Monday’s Numbers: May 19, 2014

The following two articles appeared in the May 14, 2014, issue of the PunchLine, a publication of TPL Advisory LLC . While not directly aimed at the real estate equity and debt capital markets, the thoughts put forth in these articles certainly could be directed at them at some point as markets live through a period when properties are “priced to perfection” (from the seller’s viewpoint) and “priced to disappoint” (from the buyer’s perspective).

• “Carlyle co-founder Bill Conway warned that yield‐starved investors were snapping up credit securities without properly evaluating risk, as the US alternative asset fund manager reported an 18 per cent decline in quarterly economic net income. ‘Given geopolitical and macroeconomic events, we’re surprised at how ebullient credit markets have been in 2014. The world continues to be awash in liquidity and investors are chasing yields seemingly regardless of credit quality and risk,’ Mr Conway said during a conference call with analysts. . . . Institutional investors are investing in riskier debt securities such as leveraged buyout loans in their hunt for yield amid record low interest rates. They are also abandoning normal creditor protections at a faster rate and in greater proportions than at the peak of the credit bubble. Mr Conway said cheap debt financing inflated asset prices, making the investing environment ‘more challenging’ for private equity groups such as Carlyle.”
• “Investors hungry for high yielding assets are turning to one of the riskiest corners of the US corporate debt market, that of long-dated debt rated triple C, lured by the potential of stronger returns. Overall, sales of triple C debt in the US have surged in recent weeks, along with the performance of the bonds, which mature in 10 years or more. The combination of very low credit ratings and longer maturities is a risky one for investors. Triple C debt, deep into ‘junk’ territory, is sold by companies that have the greatest probability of default. . . . The move into the riskiest corner of the junk bond market is coming as interest rates have moved in the opposite direction to what many expected this year. They have dropped from last year’s levels even as the Federal Reserve has been ‘tapering’ its bond purchases. . . . Long-dated triple C bonds have rallied this year, with total returns on the debt reaching the 10.5 per cent mark . . . , according to Barclays indices. That compares with total returns of 3.9 per cent for the broad high-yield market and 4.6 per cent for investment-grade corporate debt.”

As we said, the articles are not directed at the real estate industry—yet. But it doesn’t take a rocket scientist to see that mortgage underwriting metrics are under pressure due to the highly competitive nature of the capital markets, and equity investors are moving further and further down the credit spectrum in search of yield. We have even seen mention of spec office projects, albeit with low-leverage construction financing and institutional-quality sponsorship, starting to see the light of day.

So, we wait and see, hoping that no one loses control and goes stupid again. And by the way, we are not the only ones worrying about this. Standard & Poor’s Rating Services noted in its May 13 “Structured Finance Research Update”: “Q1 loan credit metrics deteriorated; as of January 31st, 37 firms were either originating CMBS loans or in the planning stages. The roster of active B-piece buyers is also expanding. [The] competition for lending is driving weaker underwriting. . . . Loan metrics including loan-to-values, debt service coverage ratios, and the percentage of collateral with interest-only periods have also continued to deteriorate.”

Monday’s Numbers

The Trepp survey for the week ended May 9 showed spreads unchanged and apparently unlikely to change without some type of financial or political event occurring. The implied ten-year commercial real estate mortgage rate remains at 4.00 percent for pristine, institutional properties. We have even heard talk of sub–4.00 percent rates for seven-year commercial mortgage paper.

The Cushman & Wakefield Equity, Debt, and Structured Finance Group’s monthly Capital Markets Update of commercial real estate mortgage spreads, dated May 9, showed spreads coming in 5 basis points across the board.

In comments accompanying the survey, C&W highlighted the following:

• The U.S. economy added 288,000 jobs in April as the unemployment rate reached 6.3 percent, its lowest level in five years.
• Moody’s first-quarter 2014 CMBS review noted continuing deterioration in the underwriting risk profile of recent offerings.
• Investment sales of commercial property remained strong in the first quarter of 2014, with Real Capital Analytics reporting volume of $87 billion, an increase of 15 percent year-over-year.

Year-to-Date Public Equity Capital Markets

Dow Jones Industrial Average: –0.51%

Standard & Poor’s 500 Stock Index: +1.60%

NASD Composite Index (NASDAQ): –2.06%

Russell 2000: –5.22%

Morgan Stanley U.S. REIT Index: +11.73%

Year-to-Date Public U.S. Treasury Yields