The Shift in Concern as 2022 Comes to an End - Part 2
This is something of a follow-up piece to the one that I wrote two weeks ago titled the “Shift in Concern….” Today, the point is purely to relay what I’m seeing out in the market from lenders and investors, new themes in lending, and potential opportunities. How you link them together and use that information is up to you.
When you have a volatile debt market, the issues aren’t always the same across lenders. It depends on the type of lender, how they’re regulated, and how they get their funds to finance real estate transactions. Larger debt funds often have something called “warehouse lines” that finance deals. Banks have a number of sources of capital that often tie into treasury rates, whereas credit unions are sometimes purely off of deposits. Let’s go into a few examples on what we’re seeing.
Let's recap “warehouse lines” to start out. Investopedia defines it as, “A warehouse line of credit is provided to mortgage lenders by financial institutions. The lenders are dependent on the eventual sale of the mortgage loans to repay the financial institutions and make a profit.” Those deals that I’m typically working on are ground up construction, the mortgage lenders, are typically large multi billion dollar debt funds, and the financial institutions that those debt funds are working with are typically groups like Goldman Sachs, Morgan Stanley, JP Morgan, and other large banks. I mentioned the freezing up of the secondary market in the last piece I did. I worked on a deal with a debt fund where the warehouse line was being financed by a couple of groups similar to the ones I mentioned above. In the end, the financial institutions providing the warehouse line were pressuring the lender to provide more optimal terms (for the lender) to ensure the loan would have a more marketable sale after the deal closed. We were lucky that they only decreased our LTC by 5% and increased the rate by 50BPs. It could have been worse as the initial terms were exceptional and some lenders are having all of their warehouse lines pulled completely.
I spoke with a community bank the other day who was having a very common issue of where to price their new terms offered. What I mean by this is, ‘what rate could be attractive for the sponsor, and still allow the bank to make money in a turbulent market where rates are increasing rapidly?’ I personally think this takes a little more number crunching and scenario analysis, but the banks are already doing that. Their solution is telling developers and investors that they’ll only lock a rate for 3-4 weeks, which is about the time it takes to get an appraisal done. What that really means, is that in a world where it takes 45-60 days to close a loan, you better get any requested due diligence items in immediately after the lender asks for them. I’m supposed to close a deal next week where the buyer delayed getting their due diligence items completed/submitted for multiple weeks. The term sheet was offered with a 5-year term at the beginning of August. We blew right through the 60 day window the lender offered to lock the rate. Now, we’re over 100 basis points higher on a newly offered rate.
This last situation is a little more unique. I spoke with a credit union last week that was historically beating the competition in their offered terms. As most seasoned real estate investors know, credit unions can be a great source of capital, despite having some different rules. I’ve worked with quite a few, but I have a relationship with one located in the midwest that is always 50 basis points better than the next best offer for any stabilized multifamily deal. Their cost of funds is directly tied to their deposit base. With inflation and the cost of goods going up, their client and deposit base has dropped significantly. Even in a world where some banks are still seeing increased deposits from good employment and PPP, this particular credit union’s deposits have dropped. Now, they have to issue bonds through the Federal Home Loan Bank (FHLB) at 4.25% to finance real estate deals. With their overhead, they need to charge close to 7% for new deals. They went from being the best in the area to being the one of the least competitive in a volatile debt market.
The recap is, it depends on who the lender is, so ask us if you have questions. Just listen to some of the bank earnings calls from last month. Brian Moynihan at Bank of America is saying deposits are good, and things are looking good overall/not so bad right now. They might become bad, but right now, they’re doing well. Then you have Jamie Dimon, on the other side, telling everyone to brace for the imminent hurricane that will take us down a pike or two or three. He hasn’t really been too technical with his commentary, which I tend to want more of. But, he’s not painting a rosy picture.
Right now, we’re seeing a seller hangover in the market. A year ago, you had stabilized multifamily being sold in parts of Texas at 4 cap rates. Incredibly low. You had multifamily in Cleveland being sold in the 5s. Now, you still have sellers in the market trying to sell at those rates. Then you have a buyer going to a bank and saying they want to buy a $10mm building in Cleveland that has $550k in NOI. Unfortunately though, as I explained in the last piece, the debt service for a deal like that is much higher than it was a year ago. And with that, you may have been able to finance that building a year ago with $7.5mm in debt. But now, because of the increase in rates, that $550k in NOI won’t cover the debt service associated with $7.5mm in debt. It will only cover debt service in line with $6mm in debt. Now, the cash on cash yields and overall IRR for the deal, when you have to put down another $1.5mm in equity, is completely shot. In return, this brings down the overall value of the building. And because this happened so fast, you have a bunch of sellers that are not in tune to the reality of the situation and are telling their banks and sales brokers they don’t know what they’re talking about when in fact, it’s unfortunately the other way around.
So, What Now?
For many in the investing world right now, it’s pencils down. For ground up and value add deals, larger funds and developers can’t make the spread between their yield on cost (NOI/project cost) and their assumed exit cap rate make sense. And for that, it’s time to hang on and start looking for deals to cherry pick. Where are there deals to cherry pick? Check out the last piece I did and the section of “A new Concern…” This is where there may be potential to scoop up deals.
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