While Readily Available Cheap Money and Relaxed Underwriting are Fueling Deals, Markets Don’t Seem Overheated, Observers Say
Morgan Stanley and Bank of America/Merrill Lynch are going to market in the coming days with a CMBS offering that has a kind of scary déjà vu feeling to it for investors.
The loans in the offering (MSBAM 2013-C9) have a 98.8% loan-to-value (LTV) ratio, according to Kroll Bond Rating Agency. That is above the high end of the range of the last 11 CMBS conduits Kroll has rated since September 2012. In addition, there are 29 loans packaged as part of the offering (42.7% of the pool) with LTVs that exceed 100%, according to Kroll.
Those are the kind of valuations that evoke the heady days of 2007 when commercial real estate
values and liquidity soared to unsustainable levels, then collapsed. The CMBS LTVs aren’t the only numbers that conjure up peak comparisons.
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Value-weighted composite CRE values (those heavily influenced by larger transactions) have risen from their nadir to the pre-peak levels of 2006, according to this month's CoStar Commercial Repeat Sale Indices (CCRSI.)
In a welcome development credited with helping to support ongoing recovery, CRE lending activity increased 40% in 2012 as lenders started to let up on stringent underwriting standards. And CMBS issuance volume in the first quarter of this year already totals nearly half of the volume for all of 2012.
However, with prime interest rates almost half the levels they were heading into the market peak before the recession, some in the CRE industry are starting to wonder if the current lending conditions might be too much, too soon.
The debate extends to the highest levels of policy making, including the Federal Reserve, where officials have expressed differences over the optimal timeframe for winding down the latest 'quantitative easing' bond-buying program sometime later this year. Minutes released this week from the Fed's last policy meeting show that Fed officials are divided over when to curtail the bond-buying program, with different members concerned with 'over-heating' the already better-than-expected economy and bullish stock market, and others worried over tepid job growth and the impact that rising taxes and spending reductions could have on the recovery.
While it appears the Fed has so far successfully negotiated between too much, too soon and too little, too late in its stimulus, the tricky question over timing the transition to less stimulus remains open to debate.
“We are seeing what I consider irrational loan pricing combined with a relaxation of credit standards,” said Peter W. Jaworski, executive vice president and chief credit officer at WesBanco Inc. in Wheeling, WV. “I am probably one of the few people in the world that thinks amortization periods have become way too long across the board and that the concepts of real equity and guarantees are often forgotten.”
Other agree that low interest rates are having an enormous impact on the sustained growth in the commercial real estate market while adding that any such impact has plusses and minuses for investors.
“Financial institutions are active and lending again compared to three to four years ago. There is a mountain of capital being deployed into the commercial market. Money is inexpensive,” said Tim Feagans, president of NAI Global Investment Services Group (ISG), a division of NAI Robert Lynn in Dallas. “However, there is a new normal. Lending qualifications are more stringent to secure a rate and disqualifies some investors. Equity requirements are greater and amortization schedules are shorter which, in turn, do not promise a higher yield.”
“The trick is to find the solid, income-producing opportunities or compete for a tsunami of distressed assets. Prior to the crash a few short years ago, many investors were negatively leveraged and purchased on the hope of appreciation in property value rather than from income valuation approach,” Feagans said. “Unfortunately, some of the same investors were eventually undone by a drop in property value, income and the inability to cover their debt service.”
“The volume of investment sales continues to increase across the board as investors look for alternative markets to invest their money. Fortunately cap rates have remained steady and there is a healthy supply and demand,” he said.
The Same, Only Different?
In a report this past month, Wells Fargo Securities said there are a lot of similarities in the current conditions in the CMBS market to those of late 2005 or early 2006, “but not close to the excesses the market experienced in 2007,” noting several important dissimilarities between then and now.
The current issuance volume is still below 2005 levels; and the buyer base is still using less leverage than 2006 and 2007, Wells Fargo reported.
“We see less credit risk now in new issue than in 2007 transactions due to greater credit enhancement and near bottom of the market cash flows,” the Wells Fargo report stated.
“There’s no question that current commercial real estate sales have been at least in part debt-fueled from the historically low level of current interest rates,” said Bradley J. Feller, director of Stan Johnson Co. in Chicago. “That being said, it’s important to also consider that cap rates still remain at historically high spreads compared to corporate bonds.”
“Inevitably, interest rates will begin to rise as the economy improves, however, it’s entirely possible that cap rates will resist upward movement to some extent,” Feller said. “This is further enhanced by the fact that the economy is seeing a large generational shift as the baby boomers go from being net savers looking for investments with growth, to seeking yield-driven investments. Commercial real estate presents one of the most attractive investments for this generation as a safe haven of steady and long-lived returns.”
Bill Clark, principal of Clark Investments, an apartment sales firm in Pasadena, CA, said he likes the “realistic" lending practices he sees now compared compared with how difficult it was to get a loan a few years ago.
“From 2008-2011 lenders killed a number of my transactions as they got multiple appraisals and always went with the lowest one,” Clark said. “While it is still a challenge to get a loan, it is not ridiculous."
Rising Interest Rates Could Douse Enthusiasm
“An increase in interest rates will impact everyone,” said Tanya Little, founder and CEO of Hart Advisors Group in Dallas. “Currently there is more than $64 billion dollars in debt in some form of distress with special servicers. Many of those are not able to be refinanced. An increase in interest rates will only make these loans more stressed and slow the acquisition rate of real estate overall.
“While I personally think we are 24 months out before we see rising interest rates, unemployment will likely have to fall another percentage point (to 6.5%) before we will see rates climb,” Little added. “But there are other factors that may support rising interest rates, such as momentum in U.S. housing, a strong stock market, growth in exports, manufacturing and/or consumer spending.”
Patrick Gates principal of Matrix Holdings in Cincinnati, said in his experience, the cost of debt has not been a primary driver for doing deals.
“The low cost of debt helps sweeten the deal, but the 'story' related to the asset is far more important,” Gates said, adding that the market will adjust and factor in any interest rate changes. “In regards to debt, if (or when) rates increase in the coming years, those increases will be integrated into the deal.”
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1st Service Solutions: Top 10 Things You Didn’t Know About Restructuring CMBS.