If headlines and stories in the financial and real estate press are truly indicators of the state of the real estate debt capital markets, then we are at or near—or may even have reached—an inflection point.
It has been a while since we’ve heard dire warnings of a “race to the bottom” or the caveat “so long as mortgage lenders don’t ‘go stupid’ again” to describe a perceived deterioration in underwriting standards. Now, we hear about this deal or that deal whispered in the hallways and boldly reported in the press. Recently, the Federal Reserve as well as other financial market regulators described their concern regarding the potential that bubbles are developing in the financial markets as well as concern about deterioration in underwriting quality and financial controls. While real estate was not specifically singled out by the Fed, underwriting is underwriting and there is no reason to believe that if real estate had been considered, it would not have been on the watch list. The ratings agencies—Standard & Poor’s, Moody’s, and Fitch—have publicly expressed concerns regarding weakening underwriting standards.
The real estate industry faces a “wall of capital” (that is, unprecedented liquidity) that has driven investors far afield of their positions of just a few years ago. Core assets in many markets have become so pricey that investors feel forced to retreat to secondary and even tertiary markets to find investments. Competition for investments has become ruthless, causing buyers to speak of property as “priced to perfection” (from the seller’s point of view) or “priced to disappoint” (from the investor’s perspective). No one seems likely to believe that appreciation in value through spread compression will rescue them this time. Value will be increased by growing net operating income.
Commercial real estate mortgage lenders face similar issues as they, by and large, have completed the deleveraging process as well as the resolution (via restructuring, loan sale, or foreclosure) of problem loans from the last cycle. Many commercial banks now have the resources to reenter the commercial real estate mortgage business. Insurance companies (which rode through the last crisis basically unscathed) are hungry for product and have expanded their focus from core-only properties in gateway markets to secondary markets and niche properties. The commercial mortgage–backed securities industry, which was thought by many to be down for the count a few years ago, is becoming increasingly active as more and more originators enter the space.
Competition for mortgage loans is intense; the ammunition being used to fight this war is dollars (via increased loan proceeds) as well as more liberal underwriting metrics such as higher loan-to-value ratios, lower debt-coverage ratios and/or debt yields, interest-only periods, and pro-forma underwriting of property net operating income. In many respects, this mirrors the events of the 2005 to mid-2007 period when risk was not rightsized or priced appropriately.
As one online reader of Urban Land noted recently: “Risk is being underpriced because [equity] investors want yield and believe real estate is a safe bet. Deals are getting done because of cheap money [mortgage debt] in the face of weak economic growth. Market participants would do well to exercise some discipline before everything unravels again.”
Adding to the mix is the Federal Reserve’s tapering of its monthly purchases of mortgage and U.S. Treasury securities and the widely anticipated increase in interest and capitalization rates. Those increases may not come until late in 2015 or even later, but they will occur just the same. Against this backdrop of an inevitable increase in interest rates are investors and lenders who are now accepting subpar, risk-adjusted investment rates of return as the price of investment. Higher interest rates have historically led to higher capitalization rates as real estate yields increase so as to remain competitive with alternative investments. Unless net operating incomes increase in tandem with required rates of return, returns and values will be eroded.
Waiting for Evidence
The one problem with this analysis is that it is based solely on observations and conversations, on anecdotal evidence and articles in the real estate press, and not on scientific study. Unfortunately, by the time we get the scientific evidence it will be too late in the real estate industry’s business cycle and we will be forced to relive the past yet again.
There may be nothing that we as an industry can do to affect the expected outcome resulting from too much money chasing too few deals. It may be in our “business DNA” to just take the money and run—and wait to see if the consequences of unsafe investing and unsafe lending ever catch up with us.
What we will not do, one hopes, is ignore the warnings of the Federal Reserve when it comments on potential bubbles in the financial markets together with those of the rating agencies, which have noted weakening in underwriting standards. Add to this anecdotal evidence and market observations and the circle is complete.