Discover the Market Factors That Really Are Influencing Today’s
Much of the real estate finance industry operates on dogma,
most of which is grounded in sound theory about the factors that drive
commercial real estate markets and risk pricing. During the past 15 years there
have been significant advances in methods for assessing and quantifying risk,
which contribute to more disciplined debt and equity investors.
However, many of the risk models and decisions taking place in commercial
real estate today are based on assumptions that are questionable. Understanding
the reality behind some of these myths is important when making commercial real
estate financing decisions.
Myth No. 1
Real estate equity currently is a safe haven for investors. In the long term,
well-located real estate is a solid investment. However, the short and
intermediate outlooks are somewhat more clouded. The idea that today’s
valuations will be maintained is a risky proposition. Since 1993 real estate
values in this country have performed well in most markets due to a confluence
of factors that have made real estate a favorable asset class. This long bull
market must end at some point.
For instance, if a property owner places two advertisements for the same
property — one for lease and the other for sale — there might be a deluge of
interested buyers, but far fewer potential tenants. Something is wrong with this
phenomenon, since investors buy real estate for its long-term cash flow
potential. If interest rates rise, values will decline, with much of the
downward pressure being caused by floating rate loans that cannot be refinanced
or cannot carry their debt service. And, inevitably, capitalization rates will
rise back to historical levels.
Myth No. 2
Spreads on commercial mortgages are too low. Many commercial mortgage debt
investors are complaining that they are not being fairly compensated for risk.
But this is only partially true. Investors that receive 90 basis points over
U.S. Treasuries for a truly conservative mortgage are being fairly compensated,
since many of those loans have an extremely low probability of ever defaulting.
In actuality, 90 basis points is a fair yield as it is a 22 percent yield
increase over a 4.1 percent treasury. When bonds were 8.82 percent on average in
1988 and low leverage spreads were at 90 basis points, the reward for investing
in a mortgage was a 10.2 percent premium over the risk-free rate. Note that 80
percent loan-to-value loans were between Treasury plus 175 and 200 basis points
in 1988; now they are Treasury plus 110 to 140 basis points for most
Complaints regarding spreads for highly leveraged loans, where debt investors
are attempting to get an additional 30 or 40 basis points of yield, are
justified. In these instances, the lender is taking on an inordinate amount of
risk for the incremental yield offered in today’s market.
Myth No. 3
Mortgage debt is a solid investment right now. While lower leverage loans are
just fine in the current market, higher leverage mortgages are mispricing risk.
A commonly used term these days is debt cap rate, which generally refers to the
mortgage amount as a function of the cash flow. Often times the debt cap rate
reflects a loan amount that is more than the property would have sold for a few
years ago. In many cases, traditional lending tenets are being tossed aside.
Experts know that studying real estate markets history is a poor way to
predict future performance.
Subordination levels are in sharp contrast compared to levels a few years
ago. Commercial mortgage-backed securities originators are touting the new
“super senior structures” of their issues. This structure carves out a junior
piece of AAA bonds backed by mortgages that are subordinate to the rest of the
AAA tranches. In theory, the balance of the AAA’s is safer. However, this
thinking would be sound if AAA’s didn’t continue to take a growing share of the
entire mortgage pool; all this does is recover some of the ground lost by
more-lenient subordination levels. The rating agencies and many bond buyers are
confusing theory with reality, causing errors in judgment.
Myth No. 4
Liquidity will continue to exist. Many investors wrongly assume that capital,
both debt and equity, will continue to be consistently available. More typical
credit cycles have longer periods where liquidity is scarce, such as the cycle
that occurred between 1990 and 1993.
Real estate fundamentals are stronger now than in 1988-1989, which greatly
reduces the chance of a near-term liquidity squeeze. It is likely, however, that
in a few years there will be a lower supply of available credit, especially for
leveraged transactions. Refinance risk for loans originated now is higher than
at any time since 1986-1989. This is true for leveraged fixed rates as well as
interest-only floating rates.
Collateralized debt obligations, or CDOs, which have continued their
transformation into a core asset class in the fixed-income markets, currently
incorporate pooled B financing pieces from CMBS into their offerings. CDOs are
complex securities, even for bond investors, as they contain numerous types of
credits including home equities, corporate credits, and high-yield loans. Since
CMBS B pieces comprised only 6.98 percent of total 2004 collateralized debt
issuances, it is possible that the risk inherent in B pieces is not fully
There is a trend towards dedicated real estate CDOs comprised of aggregated
subordinate debt and mezzanine investments. The idea that pools of unrated
securities can have investment-grade tranches seems counterintuitive despite the
fact that diversification of the pooled B pieces somewhat neutralizes their
risk. Many of the buyers of B pieces are now less concerned about risk so long
as they can transfer it to collateralized debt buyers. If B piece liquidity
through collateralized debt originations diminishes, then leveraged loan supply
will follow suit.
Myth No. 5
All conduits are the same. Many investors believe that all conduit financing
is similar in price and structure, but this is not true. In case you haven’t
noticed, conduits are staffed by people, and so are the rating agencies and bond
buyers. This means that anyone originating or selling mortgages has their own
subset of experiences from which to draw upon. There are startling differences
between securitized lenders in how risk is viewed, structured, and priced. One
needs to truly understand what is happening with numerous players in this market
to achieve efficient execution.
Myth No. 6
Interest rates must rise soon. This is not as certain as some people seem to
think. A popular belief among economists and others is that we have been living
off the dole of the Federal Reserve Board for too long. The U.S. economy has yet
to establish the kind of job growth that drives gross domestic product to levels
that cause the Fed to raise rates dramatically. Hurricane Katrina may also have
an impact on federal policy in the near term, causing them to pause in their
current round of rate increases.
Inflation appears to be in check assuming that recent oil spikes do not
contribute to a spiral of price increases the way they did in the 1970s. The
largest financiers of the federal deficit, Japan and China, which hold more than
$1.2 trillion of U.S. debt, cannot liquidate their positions without
experiencing an enormous bond value loss. This is because the market likely
would panic if the industry suspected that either entity wanted to reduce its
U.S. Treasury holdings. The Fed also should realize that disastrous consequences
could occur if it raises rates too fast. Consumers are financing much of their
spending through home equity borrowing. This would collapse if rates rose
quickly, which also would deflate home prices to the extent that the solvency of
Fannie Mae and other large investors in adjustable rate residential and
commercial mortgages would be at risk.
Myth No. 7
The real estate bubble will burst soon. It is possible, but not if rates stay
close to current levels. Since rents in many markets have been somewhat
depressed for a while, it is possible that rent inflation will increase as some
markets reach equilibrium. For instance, it is hard to imagine that class A
suburban office rents can drop much more than current levels. Very little supply
has been added in areas that are supply constrained due to lack of available
land or soft leasing. Better information flow regarding absorption has enabled
construction lenders to enforce greater supply financing restrictions. If rents
recover in certain areas, there is upside value potential.
To navigate the current market, equity investors should tread water carefully
and debt investors need to be wary of leveraged loans based upon inflated asset
values. Existing borrowers should lock in as much money as their investments can
support for as long as possible — more than 10 years is preferable. If owners
have another method of deploying capital outside of real estate, it is time to
sell, but not to buy more real estate at inflated values.