Industry forecasts are normally made in January (the beginning of the year) or July (the midway point of the year). But why not get a jump on things and forecast the balance of the year as well as 2014 from the viewpoint of the end of April? Our views on the economy, the real estate industry, and the state of the capital markets follow:  

  • The economy will continue to “grind it out” over the next two years with gross domestic product expected to increase 2.0 percent over the balance of 2013 and accelerate thereafter, reaching 3.0 percent in 2014. Unemployment should continue to decline, averaging 7.5 percent in 2013 and 7.0 percent next year.
  • Interest rates will remain at today’s low rates through 2014; if for any reason the Federal Reserve decides to change its mind and allow rates to increase, the Fed has made it clear that it will send plenty of signals to the market that a course change is underway.
  • Real estate fundamentals will continue to improve as vacancy rates—which started 2013 above historical equilibrium—are headed in the right direction (down), reflecting the impact on real estate of the improvement in the general economy.
        o Real estate has also benefited from a lack of new construction (except multifamily) over the past few year, with developers forced to sit in the penalty box due to an inability to obtain construction financing.
         o While construction will increase in 2014, it will remain demand-driven with speculative construction literally impossible to finance.
  • Transaction volume, which reached $285 billion or so in 2013, will continue to increase, positively influenced by the “wall of capital” trying to enter the real estate space and abetted by the availability of low-cost mortgage financing from numerous sources. Transaction volume in 2014 could reach $320 billion or so as investors continue to be positively influenced by real estate’s attractive “relative value” as compared with other asset classes.
  • Core assets in gateway markets will remain “priced to perfection” for the seller and “poised to disappoint” for the buyer, leading more and more investors to look for (and find what they believe are) opportunities in the secondary and tertiary markets.
        o  Fundraising, except by the largest and most successful real estate funds, will remain difficult; legacy problems will do that to you.
        o  With competition for fewer and fewer available investment opportunities, underwriting discipline will suffer and “hand-to-hand” combat will ensue. The byproduct of this will be recapitalization/workout investment opportunities in the near future.
  • Real Estate Investment Trusts (REITs) will remain ferocious competitors as they continue to take advantage of their access to the public equity and debt capital markets.
  • Pension funds will continue to increase their allocations to real estate as they search for investments that will help them fund their distribution requirements to pension holders.
  • Foreign investors seeking safety will continue to focus on core property in gateway markets; the United States will remain the market of choice.
  • Mortgage capital will remain abundant and cheap with rates below 5.0 percent—the norm and not the exception.
    o Commercial banks will continue to deleverage where possible, practicing their recent “little of this, little of that,” i.e., extend, roll over, sell off, and foreclose operating strategy.
            §  Lending volume in 2013 will increase after a neutral 2012 as banks start to increase their allocations to multifamily and commercial real estate properties; 2014 will see continued expansion of lending programs.
    o Commercial mortgage–backed securities (CMBS) originations for 2013 are on track to reach $60 billion and could equal as much as $75 million in 2014 as additional firms continue to enter the origination space and investors remain attracted to the yields available from investing in the highest-rated CMBS tranches.  
            §  While underwriting standards have for the most remained stringent, some recent transactions have seen a repeat of some of the sins of the recent past, i.e., pro-forma underwriting, interest-only periods, and the like; this, it is hoped, is a short-term problem.
    o Insurance companies, which were volume-neutral in 2012 as compared with 2013, may lend as much as $50 billion in 2013 and $55 billion in 2014.
  • Uncertainties such as the euro crisis, North Korea, the Middle East, the U.S. budget, etc., will continue in the background, waiting to flare up and upset the capital markets equilibrium.
  • The real estate industries’ most worrisome concerns will remain:
    o    Refinancing of $300 billion per year of mortgages maturing through 2017; and
    o    The refinancing risks associated with the nexus of recent “priced to perfection” acquisitions whose increase in net operating income will not support refinancing at then-current interest rates.

All-in, a very positive forecast for the real estate industry and capital markets for the balance of 2013 and 2014.

Monday’s Numbers

The Trepp survey for the period ending April 12 showed spreads narrowing 3 to 5 basis points, indicating that the all-in cost for high-quality, moderately leveraged properties remained in the 3.5 percent range, unchanged from the prior week. Subject to “event risk,” which drives the capital markets toward “liquidity and safety,” i.e., U.S. Treasury securities, rates appear to be range-bound in the sub–4 percent range for “best in breed” borrowers and properties and around 4.5 percent for all the rest.

Asking Spreads over U.S. Treasury Bonds in Basis Points
(Ten-Year Commercial and Multifamily Mortgage Loans
with 50% to 59% Loan-to-Value Ratios)

12/31/09

12/31/10

12/31/11

12/31/12

4/12/13

Month earlier

Office

342

214

210

210

178

175

Retail

326

207

207

192

172

170

Multifamily

318

188

202

182

165

160

Industrial

333

201

205

191

168

161

Average spread

330

203

205

194

177

165

10-Year Treasury

3.83%

3.29%

1.88%

1.64%

1.73%

2.03%

The Cushman & Wakefield (C & W) Equity, Debt, and Structured Finance Group’s monthly survey of commercial real estate mortgage spreads for the period ending April 1, 2013, showed spreads for ten-year, fixed-rate mortgages secured by Class A property widening 5 to 10 basis points, while spreads for Class B property came in similar amounts. 

10-Year Fixed-Rate Commercial Real Estate Mortgages (as of April 1, 2013)

Property

Maximum

 loan-to-value

Class A

Class B

Multifamily (agency)

75% – 80%

T +175

T +180

Multifamily (Nonagency)

70% – 75%

T +175

T +180

Anchored retail

70% – 75%

T +200

T +210

Strip center

65% – 70%

T +220

T +230

Distribution/warehouse

65% – 70%

T +205

T +215

R & D/flex/industrial

65% – 70%

T +220

T +235

Office

65% – 75%

T +190

T +205

Full-service hotel

55% – 65%

T +255

T +280

Debt-service-coverage ratio is assumed to be greater than 1.35 to 1.

In its analysis of current lending sources terms and conditions, C & W noted the following metrics, which will assist potential borrowers in sizing loan requests:

Capital source

Life company / pension fund

Investment fund / finance company

Money center / offshore banks

Conduits

Local / regional banks

Preferred loan size

>$10 million

$20 million–$100 million

$10 million–$100 million`

>$10 million

$3 million–$25 million

Cost of capital

2.75% – 5.00%

5.25% – 7.50%

2.75% – 5.00%

3.50% – 4.75%

3.00% – 5.00%

Loan-to-value

50% – 65%

55% – 85%

50% – 65%

Up to 75%

50% – 65%

Debt yield

12% – 9%

12% – 7%

12% – 9%

10% – 8%

12% – 9%

DSCR

1.25x – 1.50x

0.75x – 1.40x

1.35x – 1.50x

>1.20x

1.35x

Other

Nonrecourse

Nonrecourse

Potential recourse

Nonrecourse

Potential recourse

Prefer fixed rate

Floating rate or fixed via swaps

Fixed or floating

Fixed

Fixed or floating

3- to 20-year term

2- to 5-year term

2- to 5-year term; 10-year possible

5- to 10-year term

3- to 5-year term; 10-year possible

Year-to-Date Public Equity Capital Markets

DJIA (1): +11.01%
S&P 500 (2): +9.05%
NASDAQ (3): +6.18%
Russell 2000 (4): 7.44%
Morgan Stanley U.S. REIT (5): +10.35%

 (1) Dow Jones Industrial Average. (2) Standard & Poor’s 500 Stock Index. (3) NASD Composite Index.
(4) Small Capitalization segment of U.S. equity universe. (5) Morgan Stanley REIT Index.

U.S. Treasury Yields

12/31/11

12/31/12

4/20/12

3-Month

0.01%

0.08%

0.05%

6-Month

0.06%

0.12%

0.09%

2-Year

0.24%

0.27%

0.24%

5-Year

0.83%

0.76%

0.72%

7-Year

1.35%

1.25%

1.14%

10-Year

1.88%

1.86%

1.73%

                                               

Key Rates (in Percentages)

 

Current

One year prior

Federal funds rate

0.15

0.15

Federal Reserve target rate

0.25

0.25

Prime rate

3.25

3.25

U.S. unemployment rate

7.60

8.70

1-Month LIBOR

0.20

0.24

3-Month LIBOR

0.28

0.47