Nearly three dozen of the country’s top money minds spoke frankly about navigating the ongoing credit crisis. Here is a glimpse of their off-the-record meeting.
As 2011 neared a close, discussion at ULI’s 18th annual McCoy Symposium on Real Estate Finance, a closed-door session attended by 35 senior capital markets representatives in New York City in December, focused on volatility in capital markets, the long-term duration of the crisis, the state of the U.S. banking system and housing markets, the state of the commercial mortgage–backed securities (CMBS) market, and the effects of Europe’s banking and capital market crisis.
Volatility and uncertainty increase risk, diminish clarity, and decrease deal flow. Stock market pricing swings, especially during the final hour of trading, triggered by program trading increase the risk of bringing new securities to the market. The perfect storm of Europe’s financial instability combined with a brutal U.S. election campaign featuring finger-pointing is a negative for risk assets. A wide range of possible outcomes exists for such issues as taxes, the federal budget deficit, election results, and the impact of new regulations on the banking system. A wall of maturities in CMBS and bank loans is coming due during the next five years and no vehicles are in position to deal with them. Liquidity is in place, but volatility and uncertainty keep much of it on the sidelines.
It increasingly appears that the U.S. economy is in a long-term crisis. This year will be the fifth year of the slump, and a bottom has yet to be found in housing prices and, perhaps, unemployment. It seems fairly certain that the crisis will persist for another five years. One symposium participant described this as a low-conviction market in which it is difficult to underwrite risk. Without massive changes, the economy is likely to bump along for the next five to ten years.
Housing prices are likely to hit bottom in 2012, but it will take several years to make up the cumulative deficit in housing starts. Housing prices continue to lack clarity, with as many as 30 percent of home mortgages underwater. Foreclosure, an arcane, one-off process fraught with delays, political posturing, and litigation, creates a bottleneck in price discovery.
Uncertainty pervades other aspects of the U.S. economy. There is no clarity on the government’s future role in housing. Unemployment figures are probably understated, with many dropping out of the workforce to swell the ranks of the permanently unemployed. Population growth requires about 100,000 new jobs a month, which means the U.S. economy needs to add 200,000 jobs a month for several years to keep up with growth and absorb the unemployed. The wall of real estate debt will roll over for most of this decade.
The U.S. banking system has plenty of liquidity, including billions of dollars on reserve with the Federal Reserve System. While individual banks can point to billions of dollars of so-called new real estate loans, the bulk of such loans consists of rollovers and extensions, with additional injections of equity. Refinancing of existing mortgage debt is a long-term, global problem, with the process of amending, pretending, and extending becoming institutionalized.
It is extremely difficult at present to construct a meaningful business plan for a commercial or investment bank. Dividend policy and share repurchases are conditional on the outcome of additional stress tests during the first quarter of 2012. Imponderables include the amount of equity capital to be required, definition of a normalized expected return on equity, appropriate compensation policies, the degree of worldwide linkages and counterparty risk on derivatives and other financial products, the future of the euro, and the degree of vulnerability to a European banking collapse. Government officials say it will take several years to clarify the details of new financial regulations such as the Dodd-Frank Wall Street Reform and Consumer Protection Act. With 70 percent loan-to-value ratios and appropriate covenants, bank financing is available for up to ten years (in limited cases) floating at 3.5 to 5.5 percent over the London Interbank Offered Rate (LIBOR); five years is a more typical term. Fixed-rate coupons are 5 to 5.5 percent. European banks are pulling out of the U.S. market due to their own stresses, making the U.S. market less competitive.
Instability in the housing market remains unresolved, with some prices still falling, and a lack of market-clearing prices and a problematic foreclosure process lingering. Symposium participants predict it will take three to four more years to clear the housing market, and perhaps longer. Mark-to-market issues remain. Housing is a key factor in any recovery because it is the bellwether for consumer confidence, as well as for demand for construction and household goods.
Hopes were high for the CMBS market in 2011, but by late summer activity was curtailed by the combination of the European crisis, the U.S. government’s deficit deadlock, and the failure of the rating agencies. Securitization does not work well in a volatile market because of the time required to aggregate and process the various loans in the portfolio. In the words of one participant, "You’ve got to be lucky!" There has been push-back from both the rating agencies and the buyers. One of the larger offerings of the year had to be pulled from the market when Standard & Poor’s pulled its rating after the deal was placed and scheduled to close. Risk retention remains unresolved. Only four or five credible B-piece buyers exist. Foreign banks have pulled out of the markets and are selling their portfolios. There is less capacity for extending existing deals; nonbank holders will not extend. The annual market as of December was about $40 billion versus an estimated $250 billion of fixed and floating-rate CMBS scheduled to mature between 2012 and 2016. New financing vehicles such as mortgage real estate investment trusts (REITs) are not filling the gap. There is a lack of confidence in real estate pricing and a lack of trust in the special servicers. Some servicers will extend, but some will conduct a fire sale.
European banks are leveraged 40 to 1 and have yet to take their writedowns. They will engage in massive asset sales, estimated by one participant at $2 trillion. They will be competing in the global markets for enhanced equity capital. Though it is unlikely, if the euro collapses the effect would be catastrophic. Insurance companies remain a key source of capital, putting out $50 million to $60 billion in 2011 (a significant portion being rollovers) with coupons at 4.5 to 5 percent and conservative underwriting.
Japanese investors were active in 2011, mainly in the REIT area. A few symposium participants were more bullish, but they were relying on isolated transactions in premier properties.
What will indicate when this crisis is over? Growth in demand will return, with speculative building in key cities. Apartment renters will begin to purchase single-family homes. Talk of inflation will increase as the trillion dollars held by the Federal Reserve Bank and the U.S. Treasury is monetized. Interest rates will normalize—that is, increase. Construction financing will become available. Class B properties in the hinterlands will be financed and sold. Loan-to-value ratios will rise. Pro forma rental increases will be underwritten. And, finally, a new generation will enter the business with its own innovations and "creative" financing techniques.
Amid so much doubt, the advice to real estate professionals is straightforward: borrow prudently at the lowest rates in a lifetime, and for up to ten years. Make certain to perform a personal stress test on rollover refinancing by assuming an interest rate at least 300 basis points above the current borrowing rate. In the last crunch, the industry learned that land is toxic. This time it learned that debt is toxic. Be careful!