MORTGAGE LENDING: DEBT MARKETS

APARTMENT FINANCE TODAY • OCTOBER 2007

Stalled Deals May Move Again Thanks to Fed Rate Cut

By Andre Shashaty and Liz Enochs

With signs of instability in the economy and capital markets continuing into September, some borrowers ended the summer “sitting on the sidelines, kind of in a stupor, trying to figure out what’s going on,” as one lender put it.

Mortgage interest rates were still reasonable for attractive deals in good markets, lenders said, but it had become much harder to find the aggressive underwriting and interestonly loans that had previously made even marginal deals and high-priced acquisitions feasible.

As a result, investors and sellers alike were scratching their heads about how to salvage deals that were no longer feasible without generous loan proceeds and the availability of 10-year “interest-only” loans (where you pay interest but do not amortize the principal loan balance).

Until subprime home mortgage woes sent the capital markets into turmoil this summer, loans were being sized based on the debt-service constants of 10-year interest-only loans, said Hollis Leon, executive vice president of ARCS Commercial Mortgage. “Now everyone is rethinking interest-only, and rethinking what level of debt coverage they will accept,” she added.

The new reality of mortgage financing threw property valuations into question, as lenders took a stricter view of loan-to-value (LTV) and debt coverage requirements. The change in debt financing terms may have closed the curtain on several years of steady decreases in capitalization rates, which measure the annual return on investment in a property. At press time, there was new data from Real Capital Analytics showing that cap rates were rising and that conversely, sales prices were declining.

Sellers went to market with apartment properties in “full force” in July, said Real Capital Analytics, with $8.2 billion in apartment properties placed on the market, the highest monthly total ever recorded by the firm.

“Sellers’ expectations did decline, as asking prices fell and cap rates rose slightly,” the New York-based research firm noted.

However, buyers were apparently more cautious than sellers anticipated, Real Capital Analytics added. In July, only about $3.9 billion in significant apartment sales closed, a 61 percent decline from the same month in 2006.

The firm noted that deal volume would probably remain sluggish until there was a clear sign that the “liquidity crunch” was easing.

The markets may have got the reassurance they needed on Sept. 18, when the Federal Reserve made a half-point reduction in the federal funds rate, a key benchmark for shortterm lending rates throughout the economy.

That brought the rate down to 4.75 percent, its lowest since the spring of 2006. The yield curve had become steeper, which means that long-term rates were higher than short-term rates, but lenders contacted by APARTMENT FINANCE TODAY felt the Fed’s action would probably lead to more softness in mortgage rates.

The Fed rate cut restores liquidity to the capital markets and signals to the market that the so-called credit crunch will soon pass, lenders told APARTMENT FINANCE TODAY.

The yield on the 10-year Treasury security was 4.53 percent at press time in September, up from recent lows but still well below its 2007 high of 5.3 percent in June.

However, the benchmark interest rates were only part of the story. Loan pricing was also affected by increased spreads as capital markets continued to react to the increase in foreclosures in the home mortgage market, and the troubles of major residential mortgage lenders.

What individual borrowers will pay for loans varied widely based on deal quality and the amount of loan proceeds requested as a percentage of project value (the LTV ratio).

Interest rates had not risen dramatically for solid deals with conservative underwriting, said R. Lee Harris of Cohen-Esrey Real Estate Services, Inc.

However, lenders said they were charging more for higher LTV loans.

At press time, Fannie Mae and Freddie Mac were pricing loans at 150 to 170 basis points over 10-year Treasury yields.

The ripple effect of the home mortgage problems was felt most strongly by the firms that originate loans for securitization through mortgagebacked securities. Wall Street mortgage conduits saw a big drop in their activity in the summer, after a very strong second quarter. At press time, conduits were quoting loans at 190 to 210 basis points above Treasuries.

What are lenders looking for?

“They want to see good debt coverage ratios, and if you are a bit more conservative on your projections, they like that. Don’t be trending income at ridiculous percentages. I think a bit more conservative financial model goes a long way with lenders right now—and they like to see a little bit more equity now,” said Harris.

Instead of 75 to 80 percent leverage or more, which was common in the past, many lenders are stopping at 70 to 75 percent, said Harris. “It’s not a huge change, but there has just been so much activity in the sale of properties at cap rates that just make no sense. So there are some lenders now saying, ‘If they want to buy these deals at 5.25 caps fine, we’re just going to build in a little bit more margin of safety.’”

That conservative trend was confirmed by Mark Ragsdale, senior vice president of originations at PNC MultiFamily Capital. “You’ve seen a bit of pullback on some of the more aggressive terms—things like doing loans at maximum debt levels without any impounds or replacement reserves and going five or 10 years interest-only on a 10-year deal,” he said. “Some of those more stretched deals you won’t see anymore.”

The problems Wall Street conduits had in selling their inventories of CMBS set the stage for a reversal in the battle for loan origination market share. In the second quarter, conduits did a brisk business, dominating the agency lenders, according to data from the Mortgage Bankers Association.

As the summer ended, the conduits’ problems gave Fannie and Freddie an opening to reclaim market share, and they were doing so aggressively, raising prices and tightening underwriting a bit, but not too much, lenders said. (For our story on Fannie Mae, see "Fannie Mae Filling the Void". For our coverage of the changing fortunes of the conduit lenders, see "Capital Crisis Hits Conduit Lenders".)

Several lenders reminded borrowers that the recent troubles make it more important to be careful to choose lenders who can be counted on to close their deals.

“A lot of lenders that were red-hot now aren’t even in business anymore, or they are on the sidelines,” said Keith Van Arsdale, a director at BMC Capital. “You have to be very careful who you work with on a loan, with a mortgage broker or lender. I would want to work with someone who has a great record of executions and who understands what’s going on in the market.”