What happens when the Federal Reserve Bank fully tapers off its massive liquidity support for the economy and the capital markets, including real estate—and when is it likely to occur—were major questions discussed at the 20th annual ULI McCoy Finance Seminar in New York City in December.
Participants said a key determinant will be the state of the general economy. The ongoing recovery has been weak and prolonged, but it provides an element of optimism for the future. The current unemployment rate—about 7 percent—is usually associated with the depths of a recession, not a recovery. Households and businesses have de-levered, with combined debt reduction of $7 billion while government debt is up by $7 billion. Today’s government borrowing ratios are unsustainable; the Federal Reserve is purchasing 40 percent of all newly issued government bonds and as much as 75 percent of selected issues. Over the period of the most recent recession, average middle-class household wealth is down $100,000. The issue becomes this: who gets hurt when the music stops?
The Federal Reserve has engineered a fourfold increase in the monetary base. There is no history to guide us in unwinding this, yet Federal Reserve officials say they are “highly confident” they can manage it. With this unprecedented liquidity, banks should be lending more, but they are not. Business capital expenditures are frozen. Uncertainty prevails as to resolving the government budget issues and the deleveraging of the Federal Reserve. We are therefore stuck in slow-growth mode, with weakened demand. The Federal Reserve is caught in a “liquidity trap” with no ability to reduce interest rates any further to stimulate demand. Never in modern times have interest rates been so low for so long.
The excessive liquidity has lifted the value of all financial assets. We now have balance sheet inflation and perhaps an asset bubble, which is not bad news for real estate values in the near term. Participants worried that in unwinding its balance sheet, the Federal Reserve will collapse the current financial assets bubble.
The Economic Policy Uncertainty Index is at an all-time high. We no longer know the rules under which we must operate. Dodd-Frank regulations are still only 40 percent drafted. Health care is in chaos. Taxes are changing every year, with no consistent tax policy, and we have unsustainable monetary and fiscal policy. It is likely that Janet Yellen, the new chairman of the Federal Reserve, will keep interest rates low for longer than the other candidates for that job would have. The Federal Reserve appears to be too concerned with unemployment, and Fed directors are convinced that their policies are working. The quandary for the Federal Reserve was described as being similar to holding a beach ball under water—eventually it will come bursting through the surface.
There is no policy room left to handle the next crisis. The Fed’s recent “tapering off” from $85 billion a month of bond purchases to $75 billion is a significant change in inflection, but not in substance.
We may continue in the doldrums for the next couple of years, but eventually the bubble will burst. The next crisis could come in many forms: another stock market crash, or the Chinese bubble bursting—with a sell-off of U.S. Treasuries. To avert the next crisis, many believe that we need a long-term solution to federal spending entitlements and an orderly withdrawal of the Federal Reserve from the government bond market. In the intermediate term, this would assume normalization of short-term interest rates to around 3 percent and the longer-term ten-year Treasury rate to around 4.5 to 5 percent. Combining short-term fiscal stimulus with long-term deficit reductions would allow the Federal Reserve to stop trying, with increasing futility, to shoulder by itself the burden of saving the economy.
The current crisis was stimulated by an enormous bubble in housing, which was sustained by keeping interest rates too low for too long during the 2001–2005 period. The housing bubble was aided and abetted by the irresponsibility of the capital markets, the federal government, the rating agencies, and the gullible public—all of whom engaged in increasingly bad practices in the capital markets, which led to the abandonment of underwriting standards.
By 2012, housing prices were back up to normal levels and there was little inventory of new homes. Helped by low interest rates, affordability ratios were improved. We are currently building 1.4 million homes a year. It is estimated there will be 13 million new households formed by 2020, requiring new-home starts of about 2 million a year for the rest of this decade. Some believe that building this many houses over the next seven years would add 0.4 percent annually to the gross national product (GNP).
Debt markets, especially at the 12 megabanks, are awash in capital thanks to the Federal Reserve policies. Life insurance companies’ rates remain very competitive. Spreads are low. Leverage remains historically low. Foreign lenders are essentially out of the market. Under certain conditions, nonrecourse construction loans are available. The markets are controlled essentially by the 12 major banks, which are bigger than ever. Three of them could do up to $1.5 billion to $2 billion each in a syndicated deal. Major syndications could involve 15 to 25 players, with the originating bank holding 10 percent of the total loan amount. Term loans are available to public real estate investment trusts (REITs), rated Baa or better at narrow spreads. Commercial delinquencies and defaults have been cleaned up fast by extending, restructuring, and refinancing with the “wall” of debt money available.
In chasing loans, banks have moved into the insurance company space. Insurance company debt spreads on high-quality loans are roughly 200 basis points over the ten-year Treasury bond. Insurance company fixed-rate spreads have varied from 150 basis points over the ten-year Treasury to 220 basis points. The largest insurance company syndications are $450 million to $500 million, and there are five or six insurance companies in this market. Capital rules for insurance companies favor a 60 percent loan-to-value (LTV) ratio. It appears that a few of the largest insurance companies will, under new regulations, be classified as “systemically important financial institutions” and come under supervision by the Federal Reserve, which has no experience in regulating insurance companies.
U.S. commercial mortgage–backed securities (CMBS) issuances were predicted to total $45 billion for 2013 and will come in at about $85 billion. There are 30 to 35 CMBS lenders. Loan-to-value ratios are 70 to 75 percent, reaching as high as 80 percent. In a syndication package, the top ten loans will have LTVs at about 65 percent, and the bottom loans about 75 percent. The time at risk for the underwriter has gone down from 65 days to 17 days. Some $500 billion of “old” CMBS burns off in the 2015–2017 period, and it will be either “hammer time” or rollover time. Participants predicted that as much as 80 of them will roll over, due to the “wall” of liquidity. A limitation on the CMBS market remains the limited number of “B” piece players.
The real estate equity markets are driven by pension funds’ need for return, especially sovereign funds. Cap rates on pension fund core investments are 4 to 5 percent on net operating income before capital expenditures and leasing reserves. Reversion capitalization rates are about 75 basis points over the initial investment yield. Unleveraged internal rates of return on core property are 6.5 percent. There are $25 billion of questionable loans in Europe, with distress loan pools offering opportunity returns exceeding 20 percent.
This year, participants also discussed the role of the ULI McCoy Finance Seminar. In the early years, it was a meeting among senior real estate practitioners and key government and regulatory officials. In fact, the original meeting was held in Washington, D.C., and Alan Greenspan, then chairman of the Federal Reserve Board, attended. Over the years, officials from the Fed, the Treasury Department, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and others have attended. In recent years, participation by government officials has declined, and attendees deemed it important to retain this role of impartial discussion of real estate conditions with key government officials. It is clear that government regulation will continue to have a greater impact on the capital markets, including the real estate markets, and ULI needs to share its voice with government officials and regulators. The ULI McCoy Finance Symposium is well suited to provide such engagement. Otherwise, participants said, we are just talking to ourselves.
Also discussed was the difference between taking a passive reporting role and acting as an active proponent of change. The ULI McCoy Finance Symposium had predicted the traumas that affected the capital markets as early as late 2005, but no action was taken. There was discussion of the nature of ULI’s role in assuming responsible leadership in the real estate industry. The focus in the finance industry at present seems to be on establishing rules for regulation, negotiating rules, bending rules, getting around rules, and the like. Responsible leadership involves living beyond the rules, living out personal values, respecting clients and customers, and educating the young people in our businesses on responsible leadership. This is an area in which ULI can play an important role.
Bowen H. “Buzz” McCoy, formerly responsible for the real estate finance unit at Morgan Stanley, is president of Buzz McCoy Associates Inc. in Los Angeles.