By Erik Edwards, Nick Bertino, and Tony Petosa
For the past several years, the “talking heads” have been warning us about the coming rise in interest rates, pointing out that we are in the ninth year of economic recovery and that rates cannot remain near all-time lows forever. Some have also argued that any increase in rates will adversely impact real estate values, and that the real estate market is overheated and primed for a correction. But despite the dire warnings, interest rates have not increased substantially and, more importantly, real estate valuations have not reversed as a result of any rate increases experienced recently. In fact, values have continued to rise, and are at an all-time high according to a recent Moody’s report. While it is likely that the predictions of higher rates and lower real estate valuations will be vindicated at some point due to the cyclical nature of the real estate market, to date the prognosticators have been premature in their prophecies, and contrarians have profited.
Make no mistake, rates have crept up a bit over the past few years, and made a large jump after the 2016 Presidential election with Treasury rates increasing by as much as a full percentage point. Since then, however, yields on indices such as the 10-year U.S. Treasury Note have come back down. As of this writing, the 10-year Treasury is yielding 2.40%. While this is about 100 basis points higher than the all-time lows set in early 2012 and early 2016, it still on the low side of the median rate as measured over the course of the last decade. Furthermore, all-in interest rates (all-in rate = index + spread) remain near all-time lows, despite the increase in the Treasury yield.
How is this possible?
The all-in rate is the sum of the index yield, or rate (e.g. 10-year Treasury, LIBOR, etc.), plus the interest rate spread. The spread represents a measure of risk, and risk is generally correlated with market volatility. Today, market volatility is near an all-time low, which has allowed interest rate spreads to compress enough to nearly offset any increases attributable to indices such as the 10-year U.S. Treasury. This is why all-in rates today are similar to what they were in early 2012 and early 2016, and partially explains why increases in the indices have not manifested into a decline in commercial real estate asset valuations.
It may be difficult for many to imagine how volatility could be so low today with the headlines that cross our screens on a daily basis: “Potential Nuclear War on the Korean Peninsula”, “Russian Meddling in US 2016 Election”, “Trump’s Twitter Goes Rogue”, etc. While such headlines can create an uneasy environment regardless of your political affiliation, the financial markets often view things through a different lens, and much of the news today is being perceived by the market as positive. As one example, our nation’s unemployment rate is down to 4.1%, which would indicate that the job market is operating near maximum capacity. Additionally, President Trump recently appointed Jerome Powell to succeed Janet Yellen as Chair of the Federal Reserve, which eliminated a lot of uncertainty for lenders, business owners, and investors (Powell worked under Yellen so the market anticipates a “business-as-usual” approach). Finally, Trump’s push for deregulation of some hardline monetary and banking system policies, which have served to make markets safer, but have also restricted the flow of capital, has created some optimism in the financial markets.
What does this mean for the Manufactured Home Community (“MHC”) industry?
The MHC sector is a small microcosm of U.S. commercial real estate, and an even smaller microcosm of the overall national economy. However, the role of volatility in determining interest rates and asset values plays a critical part in determining the direction of the MHC sector. Just as investors may look at deregulation and low unemployment rates to determine market direction, so do lenders and investors look at critical data on MHCs to determine the strength and long-term sustainability of an investment.
Currently, volatility is low and lending activity is robust, in part, because loan delinquencies are low. MHCs registered just a 1.94% delinquency rate in September 2017, as measured by Trepp on Commercial Mortgage-Backed Securities (CMBS) loan pools, and Fannie Mae and Freddie Mac have not reported any loan defaults in their MHC lending portfolios. Additionally, MHCs performed better than any other asset class, including apartments, during the Great Recession. Lastly, Trepp also reported that MHC collateral in CMBS pools has showcased positive year-over-year NOI growth for all years since 2005, even when average NOIs were generally in decline across all property types through the economic downturn.
The metrics above have reinforced for lenders and investors alike that MHCs represent an excellent investment and a stable asset class. They perform well through economic expansion, provide low cost living through contraction periods, and, despite the push for more affordable housing, remain extremely supply constrained due to the lack of new MHC development. With this growing acceptance of the product type, more and more lenders continue to march into the MHC space. And with increased investment and competition, come more lending options, lower spreads, and higher values for MHC investors.
Today, MHC lenders are as active as ever. Fannie Mae and Freddie Mac collectively originated over $110 billion in multifamily loans and over $4 billion in MHCs loans in 2016. These numbers are expected to be on par or higher in 2017. Banks have also been aggressively pursuing MHC financing opportunities, but they often require a personal guarantee. Life Insurance Company (Lifeco) lending allocations have increased as well, though Lifecos tend to be more selective in the MHC lending space, focusing on larger transactions with institutional investors and high quality properties located in top tier markets. CMBS lending rebounded heavily in 2017 with worldwide issuance up over 34% to date from 2016 to 2017 and currently at $78.1billion. CMBS lenders are searching for opportunities to add MHCs to their loan pools given the strong metrics and demand from bond investors. They should continue to be a solid source of non-recourse debt for MHCs located in tertiary markets or with challenging stories.
Now, one must also consider the downside. There will always be ways the global markets and the MHC asset class could be adversely affected by world events, which can impact credit spreads and liquidity in the capital markets. Higher all-in interest rates could also put downward pressure on values or, at the very least, reduce the availability of high leverage due to minimum debt service coverage ratios required by most lenders. The Mortgage Bankers Association (MBA) is predicting that the 10-year Treasury will reach 2.70% in 2018, a nearly 30 basis point increase from where it is today. But, the MBA is also forecasting only moderate inflation in the coming years, which could translate into only moderate increases in treasury yields. All in all, if recent history is any indication of where rates and values will be in the next few years, we expect that a favorable lending environment for MHCs will continue for the foreseeable future.
Tony Petosa, Nick Bertino, and Erik Edwards of Wells Fargo Multifamily Capital specialize in providing financing for MHCs through Fannie Mae, Freddie Mac, conduit, and balance sheet lending programs. For more information or for a copy of their Manufactured Home Community Financing Handbook, please contact: Tony at (760) 438-2153 or email@example.com; Nick at (760)438-2692 or firstname.lastname@example.org; Erik at (760) 918-2875 or email@example.com; or visit www.wellsfargo.com/mhc.