The Debt Market Today – Andrew Westling

The Debt Market Today – Andrew Westling Transcription:
Steven Pesavento 00:05
This is the Investor Mindset podcasts and I'm Steven Pesavento. For as long as I can remember, I've been obsessed with understanding how we can think better, how we can be better, and how we can do better. And each episode we explore lessons on motivation and mindset for the most successful real estate investors and entrepreneurs in the nation.

Welcome back to the investor mindset podcast. I'm your host, Steven Pesavento. And each week, we share mindset tips and real estate investing strategies to help you take your business and your investment portfolio to the next level. And today, I'm very excited. I've got a very special guest with us. Andrew Westling from Walker Dunlop in the studio with us today. How you doing today, Andrew?

Andrew Westling 00:52
I'm great. Thanks for having me, Steven, I'm really excited to be here.

Well, I'm excited to dive in with you. We had a great webinar about a month back where we were talking about the market and some of the impacts that are happening there. And I thought it would be really timely to have you on the show to really speak to our audience of 1000s and 1000s of passive investors who are unsure about what's going on in the market today. You know, we recently shared a short update about kind of what Von Finch sees going on in the market and kind of how we're reacting and changing some of our strategies. So I'm really interested to dive into the debt side and the equity side, as you're placing, you know, billions of dollars of debt and equity. And I'm sure you've got a lot of information that is from behind the scenes that, you know, we all need to know.

Absolutely. It's it's an interesting time. It's a fun time, and it's time for opportunity. And so I think just the excuse me, the overarching theme that I'd like to convey is that in when times are tumultuous, and there is volatility, it always means that there's opportunity. And it's also a great time for first time or less experienced investors typically to enter the marketplace. And so that's really exciting as I get to help more and more clients and you know, educate more and hopefully allow people to get in at a time where there's less barriers to entry. So there's always silver linings to, to even the most tumultuous times.

You know, this is one of the really important point people get scared during times of uncertainty. And absolutely, there's reason to have fear or question, that feeling that emotion can really help focus you in the right direction. However, there's a benefit that goes along with it. And we're gonna get into some of those benefits today. Tell us about kind of what the book of business at Walker Dunlop looks like, just so we can give a little bit of scale to the experience that that your firm has?

Sure. So we are a national commercial real estate finance and investment sales firm. In 2021, our total transaction volume was just over 68 billion with a B. We have 40 plus offices nationwide. Annually, we are Fannie Mae's largest partner for multifamily debt through that side of the agency. We're actually the number three largest investment sales broker in the country, and we only sell multifamily. And in 2020, we actually became the largest capital provider to the multifamily industry. We do finance all asset classes, but about 50% of our business is multifamily finance and investment sales. With the other asset classes making up the other half. We have about almost 120 billion of loans within our servicing portfolio. And that's a really great data point for us because we get to mined all of that data and create our own internal comps as we're underwriting deals. So that gives us a lot of proprietary intellectual property that we use when analyzing and making credit decisions. And we continue to grow. We have bullish hiring goals this year. And we continue to want to grow our our asset management and our fee based business side to make sure that we're a well rounded company, for our investors as we're a publicly traded company.

Yeah, well, absolutely. You guys are doing some really big things. And I think it's exciting for folks to be able to see and understand exactly what the market looks like today. So I'm really curious to hear from your perspective. What are you and what is Walker Dunlop seeing happening within the debt and equity market today? And how can we contrast that with what we were experiencing at the end of the year? Back in November and December? Yeah,

well, let's start there because November in December of 2021 And the entire industry in the economy really was firing on all cylinders. And it felt like pre pandemic tailwinds. And, you know, everyone was transacting, we had seen almost record transaction volume, especially for acquisitions. And so people were extremely bullish on on the market. And you know that as is typically the case, you know, recessions typically come out of nowhere. So no one saw Russia invading Ukraine, and no one saw the volatility that would spike in the oil markets and some of the other things that have spilled over into other asset classes. But what we've seen just across the board is a fairly material slowdown in acquisition volume. Although transaction volume remains fairly steady in the debt, capital markets being that people are still refinancing. And in most of that's due to a wave of maturities, that continues to come due from the favorable times that we've had over the last 10 plus years with 10 year loans maturing. But we are still seeing, and I say the markets a little bit bifurcated, because it depends who the ultimate buyer is, people are still buying. What I'm seeing, at least in our book of business, is that most of these are still syndicators. And they're still doing a good job of negotiating prices, and getting price discounts making deals pencil. Whereas some of the institutional equity players and family offices seem to be taking a little bit more of a slower approach, and even a pencils down approach, waiting to see where things might shake out in hoping almost that we haven't hit maybe the bottom yet, of what could be a little bit of a further pullback in prices, or an increase in cap rates potentially.

And you've even seen that change itself, you've even seen that change happen even since last month, when we spoke, you're now seeing some of those, you know, institutional and family offices pulling back and questioning, you know, is there going to be more in this market, you know, more discount for us to be able to find, yeah, and

it's interesting, because it also feels like it's asset specific bifurcated. And there's so much capital that's pouring into multifamily and industrial specifically. And this has been ongoing now for, you know, five plus years that these two asset classes seem to have just really won favor from both institutional equity and retail investors that want to be a part of it. And so what we're seeing is people are still buying those types of properties, even at negative leverage, meaning that their cap rate is typically below the cost of their debt, which makes it a little bit more of a riskier transaction. But what that tells me is, they still see those asset classes as less risky than the rest of the real estate industry. So things like Office, parts of the retail sector hospitality. And even within those, those alternative asset classes, you know, there are winners, and there are losers. And so, you know, it's hard to make a broad general statement about the market today, because it's so differentiated depending on where you're investing on either asset class or geography.

Yeah, and let's touch on that negative leverage. So that essentially what that means is that someone's buying a property with a cap rate that is lower than the debt that they're putting on the property. And so there is only a few instances where that's going to make sense. One is if you have really no other option, and you need to put your money somewhere and you think it's going to be more secure there, or to your you find a property that you believe is going to have more value that you can create out of that property by adding you know, additional revenue or somehow saving on expenses, that is then actually going to put that in a different position in the future. You know, it's very different, you know, markets and market. We're talking on August 3 of 2020. To talk to me about what you're seeing in general in the multifamily market. From a rates perspective, where's that ranging? How is that different between C class properties versus A class properties? And how was that different in different regions? Because I know, you know, obviously, you're based out of the LA office, but I'm sure you're getting information on daily or weekly updates, you know, from offices across the country.

Yeah. So what we're really seeing is, and maybe maybe I'll start by just giving a quick overview of the spectrum of the debt, capital markets that are playing in the space. So on one side, we have the bank lenders, right banks and credit unions that are typical, more regional and local to the areas where they're lending in. There are national banks, but they've really pulled back a fair amount. In the middle you have your life companies, your life insurance companies that are matching assets to liabilities and they're making loans Some commercial real estate typically at lower leverage trophy assets, really high mark high end marketplaces where they want to park long term fixed rate capital and match that to their policy premiums that are coming in on the other side. And then on the on the sort of far end of the spectrum, you have the debt funds and the securitized lenders, who are really placing capital but short term and ultimately securitizing them into bonds for ultimately bondholders to go out and buy, as opposed to someone holding the actual real estate. And we've seen schisms in parts of the market, specifically on the securitized lending side, as rates have gone up in the cost to borrow has increased the cost for those lenders who are operating off warehouse lines of credit and making loans off of loans. It's become a really tight and almost non profitable business for some. And so we've actually seen some exit the market or stopped originating deals of late, which is really interesting. Because over the last, especially the last 18 months, that has been a huge sector of debt capital for multifamily finance, especially for value add, property and business plans. So what we're seeing now is the banks who are sitting on a ton of reserves and deposits, partly fueled by all of the stimulus that has been going on over the last couple of years through the pandemic. But they've really stepped up and become a major player, I think more so than a lot of us even thought they would be, but they're still getting deals done. Now, granted, it's probably lower leverage than what we've been used to over the last 12 to 24 months. But they've been a really nice stop gap in that side of the market for the value added transactions on the permanent side. Of course, the agencies are still rolling, so you have Fannie Mae and Freddie Mac. Again, their leverage is a little bit lower than historically, as we've seen. But I think this is a great opportunity for them actually, to step up and fill a little bit of a gap in the market that's been closed by some of the other lenders who have pulled back lately. So it'll be interesting, you know, they have a, they each have a cap on an annual limit where they can lend, I believe it's 78 billion for 2022. And there's, you know, now that we're more than halfway through the year, I haven't seen the scorecard. But I'd imagine that they're probably around 55 ish percent of the way to that cap. And this next, you know, three, four months could be a really interesting time to see the agencies shine and win a lot of business away from some of the more competitive banks in the life companies have been doing a lot recently in the space.

So really, to summarize, what you're saying here is that you're seeing many, many banks and capital providers on the debt side are actually pulling back, they're pulling out of the market, it's not making economic sense for them, because of where they're getting their capital of that be from Warehouse lines, or whatever that source might be. But we're seeing some other banks that are actually stepping up, getting deals done kind of filling that gap. And there's an opportunity for agency to be stepping in what I'm also hearing, and what we've been seeing ourselves is that leverage has been greatly reduced. And so people's ability to get a high leverage 70, maybe even 75% loan to value loan, which was quite typical for the last 24 months is nearly not being done at all. We have seen a few we have a product that, you know, one project that we're closing here shortly that we do have a 75% LTV on but it is extremely rare. And what I'm curious is how is that, from your perspective impacting the market? From a buy and a sell side? Yeah.

So I think what we're seeing it, we're seeing it on the cap rate. And what's interesting is, you know, we're really not yet seeing cap rate inflation in where we thought we might, because people are still buying multifamily, and especially in the most desirable markets, people are still funneling a lot of capital, and they're willing to put more equity into those markets because they feel safe there. What I think, you know, looking at the market as a whole specifically for multifamily, and I'll put you know, we do a lot of manufactured home communities and student housing and senior housing as well. So it's all sort of amalgamated. But what we've seen over the last three to five years is almost a homogenization of cap rates across multifamily. You could have a brand new construction a plus property in Santa Monica. Here in Southern California, and that would trade at right around a four cap. And you could have a old, much older vintage 60s 70s, two story garden style project with a lot of deferred maintenance, call it work workforce housing and the outside of Las Vegas. And that was also trading at a forecast. And, you know, we saw this with manufactured home communities. You know, seven years ago, they were trading at 10 and 12 caps, because no one really understood the castle and the value that they were driving. And now the secret's out, and they're trading at four caps. And so when I think we might see and this is a personal opinion, but I think we might actually finally see some of the lower quality assets. Normalizing back to the mean. And what I mean by that is, I don't think a and b, multifamily in solid markets, I don't think those cap rates are moving very much, they're so desirable, they're considered almost, you know, a risk free investment for a lot of people compared to the rest of the market today, that people are always going to buy them, and they're going to want to put more equity into those and accept lower debt. But what I think we'll see is more delinquencies in C class properties and workforce housing. And that might drive prices a little bit higher, or certainly lower than then we've seen in the past. And actually, we get some, you know, some differentiation between A, B, and C and workforce housing properties. And so we haven't seen that yet. But if we really are hitting and going towards a recession, that might be something to keep your eye on, and also an opportunity where there might be some distress to pick up an asset that has a value add business plan that you could implement as an operator.

Yeah, we're we're definitely seeing that in the deals that we're taking a look at it, as we you know, discussed previously, we're in the midst of putting together a private equity fund, we see a big opportunity to kind of fill that gap on assets. And what we're noticing is that some of the assets that are in the most need of that capital of that bridge capital to really be able to fill out the capital stack are those properties that are on the lower income scale, older vintage. And these are the exact properties that we're looking to avoid during this time, because there's a lot of uncertainty, folks who are in the lower income bracket are being hit a lot harder than those who are in the higher income bracket, we're not seeing almost any distress at any of our properties that are, you know, b plus or higher. But at some of the properties that are in areas with lower income tenants, it is becoming more difficult, it's just taking more effort than it was before to find the right tenants who can have that ability to pay. And that is likely only going to increase. And so what that does is it creates a great opportunity, if that happens to be your specialty, to go into those areas and clean up those types of properties. But it's also going to be an opportunity to be able to find the right type of assets that you believe are going to stay strong during any type of economic change.

Yeah. We talked about this on our on our podcast a month ago. And I think I think I made this claim, but you know, it wouldn't surprise me to see cap rates actually come in, in certain markets and uncertain assets. Because the demand is so high. And actually, you know, interest rates have done a really interesting thing here. Everyone says, oh, woe is me, I can't borrow 75% on my multifamily anymore, I can only get 65. But on the flip side of that what they're not talking about is that their renter pool has greatly increased and improved, because there are a lot of people who were going to buy a house at 3% mortgage rates. And now that we're at 5% 30 year residential mortgage rates, all of those people are extremely qualified renters who are going to continue renting for at least, you know, however many years and so I think the demand will be there for rental housing. I think we've talked about this many times, Stephen, that just the overall supply and demand nationally is still the fundamentals are good for multifamily. And for rental housing in general. Obviously, you have to look Market to Market for oversupply, concerns and building concerns. The the cost to build and the barriers to build have been inflated by the pandemic and with inflation. So I think less building will continue to happen, meaning there will not as much supply coming online. And so if you're in a market that has a housing shortage, which is most of the top 25 Major MSA is across this country. You now actually have have more people qualified to rent your A and B class properties and maybe even your C class properties for a number of years to come. And so there's there's a benefit there and a tailwind. And I don't think we expected, even going into the pandemic.

And and back to what we were talking about earlier. I'm curious, are you seeing any pullback on leverage in any specific markets? Are you seeing lenders have any reservations over any markets that have been overheated, or that there might be some concern of some reduction in value in the future?

Nothing yet, and can speak for the agencies, because they continue their mission has always been to finance and provide affordable housing nationally. And so they're really their their objective is to go into places that may not be receiving some of the attentions from the banks and other lenders to ensure that there's liquidity in those markets. I have not seen it yet. I think what we're seeing just in general, though, is that lenders are sticking to what they know, they're kind of going back to basics. And if they're in Southern California, and they had been venturing outside or into Northern California for to follow their clients a bit, that they're really sticking to their footprint again, and that they want to do business in their backyard where they can touch hold and, and feel what they're investing in what they're lending against, from a collateral standpoint. So nothing specific as of yet. But again, I think we're in the early stages, so it's yet to come, I think smaller markets are going to feel it. I think there's opportunity, but again, you're gonna have to bring more equity capital, to convince a lender to take that additional risk.

So you're thinking those primary those tier one, tier two markets are going to be the the focal point for many of these lenders, therefore, saying, hey, there's less risk, there's more certainty by going to these tier one, tier two markets. Tier one market would be like an LA New York, Chicago to your to market would be like a Denver, Dallas, Phoenix, something like this. What, from your perspective? on the sales side of it? What are you seeing, as far as changes in the amount of transactions that are happening or the valuation of those individual transactions? You mentioned that deals are still getting done? We're seeing that people are having to bring more leverage. But how is that impacting the actual sales value right now? Or is there an anticipation that that's going to happen in the future? Yeah.

I mean, we saw this starting about 90 days ago. And it started with deals that were under contract, that as rates were moving against the buyers and the borrowers, they were realizing that their leverage just wasn't what they thought it was when they put the deal under contract. And so they began asking for price discounts, and they began getting them. And I think what we've seen now is, with fewer institutional buyers playing, there are just fewer bidders out there. And so what used to garner 40, best and final bids, might be getting a dozen, or half a dozen today. And the qualifying factors of those are going to they're going to be much wider, whereas everyone used to be sort of right on top of each other. And it was just highest price wins with the most amount of hard, hard money down day one, I think you're starting to see buyers, flex their muscles a little bit and use a little bit of leverage and saying, Look, we know that the buyer pools a little bit more thin right now. So we're not, we're not going to negotiate, negotiate against ourselves, and they're coming in just at lower price points, lower hard money deposits down, maybe longer escrows more contingencies if they can get them. And listen, I still think ultimately, it's a seller's market. But it's an opportunity for buyers to maybe get a little bit of a break compared to what we've seen, especially over the last three to five years.

Yeah, that makes a lot of sense. I mean, as rates go up and and leverage goes down, the returns that investors are going to have to expect moving forward are going to be reduced. What what we've been seeing is that the exact same deal that may have produced a Proform of 17% IRR over five years might be a 14 or 15. And the real that's just the reality that we're in and and it may move further down depending on how high those rates go. There's still a strong argument about why to continue to own and buy multifamily real estate, commercial real estate and what makes sense there. But with that, you know your risk versus reward goes away and it starts making a lot more sense to start looking about what options are available in the market, where I can get a pretty darn good return where I get most of the return I normally get, while taking much less risk. What are you seeing

are some of those opportunities? Before we get into that, just to piggyback on that point, you know, one thing that we've been accustomed to over the last couple of years specifically, is short term holds. And the the easy exit, right, that quick flip, do a business plan. I mean, we have clients who are buying 200 unit apartment buildings, turning 50 to 75 of the units, not even making it, you know, halfway through their business plan, putting it on the market, because you know, someone's telling them, they'll pay almost double what they paid for it 18 months earlier, and they're leaving on a 2x Multiple and returning all the capital or investors, I mean, the market dynamics have just changed. As an investor myself, and as someone who's underwriting deals, I don't think that exists anymore. And I don't think we should be expecting it as investors. And so I think what we need to be doing instead is looking at assets as potential long term holds, I understand that there could be opportunities to sell in 357 years, but you want to, in my opinion, I think you should be looking at in place cash flow, today's leverage, make sure that you're okay in the event that you do need to refinance. Quicker than then you might imagine. But really looking at things with a with a little bit of a harder magnifying glass, to make sure that you can stay in this deal long term, even if things get bumpy. So no matter what the market is, in three years, you're not having to exit and you don't have a gun to your head to either refinance, or put it on the market and take a bath. So I think as you put, you know, investors need to learn to to expect lower returns, part of that is it could be a longer duration, right? It could be, you know, similar annual cash on cash, but you're getting it over a longer duration. So your IRR is not as high. So there's some tweaks, I think, just to the psyche of the investor, that that we need to be expressing and make sure that people are on board with but part of it starts with underwriting deals in a little bit more of a conservative manner and not anticipating certain rent growth potentially. And also just not that quick exit.

For so long, people have been saying they've been underwriting things quite conservatively, but with very, very high growth. And in today's market to be conservative, you really have to pull back dramatically on their growth. From your perspective, what are you seeing that that growth looks like over the next the near term and and over the long term?

So I think it's a, it's all in multifamily. It's difficult because it's so market specific. And again, we have a lot of data points, we track rent growth in every market that we have alone, we track expense growth, we track noi growth, and then we do sort of average and cumulative cap rate, compression and increasing. rent growth will be ultimately the dictator of, in my opinion, a good investment versus a poor investment over the next 24 to 36 months, there are certain markets, I think that will outpace inflation. And if they do that you have a winner on your hands. And if you're in a place that's more of a sort of a stagnating or a stabilized or mature market, inflation is going to eat away at your cash flow, ultimately, but it's what you want. I think cash flow carries the day for a lot of investors through tough times. And of course, appreciation is the cherry on top. But the trade off today, you might be able to get a slight discount on a property in a tier one market that's going to appreciate over the long term in exchange for giving up some of that cash flow short term.

Yeah, well, this has been really great diving in with you. What would you want to leave the listeners with when it comes to the market that we're currently in? Now? While you think about the answer there, I just want to leave a little bit of a reminder that everything we're talking about is a point in time. So I guess third, we're talking the Fed just raise 75 basis points. If you listen to this next week, we may have completely different views on what's going on in the market. But from your perspective, right now, Andrew and all the data that you guys are looking at, what what would you want to leave investors with as they think about what type of investments are going to be the right fit for them and choosing to place their capital into those right assets?

Yeah, just a couple of things. You know, one is really do your due diligence, right? No one's going to do it for you. So make sure that you're reading all the fine print. Knowing who the operator is looking at experience and experience really matters. This is the first really rocky period we've had in almost a decade. And so if you're investing with operators who have done well over the last three years since inception, that's wonderful, but you don't really know how they're going to handle turmoil. And so knowing and looking at long term performance and partnering with operators, who have been through cycles and understand and can carry through with cash flow and low leverage is really going to make a big difference in this market. Secondly, I'll say is that transactions are still getting done. We're very bullish on multifamily and other sectors of commercial real estate as a firm. And as an individual as an investor I am. There's tons of debt capital out there, even though it is pulling back slightly in leverage. I think it's, you know, ultimately, for the best. Again, we're trying to curb inflation as an economy. And so anything that we can do to get there to help everyone, ultimately, will, will help this market. And especially if we can garner enough steam into a soft landing, as opposed to hitting a full on recession where we see a lot more pain, that would be a good thing for everybody. And lastly, you know, don't be afraid. Just because things are your stock market is volatile, Kryptos volatile. Real estate is a long term play. And even if you're not transacting right now, it doesn't hurt to be out in the market, talking to people, educating yourself, underwriting deals, and tracking, keeping a finger on the pulse. You want to be ready to transact at at a moment's notice. Because this is the type of market where opportunities arise. And you can take advantage of potentially someone else's fear or panic. And so stay motivated. Keep keep keep your head in the game and and make sure that you have a team built around you that's ready to move and be nimble as soon as something comes across your plate. That looks good.

Absolutely, I couldn't agree more I, I echo the same sentiment, there's a lot of opportunity in the market. Now. There'll be a lot of opportunity in market tomorrow. You know, the way that these things go is that when things get bad, many people turn and run. And for those who end up finding a different path or the people who end up making above average returns. So we're going to be out there doing the hard work. Andrew is out there doing the hard work. And I hope that you guys will step out of a place of fear and into a place of faith, but only after doing your due diligence and really diving in and really understanding what's happening. And that's exactly why we're here to share some information with you and help you feel a little bit more comfortable by getting up to speed on what's going on. Thanks so much for joining us, Andrew. I really appreciate you coming on today will have to have you on again in the future to share an update on where the debt market goes in the next couple of months.

Thank you Steven pleasures all mine

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The Debt Market Today – Andrew Westling

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