Given the turmoil and volatility in financial markets that have been reported in the daily press, participants at the ULI McCoy Symposium on Real Estate Finance, held in New York City in December, were surprisingly optimistic. Their reasons: The Federal Reserve has suggested that interest rates will remain at historically low levels until at least mid-2015. There is little overbuilding. Relatively modest annual levels of commercial mortgage–backed security (CMBS) rollovers have been handled by deferring and extending, and through new equity and mezzanine funding. When cautioned about the increasing maturities of CMBS over the next few years, participants felt the Federal Reserve easing, more deferring and extending, and high levels of additional capital availability would be sufficient to deal with the problem. Following are some fly-on-the-wall observations gleaned from this closed-door event.
The Marriner S. Eccles Building in Washington, D.C.,
houses the Board of Governors of the Federal Reserve System.
The U.S. market is recovering, but it is a slow grind. Interest rates are low. There is excess liquidity in the system. The flood of money will drive pricing and compensate for decreased underwriting standards. “This wave of capital will make up for any mistakes in underwriting assumptions,” one participant noted.
The tone of the meeting was optimistic, as participants apparently have adapted to the new reality of slow growth, volatility, low interest rates, and political turmoil. Their optimism was further buoyed by the prospect of energy independence and a resulting $300 billion swing in annual trade balances and a cheaper dollar.
Long-term demographics also favor the United States. Those with a more negative outlook were concerned about the political impasse over fiscal solutions, the longer-term impact of government deficits, unfunded pension and social liabilities in the public and private sectors, and the ability of the banking system to “extend and pretend” indefinitely.
Of greater long-term concern is the issue of removing more than $4 trillion of assets from the balance sheets of the Federal Reserve, the Treasury, and the government-sponsored housing agencies, Fannie Mae and Freddie Mac. This is an unprecedented problem, which can cause further long-term turmoil in the capital markets and perhaps provide inflationary pressures. The magnitude of the long-term problems makes assumptions regarding exit strategies for real assets problematic.
Financial services firms are suffering from low interest rates, which narrow spreads earned on transactions, and the great uncertainty regarding regulation. Most participants thought that uncertainty and volatility would remain for some time to come. Some thought interest rates might be up 150 basis points within two years. Home values were up in 2012. Normally, a million households are formed each year, but in the past several years only 500,000 were formed each year, creating a demographic backlog that will help support a recovery.
We are seeing declining underwriting standards in both debt and mezzanine finance primarily driven by competition due to the record amount of equity capital available. Unleveraged returns on equity for core assets are 7 percent to 9 percent, with apartment valuations actually pricing at below 7 percent internal rates of return. Core and distressed properties are close to fully valued. There are better returns in value-added properties. All investment valuations take account of replacement cost, and in most cases a discount to replacement cost is a key driver of valuation. Pension funds prefer low leverage of 30 to 50 percent. Opportunity fund returns are closer to 15 percent leveraged, despite some claims of 20 percent. There was consensus that returns from real estate investments would be lower in this slow-growth environment.
There is a “creep” in underwriting assumptions, with unrealistic tweaking. Loan-to-value ratios are edging up from 65 or 70 percent. Underwriting has not relaxed to 2006–2007 levels yet, but standards are under pressure from the practice of “pretend and extend.” Properties under development may end up being worth less than replacement cost because of lower-than-expected rents. It is difficult to price in the true long-tail risk of exit strategies with the imponderables of slow growth or high inflation.
One participating bank quoted a ten-year loan priced at 3.5 percent with a 60 percent loan-to-value ratio and interest coverage of 1.50. While the borrower in this case hit the jackpot, borrowers with unresolved assets will find the equity requirement devastating.
Real estate practitioners are inherently entrepreneurial, optimistic, and flexible, so they can adapt to almost any new reality, be it slow growth or high inflation. They just need to know when, and how much. The consensus seems to be it will take two to four years to normalize, clear out the housing market, and revert to a 5 to 6 percent interest rate environment. In the meantime, money will be made by opportunistic, well-capitalized investors.
In the interim, the best strategy is to borrow as much as possible, as long term as possible, but within prudent guidelines. Cheap, long-term flexible debt becomes an asset in a rising interest rate environment. Debt ratios of 90 percent (including mezzanine) are financial suicide. Pay particular attention to exit strategies. And whatever the pro formas indicate, make sure there is room to refinance if the sales market is constrained. Meanwhile: “Be adaptable.”