Sixty leading figures in real estate capital markets came together in New York City in December to participate in the 22nd annual ULI/McCoy Symposium on Real Estate Finance. The annual invitation-only event was attended by a wide array of real estate industry participants, including public and private owners and developers, conventional and securitized lenders, institutional investors, investment bankers, real estate investment advisers and managers, and economists, as well as the leadership of various real estate industry associations.
Because Chatham House rules, which provide anonymity to speakers to encourage openness and the sharing of information, applied to the discussions, the following is a summary of the key findings and themes of the symposium.
This year’s discussion focused initially on the state of the U.S. economy and assumed that the Federal Reserve would begin the move to a rising-interest-rate environment, which it did just two days later. “Interest rates are three years behind where they would normally be at this point in the cycle,” one speaker pointed out. The group forecast that the Fed would increase interest rates slowly, perhaps by a quarter of 1 percent per calender quarter, or by 200 to 300 basis points within the next three years.
Overall, the many positives in the economy and commercial real estate cycle (i.e., there is not a significant increase in new construction in most sectors) provided the basis for a consensus that while the end of the growth phase of this cycle is “not near,” we are in the “bottom of the sixth inning” or later.
Still another perspective was that there are always two cycles—a capital cycle and a fundamentals cycle. More frequently they are in sync, but not this time. The capital cycle happened “way before” the fundamentals cycle, some participants said, pushing prices past peak levels in many core markets, but now the fundamental cycle is strong.
Participants agreed that the commercial real estate market has enjoyed one of the longest periods of recovery in recent decades, now coming up on seven years of growth in transaction volume, sustained by low-cost capital and improving fundamentals. Factors that would support a continuation of this trend include strong job growth (the United States has now had six years of job growth, and although the average rate of monthly job growth decelerated a bit in 2015 compared with 2014, the pace is still considered strong), a declining unemployment rate that is now at the full-employment benchmark of 5 percent, the recovering single-family housing market, and the expected continuation of easy availability of debt and equity capital.
Speakers noted that the mitigating factors that could otherwise influence these positive factors are primarily external to the United States and include a sharp slowdown in China, emerging-market weakness, a plunge in commodity prices, currency declines, excess liquidity creating bubble-like pricing in many asset markets, chaos in the Middle East, interest rate normalization in the United States at the same time as global divergence in monetary policy, and volatility in capital markets.
It was also noted that job growth is slowing because “we’re running out of people to employ,” and that there is a shortage of labor in construction, health care, and technology.
Giving particular weight to one speaker’s reference to the large volume of loans that are traded in emerging markets in dollar-denominated debt at a time of commodity price declines and currency weaknesses, the bubble-like pricing in commercial real estate, and the Middle East chaos, we could be at the beginning of an inflection point.
The majority of attendees expected that the next slowdown would be moderate, a “whimper” as opposed to a “bang,” occurring in about two to three years. Previous bangs in real estate have been caused by overbuilding, the use of too much leverage, or an economic recession that affects fundamentals. These factors do not appear to be in play at this point. Also important is the fact that capital stacks are more conservative today, levered on average at 50 to 65 percent versus around 80 percent in the last cycle, and underwriting is more disciplined. Capital is less concentrated in the commercial mortgage–backed securities (CMBS) market, with roughly 25 percent of total dollar value of loan originations today compared with 50 percent in 2006.
The other types of potential sources of economic bangs are the global issues noted previously, and the uncertainty associated them, plus—as always—black-swan events, which by nature are unpredictable. More in our control, and appearing to be less likely to occur than in previous years, are events such as government shutdowns and the threat of a U.S. Treasury default.
The discussion then turned to the sentiment that with “more capital than there are deals” from both onshore sources (many of the big institutional investors are increasing their real estate allocations from 8 percent to 12 percent in 2016) and offshore sources, participants said the “wall of capital is not going away.” But what are the attractive deals on a risk/return basis? For opportunity funds, they said, replacing some of the opportunistic deals made earlier in the cycle are the more defensive value-add deals; eyes are on Europe, where certain markets are still several years behind the United States in terms of economic recovery; and the public market will continue to generate opportunities. Core funds are looking at good-quality properties in secondary markets and at secondary production in good markets; repositioning in core strategies; engaging in build-to-core development; pursuing niche strategies such as senior housing, student housing, and medical office development; and using low (or maybe a bit higher) levels of leverage to differentiate themselves.
Other observations regarding opportunities included the following:
- One can still purchase commercial real estate below replacement cost and with positive leverage.
- Fundamentals are expected to remain strong, with 6 percent growth of net operating income (NOI).
- Returns in the core funds have been approximately one-third annual income and two-thirds capital appreciation, although many expect that split to change.
- Exit capitalization rates are 5 percent (again assuming benign interest-rate increases over time) and 7 percent total returns on an unleveraged basis.
- The full impact of the U.S. millennial population has yet to be felt. Only 16 countries in the world have a greater total population than the U.S. millennial population.
The next focus was on what may be ahead for various financial players, with the following observations: - The current increased spread between public market pricing and private market pricing of real estate assets presents special opportunities for going private. A clear majority of participants said there will be more go-private transaction activity in 2016 than there was last year, possibly with core-plus funds entering this space in addition to opportunistic funds—the main players in both this cycle and the last.
- Nontraded real estate investment trusts are expensive for the investor as a result of payments for marketing and acquisitions. Reputational issues have perhaps reflected the notion of “too much money too soon.” Huge opportunities remain here subject to this segment reaching maturity and figuring out how to market shares and property acquisitions on a more transparent and traditional basis.
- In recent years, commercial banks’ capacity to fund real estate has probably dropped by 20 percent as a result of consolidation and regulation, including capital rules. Each of the several federal agencies monitoring the banking system has its own “stress test.” Overall, credit remains high-quality, with loan-to-value ratios holding at 70 percent.
- Commercial mortgage–backed securities (CMBS) will have topped out at about $100 billion of originations in 2015. Risk retention remains a huge issue, and it will probably be resolved in 2016. Another major issue is the new U.S. Securities and Exchange Commission requirement (as of November 24, 2015) for an issuer’s chief executive officer to validate the disclosure in the CMBS package, making him or her personally liable for any false information. Another developing practice that is adverse to borrowers is lenders or issuers renegotiating loan terms two or three days before the closing, which allows the lenders/issuers to “flex” the interest rate to meet the costs required by the CMBS market.
- Shadow banking capacity has increased, with perhaps as many as 50 new names operating in this arena. A major constraint on further growth is the ability of nonfinancial institutions to get bank lines, and the resolution of the federal requirements for risk retention.
A few years ago, many of the symposium participants were deeply concerned about dealing with the outsized maturities in CMBS and the massive job of trimming the Federal Reserve’s balance sheet, and the impact these actions would have on the markets. Because we have enjoyed several years of slow growth and employment has slowly gained ground, such concerns have been mitigated. It appears that the Fed’s policy is to moderate the adjustment of its balance sheet, and participants felt this moderate adjustment will take between three and ten years. The business cycle may well intervene in such plans, however, and until the adjustment of the Fed balance sheet is corrected, we are vulnerable to slight slowdowns becoming more pronounced than they would have been. Another major concern is overregulation and the impact of federal policy on the longer-term availability of capital. While one can make the case for a moderate prolonged recovery from the gross irresponsibility of the 2006–2008 era, more risk is built into the system than meets the eye.
Bowen H. “Buzz” McCoy, formerly responsible for the real estate finance unit at Morgan Stanley, is president of Buzz McCoy Associates in Los Angeles.
