Multifamily lending has been doing exceedingly well lately. A growing economy combined with a shortage of housing in many areas has created an increase in rents and a decrease in vacancies in most markets. The probability of default, as of April, is a mere 11 basis points. Despite the loss given default being up due to the higher loan-to-value (LTV) levels, the projected expected loss is still near a record low. In this article, we discuss pricing, return, a new potential risk in the market plus we highlight a great opportunity for banks.
It is no surprise that low delinquency rates and record low probabilities of defaults have driven pricing to all-time tight levels. It is common to see competitive long-term fixed rate loan pricing that is equivalent to Libor + 1.50%. The last time we saw pricing this low was back in early 2013 and in late 2006.
Many net interest margin-focused banks have stopped lending to multifamily altogether. This could be a mistake as the low expected loss rate allows for a risk-adjusted 19% return for many banks (see analytics below) given constant underwriting standards.
However, as we look ahead, there is a potential risk on the horizon. For starters, risk has increased during last year, when multifamily hit a ridiculously low five basis points of the probability of default. That said, the year-over-year movement is still within the normal range of volatility so, from a historic perspective, credit risk is still de minimis.
One aspect of the increased credit risk is the increasing trend in the market for more interest-only loans and loans with longer amortization. However, even with these looser underwriting standards, project loss rates are still in the 0.25% to 0.57% range.
Of course, loan pricing takes into account more than credit risk and one major difference today from the last time we saw pricing this low back in 2013 is that prepayment risk is dramatically down. Back then, rates were low and started to rise. That combination of influences caused prepayments to pick up so seeing to 20% to 25% prepayment speeds (i.e., 20% of the portfolio would repay early) on unprotected transactions were common. Now, much of the market is at lower note rates, and interest rates are rising at a faster pace. As a result, prepayment speeds have slowed to about 11% for unprotected deals and about 2% on transactions with yield maintenance.
The material risk ahead for banks lies ahead in that this above-average performance has been attracting capital and new projects. New projects are coming online at a record pace and stand substantially above 2009 levels (the peak of the last cycle). While absorption is elevated, completions still outstrip supply which has elevated vacancy rates (see below).
This could put sharp downward pressure on rents elevating risk in some markets. Oakland, CA, for example, is like many secondary markets where they have a record level of new construction coming online (some 6,000+ new units or about 15% of total rental units); in a tight time frame. This singular phenomenon is expected to drop rents by 10% to 12% in the area.
Despite increasing risk caused by new construction, almost all of the new supply is Class “A” space. Nationwide, there is very little new supply coming online for Class “B” and “C” quality apartment buildings. As a result, these properties have lower vacancy rates, lower leverage, and often better debt service coverage. This often makes this subclass a better risk for greater pricing. Where Class A space is being priced at an average of Libor + 2.12%, Class B, and C buildings are being financed at Libor + 2.35%. This creates a better risk-adjusted return (see calculation below) and positions banks more defensively in preparation for the next downturn.
Putting This Into Action
Banks need to be careful with multifamily going forward and not get lulled into a false sense of security. The asset class looks fantastic, but the amount of new supply coming online is concerning. Underwriters need to pay particular attention to new completions, permits, absorption, and rental rates in their area. Also, banks should consider placing more resources in financing Class B and C properties. Shifting to this profile will increase return, lower current risk and place banks in a better position for the next downturn.
Submitted by Chris Nichols on May 15, 2018