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Shifting demand, rising cap rates, some regulator risk

admin | November 30, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

New bank liquidity rules, modest risk for multifamily property valuations and a new director at the Federal Housing Finance Agency all look likely to shape the agency CMBS market next year. Banks hold the majority of the outstanding market, and their likely lower marginal appetite should have the biggest impact on spreads. Valuations present modest risks for supply and prepayments. A new director at FHFA could shrink the enterprise footprint. Agency CMBS should perform well relative to private CMBS, and conventional agency CMBS should do well against Ginnie Mae.

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New bank liquidity rules could weaken demand for agency CMBS

Since banks hold the majority of agency CMBS, the Fed’s recent proposal to loosen bank liquidity rules looks like a negative for spreads—especially for Ginnie Mae project loans. The Fed has proposed eliminating the liquidity coverage ratio (LCR) for banks between $50 billion and $250 billion in total assets and easing LCR rules for banks in the $250 billion to $700 billion range. A complete analysis of the impact of the rule changes is here. One takeaway is that the easing of requirements could materially reduce the need for banks to hold agency CMBS, which qualify as high quality liquid assets and help banks cover LCR requirements. This is especially true for full faith and credit instruments such as Ginnie Mae project loans. Much of the more than $250 billion in current bank holdings in agency CMBS sit in held-to-maturity portfolios, so it is unlikely that there will be significant liquidation of the positions. But banks affected by the proposed rules may be inclined to pull back on high quality liquid assets in favor of securities or loans with higher yield. Bank sponsorship of agency CMBS looks likely to soften. But wider spreads would likely draw interest from the sector’s second largest set of investors, money managers, cushioning the impact of any shift in bank demand.

Exhibit 1: Bank demand dominates the market

Source: Freddie Mac

Higher rates present a risk to property valuations

Low interest rates, tight spreads and a broad trend toward renting instead of owning has helped apartment building cap rates tighten steadily since 2009—even as rates on office and industrial properties over the last 18 months have softened. Multifamily may finally see higher cap rates in 2019. Higher interest rates could create some modest pressure next year, but the odds of a sharp rise in rates looks low. Even if rates drift higher next year, rising rents could buffer the impact on cap rates. Rates on single-family properties, a proxy for multifamily, have been rising between 3.5% and 4.0% since early 2017, a pace that would slow any rise in cap rates driven by interest rates alone. But the bigger issue is demand for multifamily housing. A rebound in US homeownership rates since 2016 has softened demand for multifamily housing, at least as reflected by declining multifamily permits and multifamily starts. That could soften rent growth broadly. More specifically, almost 25% of new construction has come in just five markets, according to Fannie Mae – Los Angeles, New York, Boston, San Francisco and Washington DC – which have above-average rent growth. It’s unclear whether these markets can absorb that much supply without rent rolls decelerating, which present a risk to property valuations. Weaker valuations would likely limit supply somewhat, but also lower voluntary prepayments.

Exhibit 2: A rebound in homeownership could help soften MF cap rates

Source: US Bureau of the Census via FRED

New FHFA director could shrink GSE footprint to attract private capital

Mel Watt, current director of the Federal Housing Finance Agency, leaves office in January and opens the door to changes in all related policy, including Fannie mae and Freddie Mac multifamily. Multifamily lending caps for 2018 and 2019 are $35 billion for each enterprise, down from $36.5 billion in 2017. The FHFA director bases the caps on projections for the overall size of the multifamily loan originations market. Excluded from the caps are loans in the affordable or underserved market segments, whose criteria are based the percentage of units with rents affordable to those at or below a stated percentage of the area median income. For example, in 2018 the FHFA added an extremely high cost market category, where units affordable to those at or below 120% of the AMI were eligible for exclusion from the cap on a pro-rata basis. This designation has been revised for 2019, with FHFA stating they have developed a data-driven approach to designate markets in which “units affordable to cost-burdened renters at certain area median income levels will be excluded from the multifamily cap on a pro-rata basis.” Additional details will be provided in the 2019 scorecard, which has yet to be released.

While the GSEs remain under conservatorship, the FHFA director has nearly unfettered power to restructure the business lines. There is considerable speculation that a new Trump-appointed director may endeavor to shrink the footprint of the GSEs. One direct method for shrinking the footprint of the GSEs in the multifamily space, and to encourage the participation of private capital, would be to work with HUD to revise the definition of allowable area median income (AMI), lower the caps on origination, or narrow the conditions for what can be excluded since most of the current origination falls outside of the caps.

Before the crisis the GSEs were bankrolling about a third of all multifamily loans. Their market share exploded to nearly 70% after the crisis, but drifted back down to 30% as private funding for apartments became more available. Under FHFA director Mel Watt, who began his tenure in 2014, the GSEs multifamily market share began growing rapidly again. In 2017 the GSEs financed a total of $140 billion in the multifamily space, roughly 53% of the total multifamily mortgage market, which was estimated at $264 billion by the Mortgage Bankers Association.

Probability that new issue supply shrinks due to some combination of higher rates, wider credit spreads and a new FHFA director: 80%. Probability that the reduction in supply is capable of offsetting lower bank demand, a marginal drag on property valuations and a broader re-pricing of credit: 30%.

 The trade: Overweight agency CMBS against private CMBS. Overweight conventional agency CMBS against Ginnie Mae project loans.