Participants in the 21st annual ULI/ McCoy Symposium on Real Estate Finance, a forum that brings together 30 to 40 leading executives in real estate finance, had plenty to talk about when they gathered in early December. Among the questions they considered were these: What is the timing and likely equilibrium point for interest rates now that the Federal Reserve Bank has announced suspension of quantitative easing? What is the outlook for commercial real estate? What has been happening in the real estate capital markets in 2014, and what is likely for 2015? What is happening in the government regulatory area? Will we remain in gridlock? What is happening with Dodd-Frank (the financial regulation bill enacted in 2010)? How much do we need to know about the future of crowd funding and private-equity real estate investment trusts (REITs)?
This year’s symposium, titled “Real Estate Investment and Finance in a Post-Q.E. World,” found participants to be quite positive regarding what that world will look like in 2015. Participants seemed to agree that the industry will continue to be in a sweet spot in the cycle at least for the next two years, with on-going improvement in real estate fundamentals, construction levels remaining low relative to pre-recession levels (except for multi-family), both equity and debt capital remaining abundant, and interest rates still on the low side. On the other hand, participants noted that the current pluses of low interest rates and abundant capital could likely build to a bubble by the end of this two-year period. As always, participants noted that a black swan event, by nature unpredictable, could interrupt these trends.
The annual invitation-only event was attended by a wide array of real estate industry participants including: public and private owners and developers; conventional and securitized lenders, institutional investors, investment bankers, real estate investment advisors and managers, economists, and leaders of various real estate industry associations. To encourage openness and the sharing of information, the discussion rules granted anonymity to the speakers.
One first-time attendee, noted that he had never before been present at a meeting where capital market players spoke so openly about their view of the market in front of their competitors. I found this to be a gratifying observation in that it gives evidence that ULI has sustained the transparent nature of this honest dialogue over 21 years.
We began with a review of the economy. The domestic economy is relatively strong, especially in contrast to most other economies; and the U. S. has become the market of choice for investors and protectors of wealth. Auto sales are increasing; oil prices are declining. Although money is not there currently for the housing mortgage markets, residential credit standards are being lowered for political reasons. Speakers believed that asset prices are too high and that we are moving into a long period of interest rate normalization—which means higher rates. Job openings are the best since 2005.
Assets held by the Federal Reserve Bank are leveling off. The Fed is not proactively reducing the assets held, but is allowing them to run off. In the next few years, participants said, short-term interest rates will likely move from 0 .1 percent to 1.2 percent, and the ten-year bond will go from 2.3 percent to 3 percent, or perhaps as high as 3 ¾ percent. The relative movement in interest rates will still be small, and it will likely have little effect on capitalization rates for commercial estate, which will remain sticky. If inflation were to grow to 2 percent, we might anticipate a 4 percent ten-year government bond rate.
Participants believe we can look forward to a stronger economy and a slow increase in interest rates. The huge amount of savings puts pressure on interest rates, and the slower economic recovery of most of the developed world also will hold down interest rates internationally. The search for current return leads investors to some unlikely places. Real estate remains attractive as the greater part of investment return is in current income; unlike historic periods, during which much of the return came from anticipated price increases upon exit..
We can hope for positive things from Washington, including the extension of favorable depreciation rates on tenant improvements, and extension of government-guaranteed terrorism insurance, as well as some easing in foreign investment rules in the United States. Regulations under Dodd-Frank are still being drafted and will continue to require retention of part of the risk on issuances of commercial mortgage-backed securities (CMBS) as well as higher capital ratios for banks. The issue of institutions being “too big to fail” has yet to be accommodated in the regulations, but participants felt that, if the financial institutions were to fail again there would likely be strong pressure in favor of wiping out the stockholders’ equity and breaking up the significant financial institutions.
Banks were more active than in 2013, according to participants. Loan deposit ratios remain low, in the 70s compared to 90 percent prior to the crisis. Money center banks have excess liquidity (one institution reported $200 billion) and are not finding many opportunities to earn a risk-related return. Construction loans are paying off early. Jumbo loans are syndicated among three to five banks. Debt markets are fully functioning. Old loan restructuring is mostly done on commercial real estate. In 2015 there will be too much capital chasing too few deals for financing. It is hard to replace loans that are rolling over. It was estimated that bank regulation adds 60 basis points to the cost structure for commercial real estate loans. The Federal Housing Administration is encouraging lenders to provide single-family mortgage loans up to 97 percent loan-to-value on “challenged” credits.
Insurance companies reported that the banks are very competitive in extending maturities. Real estate loans yield generally ł00 basis points over corporate loans. Commercial foreclosures are minimal. A low loan-to-value is sought. At a 60 percent loan-to-value, the interest rate on a ten-year loan would be around 3½ percent, and with a 70 percent loan-to-value the rate could be 100 basis points higher.
CMBS market are slowly recovering. Originations were $85 billion in 2013, $100 billion this year and forecast at $135 billion in 2015, though CMBS investors remain picky on asset quality, The wall of CMBS securities maturing in 2014 through 2016 (from transactions originated in 2004 through 2006)is being effectively dealt with through defeasance, roll overs, and equity additions.
Attendees found that stress in the real estate equity markets is over, except for single-family homes. Europe is three to four years behind the United States, with stressed markets, legacy issues, and limited capital. The fundamentals are sound in the United States, with plenty of capital and no new construction. There can be as many as sixteen bidders for packages of real estate assets.
Non traded, private-equity real estate investment trusts have come popular with several takeovers and new entrants, but concern was raised about the high fee structure. It can take four years or longer to earn back the initial fees. There can also be liquidity issues if there is ever a “run on the bank” for redemptions.
Participants also discussed crowd funding, .the internet based capital raising of debt and equity on commercial real estate. It is syndicated to an unlimited number of individuals, in small pieces, with no requirements for registration with the U.S. Securities and Exchange Commission other than certain rules pertaining to qualified investors and fraudulent behavior. Participants found this market to still be like the wild west. There are more than 100 firms doing crowd funding, and at present there is no filter on asset quality, no professional codes of quality, or standards for best practices. Financial institutions will be watching this phenomenon closely, as there have been many attempts to efficiently bring individual investors into the real estate investment markets.
Bowen H. “Buzz” McCoy, a ULI Life Trustee, has endowed this annual series of symposiums.
