7 Real Estate Finance Myths Unveiled
Discover the market factors that really are influencing today's transactions.
Much of the real estate finance industry operates on dogma,
most of which is grounded in sound theory about the factors that drive
commercial real estate markets and risk pricing. During the past 15 years there
have been significant advances in methods for assessing and quantifying risk,
which contribute to more disciplined debt and equity investors.
However, many of the risk models and decisions taking place
in commercial real estate today are based on assumptions that are questionable.
Understanding the reality behind some of these myths is important when making
commercial real estate financing decisions.
Myth No. 1
: Real estate equity currently is a safe haven for
investors. In the long term, well-located real estate is a solid investment.
However, the short and intermediate outlooks are somewhat more clouded. The
idea that today’s valuations will be maintained is a risky proposition. Since
1993 real estate values in this country have performed well in most markets due
to a confluence of factors that have made real estate a favorable asset class.
This long bull market must end at some point.
For instance, if a property owner places two advertisements
for the same property -- one for lease and the other for sale -- there might be
a deluge of interested buyers, but far fewer potential tenants. Something is
wrong with this phenomenon, since investors buy real estate for its long-term
cash flow potential. If interest rates rise, values will decline, with much of
the downward pressure being caused by floating rate loans that cannot be
refinanced or cannot carry their debt service. And, inevitably, capitalization
rates will rise back to historical levels.
2: Spreads on commercial mortgages are too low.
Many commercial mortgage debt investors are complaining that they are not being
fairly compensated for risk. But this is only partially true. Investors that
receive 90 basis points over U.S. Treasuries for a truly conservative mortgage
are being fairly compensated, since many of those loans have an extremely low
probability of ever defaulting. In actuality, 90 basis points is a fair yield
as it is a 22 percent yield increase over a 4.1 percent treasury. When bonds
were 8.82 percent on average in 1988 and low leverage spreads were at 90 basis
points, the reward for investing in a mortgage was a 10.2 percent premium over
the risk-free rate. Note that 80 percent loan-to-value loans were between
Treasury plus 175 and 200 basis points in 1988; now they are Treasury plus 110
to 140 basis points for most properties.
Complaints regarding spreads for highly leveraged loans,
where debt investors are attempting to get an additional 30 or 40 basis points
of yield, are justified. In these instances, the lender is taking on an
inordinate amount of risk for the incremental yield offered in today's market.
Myth No. 3
: Mortgage debt is a solid investment right now. While
lower leverage loans are just fine in the current market, higher leverage
mortgages are mispricing risk. A commonly used term these days is debt cap
rate, which generally refers to the mortgage amount as a function of the cash
flow. Often times the debt cap rate reflects a loan amount that is more than
the property would have sold for a few years ago. In many cases, traditional
lending tenets are being tossed aside.
Experts know that studying real estate markets’ history is a
poor way to predict future performance. Subordination levels are in sharp
contrast compared to levels a few years ago. Commercial mortgage-backed
securities originators are touting the new "super senior structures"
of their issues. This structure carves out a junior piece of AAA bonds backed
by mortgages that are subordinate to the rest of the AAA tranches. In theory,
the balance of the AAAs is safer. However, this thinking would be sound if AAAs
didn't continue to take a growing share of the entire mortgage pool; all this
does is recover some of the ground lost by more-lenient subordination levels.
The rating agencies and many bond buyers are confusing theory with reality,
causing errors in judgment.
Myth No. 4: Liquidity will continue to exist. Many investors
wrongly assume that capital, both debt and equity, will continue to be
consistently available. More typical credit cycles have longer periods where
liquidity is scarce, such as the cycle that occurred between 1990 and 1993.
Real estate fundamentals are stronger now than in 1988-1989,
which greatly reduces the chance of a near-term liquidity squeeze. It is
likely, however, that in a few years there will be a lower supply of available
credit, especially for leveraged transactions. Refinance risk for loans
originated now is higher than at any time since 1986-1989. This is true for
leveraged fixed rates as well as interest-only floating rates.
Collateralized debt obligations, or CDOs, which have continued their
transformation into a core asset class in the fixed-income markets, currently
incorporate pooled B financing pieces from CMBS into their offerings. CDOs are complex securities, even for bond
investors, as they contain numerous types of credits including home equities,
corporate credits, and high-yield loans. Since CMBS B pieces comprised only
6.98 percent of total 2004 collateralized debt issuances, it is possible that
the risk inherent in B pieces is not fully understood. There is a trend towards
dedicated real estate CDOs comprised of aggregated
subordinate debt and mezzanine investments. The idea that pools of unrated
securities can have investment-grade tranches seems counterintuitive despite
the fact that diversification of the pooled B pieces somewhat neutralizes their
risk. Many of the buyers of B pieces are now less concerned about risk so long
as they can transfer it to collateralized debt buyers. If B piece liquidity
through collateralized debt originations diminishes, then leveraged loan supply
will follow suit.
Myth No. 5: All conduits are the same. Many investors
believe that all conduit financing is similar in price and structure, but this
is not true. In case you haven't noticed, conduits are staffed by people, and
so are the rating agencies and bond buyers. This means that anyone originating
or selling mortgages has their own subset of experiences from which to draw
upon. There are startling differences between securitized lenders in how risk
is viewed, structured, and priced. One needs to truly understand what is
happening with numerous players in this market to achieve efficient execution.
Myth No. 6: Interest rates must rise soon. This is not as
certain as some people seem to think. A popular belief among economists and
others is that we have been living off the dole of the Federal Reserve Board
for too long. The U.S.
economy has yet to establish the kind of job growth that drives gross domestic
product to levels that cause the Fed to raise rates dramatically. Hurricane
Katrina may also have an impact on federal policy in the near term, causing them
to pause in their current round of rate increases.
Inflation appears to be in check assuming that recent oil
spikes do not contribute to a spiral of price increases the way they did in the
1970s. The largest financiers of the federal deficit, Japan and China,
which hold more than $1.2 trillion of U.S. debt, cannot liquidate their
positions without experiencing an enormous bond value loss. This is because the
market likely would panic if the industry suspected that either entity wanted
to reduce its U.S. Treasury holdings. The Fed also should realize that
disastrous consequences could occur if it raises rates too fast. Consumers are
financing much of their spending through home equity borrowing. This would
collapse if rates rose quickly, which also would deflate home prices to the
extent that the solvency of Fannie Mae and other large investors in adjustable
rate residential and commercial mortgages would be at risk.
Myth No. 7: The real estate bubble will burst soon. It is
possible, but not if rates stay close to current levels. Since rents in many
markets have been somewhat depressed for a while, it is possible that rent
inflation will increase as some markets reach equilibrium. For instance, it is
hard to imagine that class A suburban office rents can drop much more than
current levels. Very little supply has been added in areas that are supply
constrained due to lack of available land or soft leasing. Better information
flow regarding absorption has enabled construction lenders to enforce greater
supply financing restrictions. If rents recover in certain areas, there is
upside value potential.
To navigate the current market, equity investors should
tread water carefully and debt investors need to be wary of leveraged loans
based upon inflated asset values. Existing borrowers should lock in as much
money as their investments can support for as long as possible -- more than 10
years is preferable. If owners have another method of deploying capital outside
of real estate, it is time to sell, but not to buy more real estate at inflated