Despite some initial signs of a return to stability, conditions in the U.S. commercial real estate capital markets are as severe as ever—and likely to remain that way.
Participants in the annual ULI McCoy Symposium on Real Estate Finance held in New York City this past December were less anxious than they were at the one held the previous year. This reaction, however, must be placed in context. Last year was literally the end of the world as we knew it. We were scraping through a meltdown of U.S. financial institutions and what could have become a major economic depression.
Despite some initial signs of a return to stability, conditions in the U.S. commercial real estate capital markets are as severe as ever—and likely to remain that way. Net operating income from property is declining, capitalization rates are rising, and valuations of unleveraged institutional property are down an average of 40 percent. We are not sure where capitalization rates are at present.
The massive deleveraging of commercial real estate leaves a huge equity hole to be filled. In the words of one symposium participant: “We have gone from hubris to despair.” Another participant predicted no meaningful new commercial development until 2013–2014. In the memorable words of Winston Churchill, we are at the end of the beginning of the financial duress, not at the beginning of the end.
General economic conditions are improving, with positive gross national product, but the finance and real estate sectors will remain weak. It will take four to five years to return to normalized job growth. For the first time in history, job growth has been zero the past ten years.
Banks are intent on building reserves by using the interest rate spread between their low borrowing cost and the yield on Treasuries. Banks remain weak and are not lending commercially due to falling asset prices as well as their preoccupation with problem loans and regulatory issues. Roughly 133 banks have failed, primarily over the pastyear, with an estimated 500 still to go. Significant unrealized losses remain. Securitization has not returned in any fundamental way. Monetary policy is weak, as rates cannot go below zero. Fiscal imbalances pose major problems in the coming years.
We can look forward to higher taxes, inflation, and higher interest rates. Floating-rate loans will become dangerous.
Home foreclosures will continue. About 3 million residences are “owned” by individuals who cannot afford them. About a quarter of all home mortgages are underwater. Solutions to the problem include reduction in the loan balances, shared-appreciation loans, and an 18-month holiday on mortgage payments by the unemployed.
Financial policy. Despite efforts by the term asset–backed securities loan facility (TALF), the public-private investment program (PPIC), and others, the commercial mortgage– backed securities (CMBS) market has not reopened. The good news is that the commercial paper market has reopened and London interbank offered rate (LIBOR) spreads have declined. It was predicted that the CMBS market will begin to return in 2010, with more conservative loan-to-values, restrictive covenants, and higher spreads. Optimism was expressed for “covered” loans, an import from Germany in which borrowers have recourse both to the mortgage pool and to the issuing bank, as the mortgage pool remains on the issuing bank’s balance sheet.
Mark-to-market accounting remains controversial. There is pressure to adopt it in the United States as we correlate our accounting policies to converge with those in Europe. All those, including regulators, who believe in transparency are pushing for mark-to-market. The counter argument is we should allow banks to extend their loans and—it is hoped—reduce their losses as markets recover. Forcing them to mark assets down at the bottom of the cycle is unduly burdensome and could bankrupt otherwise solvent institutions.
Another accounting issue involves the consolidation of special-purpose entities, which could prevent banks and mortgage real estate investment trusts (REITs) from being conduits.
Workouts of CMBS portfolios remain cumbersome. A change in the real estate mortgage investment conduit (REMIC) enabling legislation allowing borrowers and special servicers to meet and work out loans before they become past due or delinquent has resolved some of the issues, however.
The year 2010 will see major efforts at regulatory reform of financial institutions, ranging from compensation policies to reserve capital requirements. Participants characterized the current problem as much a regulatory breakdown as a financial institutions problem. Rules-based solutions are no substitute for having the courage to speak out and the sound judgment to know when to do so.
Debt markets. The policy of “extend and pretend” has diminished the amount of distressed debt in the market, but it requires trust in the operator of the property. It is a bet that net operating income will increase sooner and faster than interest rates. Life insurance companies constituted the bulk of the debt market in 2009, but most of the new money allocations were absorbed by extensions of existing loans. About one-third of loans rolling over are not extended. New money terms are essentially pre-bubble, that is 75 percent loan-to-value, with reserves for new tenants and the like, amortization, and debt-coverage ratios. Pricing involves a ten-year term with a 350-basis-point spread, or a coupon of 6 to 7 percent. Size is up to $200 million, with club deals returning.
As CMBS returns, the size will be $300 million to $400 million, priced at a 350-basis-point spread over ten years. As “covered” debt, there will be recourse to the balance sheet of the issuer. There will be some way to get the issuer to leave skin in the game. The rating agencies will be ignored fundamentally, as due diligence will be performed in house. More typical mortgage pools will probably not come back in size in 2010. There is no market for hedging credit spreads. Almost all properties are overleveraged, and there is an overall liquidity requirement of up to $800 billion in order to meet new valuations and loan-to-value ratios. A participant opined that through the end of this cycle CMBS issuances will have on balance lost money.
Another major problem to be resolved before CMBS reopens is that of who is in control of workouts, the AAA-piece or the first-loss bottom piece? When the CMBS market reopens, it will be the equivalent of 70 percent loan-to-value and a current 7.5 percent coupon. One symposium participant maintained that the action over the past few cycles indicates that the proper loan-to-value ratio for real estate is 50 percent. Mortgage REITs made a comeback in 2009, but new issuances have fallen off. Normalized pre-bubble commercial real estate debt markets will not return before 2012–2013.
Equity markets. Assets need deleveraging and repricing before they can be sold. Values are down 30 to 40 percent. This is an $800 billion problem, and it will take three to four years to be resolved. We are basically kicking the can down the road, avoiding mark-to-market, pretending and extending. There is plenty of capital on the sidelines, but how do we break the logjam?
We know that operating income is forecast to be down, but there is little validation of capitalization rates. High-quality assets attract auction-type buyers when they come to market, but they are mostly being held off. The public equity market has been open, especially for REITs. Pension funds are being priced out of the market. Private equity is buying into distress and on replacement cost. While top-quality assets are stalemated, the Federal Deposit Insurance Corporation is filled with Class B properties from failed smaller banks, requiring workout skills. Expect to see some action in these markets in 2010.
International. We know now that capital is truly global. The best prices for sellers rest with Asia. China remains in solid growth. India has serious infrastructure problems and no debt market. Western Europe is like the United States: overleveraged, with few deals and a lack of recognition of true values. The London office market is at a 20-year low. The United States looks inexpensive on a relative basis. Part of managing risk is staying home.
While fear for the most part is over, a state of high anxiety about what the immediate future holds for commercial real estate remains. This anxiety will continue for several years, and it will lead to an era of conservatism, including, for commercial real estate, lower loan values, conservative underwriting, reserves, restrictive covenants, forms of recourse, individual buyer due diligence, and the like. There will be a tug-of-war between an implicit lower return on equity when the equity component of a project is increased and the desire to reprice risk. This same strain on equity returns will apply to financial institutions as well. An era of conservatism may continue throughout the remaining career life of the current players.
There also will be different relationships among financial institutions, the government, the regulators, and the general public. Those who turn a tin ear to the complaints about excessive compensation, too big to fail, conservative balance sheets, transparency, mispriced risk, and moral hazard run the risk of excessive legislation and regulation brought upon us by an enraged public. The great public beast is slow to arouse and tricky to control when on the warpath.
True leadership is taking ameliorating actions to resolve a potential crisis before it is too late. A focus on power and greed can cause an institution to conclude its actions do not matter in the aggregate. This is what economists term the “fallacy of composition.” We, in the aggregate, become us.
It is easy to place the blame for the current crisis on Wall Street, or on the regulators, but it was a societal failing. There is plenty of blame to go around. There was a dearth of true leadership. New rules will not create new leadership. There was a loss of values, a focus on the self, and an avoidance of institutional responsibility. There was no reference point to check the incrementalism of bad practice. There was no fixed point to tell us the game was over until it was too late.
The 20th-century Christian moralist C.S. Lewis described this behavior in a speech at the University of London in 1942:
And the prophecy I make is this: To nine out of ten of you, the choice which could lead to scoundrelism will come, when it does come, in no very dramatic colors. Obviously bad men, obviously threatening or bribing, will almost certainly not appear. Over a drink or a cup of coffee, disguised as a triviality and sandwiched between two jokes, from the lips of a man, or woman, whom you have recently been getting to know rather better and whom you hope to know better still—just at the moment when you are most anxious not to appear crude, or naif, or a prig—the hint will come. It will be the hint of something which is not quite in accordance with the technical rules of fair play: something which the public, the ignorant, romantic public, would never understand: something which even the outsiders in your own profession are apt to make a fuss about: but something, says your new friend, which ‘we’—and at the word ‘we’ you try not to blush for mere pleasure— something ‘we always do.’ And you will be drawn in, if you are drawn in, not by desire for gain or ease, but simply because at that moment, when the cup was so near your lips, you cannot bear to be thrust back again into the cold outer world. It would be so terrible to see the other man’s face—that genial, confidential, delightfully sophisticated face—turn suddenly cold and contemptuous, to know that you had been tried for the Inner Ring and rejected. And then, if you are drawn in, next week it will be something a little further from the rules, and next year something further still, but all in the jolliest, friendliest spirit. It may end in a crash, a scandal, and penal servitude: it may end in millions, a peerage, and giving the prizes at your old school. But you will be a scoundrel.
We have had our own “scoundrels” these past few years. Individuals moved from sloppy behavior to bad practices and violations of company rules to civil crimes and some even to criminal behavior. Who will be there to stop us from the next cycle? Or are these overreactions just part of normal human behavior—a part of the education of the next generation? If that is the case, then we should all learn to live a half cycle ahead and benefit from the opportunities that are sure to come.