The capital markets continue to be jolted by the overall confusion about the direction of our economy. Everything from jobs and inflation to interest rates, oil prices and housing provides conflicting information to support both the bears and the bulls. The old saying, “If you put 10 economists in a room, you will get 10 different predictions,” is just as true today as it ever was. In fact, you may even get 100 different predictions in today’s environment.
Over the past few years, the capital markets have been a great source of new and creative financial products for real estate owners. Year after year, more products were introduced with increasingly aggressive terms, ultimately achieving some of the most relaxed financial underwriting.
For example, a year ago some lenders were providing 90 percent leverage, non-recourse construction loans. These loans were priced with all-in rates around 5 percent. There is no doubt that some of the capital market problems occurring today are partially a result of the overly aggressive loan structures of the past.
Consequently, many lenders are now pulling products off the market, including straight-forward loans for qualified clients in good markets that are conservatively underwritten. In essence, they are “throwing the baby out with the bathwater” as the capital markets begin to overcorrect by swinging in the opposite direction and, thus, creating tremendous illiquidity.
The overly aggressive lending market of the past few years, combined with the current concerns about the overall economy, has created a perfect storm. Our society perpetuates the sentiment that we are exposed to every day. In a strong economy, we buy the newest products and invest in the hottest stocks based on word-of-mouth and great advertising. When the economy slows, the average consumer does not analyze in detail the current economic situation, but instead acts on emotion and the sentiment of others. With that in mind, the following is an example of some of the recent news blurbs driving our current attitude about the economy:
- Thirty-three percent of U.S. top executives plan to cut payrolls in the coming months.
- [California] median home prices plunged 30 percent, the steepest decline for any month going back to 1988.
- Investment in U.S. commercial real estate fell 70 percent in the first quarter from a year earlier.
- In February 2007, 84 percent of stocks were above their 200-day line. Today, only 27 percent are above that mark.
However, by taking a closer look at the numbers, one might determine that our economy is not as bad as it is currently portrayed. Yes, the housing market is down and the capital markets are in disarray, but the unemployment rate has increased by only one percent and oil prices have started to decline. There are many examples to fuel the experts who are manipulating data to justify their predictions about our economy in the future. This leaves a significant amount of room for interpretation as economists continue to debate our future direction.
The commercial real estate market is also adding to the confusion and creating a drain on the capital markets because buyers and sellers are not anywhere near agreement on value today. Buyers believe the market is falling apart; sellers think this is just a short-term stumble and market conditions will improve soon. Both sides have data to support their opinions. Buyers focus on the negative headlines about the economy and how it will inevitably impact real estate, while sellers argue that real estate continues to hold up over time.
For example, commercial property vacancy rates for office, retail, industrial, apartments and self-storage are actually the same or lower than they were in 2003 and 2004. The Moody’s/REAL Commercial Property Price Index is now 5.5 percent below its peak in October 2007, which is not that bad when compared to the overall stock market being down about 20 percent. Additionally, the delinquency rate for commercial mortgage-backed securities (CMBS) loans is still less than 1 percent and close to its all-time historical lows.
All things considered, plenty of conflicting information exists to create a big discrepancy between buyers and sellers. This discrepancy has led to a significant slowdown in properties changing hands. It’s estimated that total commercial real estate transaction volume is off by almost 75 percent compared to the prior year.
So what does all this confusion mean to the property owner looking for debt? First, let us focus on one of the largest providers of capital to the real estate industry over the past five years: CMBS. This market is all but shut down due to previously mentioned issues. Investors are concerned about buying loans originated in 2006 and 2007, since they believe they were too aggressively underwritten. This combined with negative data about our economy has contributed to the illiquidity in the market.
CMBS has only provided about $12 billion of debt to the market over the first six months of this year with little in the pipeline for the remainder of the year. At the same time last year, the CMBS market provided $137 billion and ended the year at $224 billion. In other words, 2008 may end with only 5 percent of the volume provided to the commercial real estate industry in 2007 by the CMBS market.
So what types of lenders have filled this CMBS void? So far, it has been commercial banks and life insurance companies. But there is continued concern that the banks are under tremendous pressure and may be pulling back soon. For example, it is estimated that commercial banks have written down less than 1 percent of their residential and land assets as bad debt. Some experts predict this could increase by as much as 26 percent over the next five years.
The FDIC is hiring auditors to look into bank reserves to cover these write-downs. There have been multiple bank failures so far this year, including the second largest bank in U.S. history, Indy Mac. Banks that are in a good position will also cut back on lending as they hit certain volume goals, geographic targets, sponsor limits and product-type restrictions.
The Exit Strategy
Many lenders are concerned about their exit strategy, so an owner should exhibit a future net operating income (NOI) that will allow for pay off of the current loan with a new lender. However, this is more complex than it seems since the future of cap rates, rental rates, occupancies, etc., in this market is so uncertain. For example, many lenders may not give an owner credit for rental increases, and then use a 1 percent or greater cap rate for their exit sizing.
Even though a loan may qualify today, the loan proceeds may be reduced because the owner may not be able to qualify for the same loan in three years when he needs to refinance due to conservative underwriting of future financial and market assumptions.
The end result is it’s going to take some time before liquidity returns to the capital markets. The economy needs to sustain a clearer direction for buyers and sellers to come to terms and for lenders to truly understand the depth of their write-downs.
When looking for a loan, owners should explore a variety of options, such as commercial banks, regional banks, life insurance companies, credit and finance companies to find the best deal. They should also be prepared to accept more recourse, less proceeds and shorter terms.
At the end of the day, this too will pass, and the capital markets will correct. In the meantime, having the knowledge to properly navigate this turmoil will help you keep one eye open for the opportunities that always arise during a crisis.
Eric Snyder is a senior vice president with Buchanan Street Partners, a real estate investment management firm in Newport Beach, Calif. Buchanan delivers complete capital solutions to commercial real estate developers and owners through its discretionary funding of equity capital and by providing commercial real estate advisory services. For more information, visit www.buchananstreet.com.