Constrained Credit Slows Market
Posted: Jul 08, 2008
Last year at this time, the first signs of problems in the investment market were evident. An investor had placed a property under letter of intent and was getting an early start on his due diligence while the purchase agreement was being drafted. He figured he had 10-12 basis points of wiggle room if interest rates moved against him. During the following three weeks the 10 year Treasury moved 40+ bps and loan spreads increased by another 10 bps. The deal was doomed. He was not alone.
Despite the upheavals that began a year ago, there were $513 billion of institutional sales transacted in the U. S. last year, per Real Capital Analytics. Through May of this year, $56.5 billion of deals have been completed. The second half of the year ought to be better, but it is only a gut feel. So what is going on?
The biggest contributor is the near extinction of the commercial mortgage backed securities market (CMBS). This accounted for over half of the debt placement in 2007. Today, Moody’s is predicting $35 billion of CMBS issuance for 2008 versus the $230 billion done in 2007. Life insurance companies are filling in a small portion of the void, but they are cherry-picking the best deals. Banks are also lending more, but are being cautious as bank regulators are heavily scrutinizing commercial real estate loan portfolios. While the percentage of problem loans is very low (.35% for CMBS as of 3/08 and .01% for life companies as of YE 2007), it is likely to rise and that is also causing some anxiety about new lending.
The loans that are being made are conservatively underwritten on today’s cash flow. Debt service coverage trumps loan to value for many lenders, with no credit for the potential owner from vacant space. Debt coverage ratios have increased and loan-to-values have decreased. Also, very few interest only deals are getting done. The result, more equity is required.
Another contributor is the “denominator effect” occurring at life companies and pension funds. Say a pension fund allocates 8% of its funds to real estate investments and the rest goes into stocks and bonds. Then stock and bond values tumble, and real estate stays the same. All of a sudden, the percentage of the investment portfolio in real estate becomes, say, 10%. Now the pension fund is over allocated in real estate, resulting in no new or net new investing in real estate until the allocations get back into balance.
A key factor holding back sales is the bid-ask gap. Leveraged buyers that are still in the game want positive leverage, including loan amortization, a concept that got lost on many in the over-exuberance of easy debt. For investors to get the returns they need, cap rates need to rise. Investors who shoot for a targeted IRR are being conservative with their assumptions, resulting in lower priced offers. However, sellers are reluctant to lower their asking prices. History shows us that it usually takes 6-12 months for sellers to adjust their thinking to a new reality. The sales that are getting done are at higher capitalization rates. Core property cap rates are up 25 – 60 bps and value-add property cap rates are up 75 – 125 bps from a year ago. Apartments are the darling of the property types and cap rates are only up 25bps. Retail is at the high end of the range. Sellers will tend to hold their pricing if they are able to raise rents, which is occurring in apartments and the better office markets.
Historically, income property cap rates were 400+ bps over the 10 year Treasury. In 2003 that spread began to narrow all the way down to about 150 over by mid 2006, with apartments below 100 over. Today the spread is around 300 over, varying from 250 for apartments to 350 for retail.
Another hurdle is that deals are taking longer to get to closing. A year ago a typical transaction had a 30 day due diligence period and 30 days to close. Now a 45 day due diligence period is more typical with up to 60 days to close, or when the lender is ready.
2nd Half Outlook:
• The 10 year Treasury is going to increase due to inflation pressures, which will
increase capitalization rates. This is going to be bigger than most real estate
owners want to think about, particularly in 2009.
• The Federal Reserve will have to start fighting inflation late in the year by raising
short term interest rates. We will probably be in a stagflation period by 2009.
• Fannie Mae and Freddie Mac have been increasing their loan spreads and will
likely continue to, as they are the best apartment lender by far today.
• Rising unemployment historically has reduced apartment demand and it is rising .
• The for-sale housing market, while separate from commercial real estate, is
going to be in the bottom of the trough through 2009. Higher home mortgage
rates, combined with already tightened underwriting are going to further delay
that recovery.
• The CMBS market will crawl back into the game in a small way, making selective
deals. Look for loan spreads to shrink only a little.
• Value growth will lag rent growth
• Retail properties are going to see the largest value declines due to failing
retailers and slower new store expansion. Risk – return pricing will return to
retail real estate pricing. Cap rates for weak credit tenants are going to rise the
fastest. Sellers are going to have to prove viability by showing their tenant
sales histories to prove their centers’ worth.
Recommendations:
• If you are buying or are an owner who can refinance, do so as soon as you can
and lock in for the long term. Inflation is running very high when all factors are
added in. Long term interest rates are going to rise and perhaps dramatically so.
Currently the 10 year Treasury is well below historical averages (See chart).
• Reposition your portfolio by moving (selling) out of second and third tier cities
and weak assets. You may not get your price, but in one to two years you will
be happy you sold.
• Accumulate cash. Be patient for the type of investment you want. Have your
banker prepared to finance you ahead of time. Move assertively when your
deal surfaces.
Written by Mark Reiling CRE SIOR.
