deals that constitute “negative leverage,” in which aggregate interest rates exceed closing cap rates. The expectation of sustained and exceptional rental growth is the key variable in this equation, and borrowers going this route are increasingly looking to debt markets for the leverage they need. .

“When you buy an asset and it doesn’t match a positive debt service coverage, you’re pulling out of some of the conventional funding markets,” Deason says. “Borrowers therefore have to put in more equity to obtain
traditional financing or go to the bridging financing market. They agree to a higher leverage deal and hope to be able to operate on their own with a positive return, then go get their long-term funding.

However, some borrowers, especially those who can afford it, such as institutional players, remain well away from this scenario.

“With the price of debt rising rapidly, institutional capital is looking to avoid negative leverage,” says Noam Franklin, managing director of Berkadia’s New York office and head of the private equity and capital group. structure of society. “We therefore expect to see some cap rate expansion, particularly in certain pockets of the country, and it will be important for sponsors to underwrite cautiously to attract institutional partners.”

“We believe that institutional capital will remain active in housing but will focus more than ever on the sponsor’s experience and track record in chosen markets, particularly for early joint ventures between a sponsor and capital,” adds- he.

Where is Texas

Positive net migration and corporate relocations regularly dominate headlines in the Lone Star State, ensuring that housing demand is unlikely to decline significantly just because the economy is overheating. As such, Franklin believes that institutional investors will not pull back significantly from major Texas markets, but rather shift their strategy to include a more balanced mix of trade profiles.

“Many sources of capital have expressed difficulty finding value-added multifamily offerings that meet their return expectations,” he says. “Many have decided to invest with a barbell approach – deploying funds in both core plus and opportunistic trades in the expectation that these investments will coalesce into value-added returns.”

“A lot of these capital sources are starting to get excited about the value-added space again as they find that sponsors can negotiate discounts and brokers are starting to award deals to groups that might have a lower bid but with certainty closing,” Franklin continues. “We believe institutional capital will continue to invest in the multi-family space, including value-added opportunities, knowing that many of the more aggressive buyers may need to pause as they assess whether they can raise capital. from their usual retail investor sources. ”

This logic behind this change is further supported by the fact that inflation and supply chain disruption have made new construction – the de facto alternative to investing in the existing housing product – beyond the exorbitant.

“Between rising construction costs and the latest rate increases, lending and offerings for new home products are going to struggle,” said Ray Landry, senior vice president of Houston-based Davis-Penn Mortgage. “So we could see acquisitions dip in the second half. Rate hikes and fiscal policy are the main culprits. Prices haven’t come down yet, and it’s still a seller’s market, but we expect that cap rates begin to rise and prices begin to fall.

As such, the overall volume of capital – whether debt or equity, foreign or domestic, private or institutional – flowing into Texas markets could decline in the months ahead. While that scenario has yet to materialize and Texas capital markets still have strong liquidity, the market mentality is moving in that direction, Knight said.

“We’re not currently in a recession or a limited capital market, but people are acting like both are happening,” he says. “There is still an abundance of capital, but it is much more diligent and regulated than 45 to 60 days ago. Everyone pays attention to detail in a much more punitive way now because they don’t want to get behind the eight ball if interest rates go up and values ​​continue to fall.

“Texas’ growth story confirms the exceptional amounts of debt and equity that have flowed into these markets,” he continues. “But we should see a reduction as we sift through uncertainty and the price correction. Capital will continue to flow into business-friendly states like Texas. But no doubt, but the overall level of uncertainty in pricing and underwriting is creating apprehension, and some groups will push the pause.

This article originally appeared in the July 2022 issue of Texas real estate business magazine.

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