Market Data

Lessons Learned

Can a new look at data prevent the commercial real estate market from repeating past mistakes?

What has the commercial real estate market taught us in the past three years? Humility in many cases, and perhaps balance, as market participants measure the pain of a 40 percent loss in value against more intangible items, such as the steadfastness of friends and family in difficult times. But if nothing else, the recent excursion to the bottom of the trough reminds us that commercial real estate is a cyclical business.

But is awareness of this cycle enough to save us from ourselves? Taking into consideration the actions of commercial real estate lenders as well as investors offers another perspective on the market cycle and, perhaps, a way to use it to our advantage.

The Bubble of Death

During the expansion phase of a real estate cycle, competition and rising property values compel lenders to increase acceptable loan-to-value ratios. And borrowers usually are happy to take advantage of the higher leverage. The combination of the inverse relationship between LTV and equity plus rising asset values magnifies the amount of available debt.

Typical Commercial Real Estate Leverage Availability

This sets up the following two conditions: smaller going-in equity amounts and increased leverage on higher asset values, which can result in significant negative equity positions as values revert toward historical mean values.

Moodys/Real Commercial Property Price Index

These relationships are illustrated in Figure 1. The implied forward value assumes a compound annual growth rate for commercial real estate values, in nominal terms, is 3 percent (assumption based on the Federal Reserve’s targeted inflation rate of 2 percent) for the initial six years and then 0 percent for the next three years. The equity at implied forward value represents the difference between the loan amount and implied forward value columns.

As a real world example of overall property value movements, Moodys/REAL Commercial Property Price Index (CPPI) is shown as Figure 2. The index is based on data from the MIT Center for Real Estate and tracks same-property realized round-trip price changes on U.S. properties.

Although more symmetrical, the property value levels shown in Figure 1 are similar to the Moodys/REAL curve in Figure 2. In Figure 3, the property value levels are shown as the market-price-movements line; also plotted are the implied forward prices and the loan amounts, all from Figure 1.

Notice the “bubble of death” where loan availability exceeds the implied forward pricing for commercial real estate. This section of the curve represents the loans made based on valuations that later became 100 percent-plus LTV loans and that continue to plague both lenders and borrowers today.

In Figure 3 this bubble is roughly a four-year period (2004 to late 2007) where rising prices drove the availability of leverage. This has resulted in massive equity losses for borrowers and lenders alike as asset prices have since reverted to levels implied by historical price movements.

The Bubble of Death

Back to Basics

Figure 3 demonstrates that as property values deviate further from implied forecasted property values, this signals that price correction risk is building. One does not need to be able to predict market peaks and troughs. With today’s availability of data, commercial real estate pricing movements can be tracked in almost real time and decisions can be made based on this information.

By combining an understanding of where the current market is within a real estate cycle, much value is added to strategic decisions such as when to buy, when to sell, and how much debt to use (borrower) or make available (lender). Decisions such as these should include an analysis of a property index based on repeat-sales price movement. In residential real estate, the most well-known repeat-sales index is the S&P/Case-Shiller Home Price Indices. Today, similar tools are now available for commercial real estate. This includes the aforementioned Moodys/REAL CPPI as well as CoStar Group’s Commercial Repeat-Sale Indices introduced in mid-2010.

Most of us know commercial real estate owners who sold many or all of their properties in 2006 and 2007. These were not chance occurrences, nor did these investors possess crystal balls that foretold the future. They just didn’t want to be on the road when the bar closed and all the drunks headed for their cars.

More specifically, these owners recognized that valuations had decoupled from traditional supply/demand factors and were being driven ever higher by some other forces. This made them uneasy so they sold.

Lender Implications

As expected, since late 2007 banks have become progressively more conservative with their commercial real estate underwriting standards. Some banks have changed leverage caps in loan policy while others have not but are operating under informal restrictions. Some have declared moratoriums on commercial real estate lending.

Unfortunate are the banks that cannot lend when asset values have declined by over 40 percent since the October 2007 peak. Now is the time to selectively lend on commercial real estate to strong sponsors and well-located properties. Undoubtedly, loan supply will return to commercial real estate markets when asset values increase.

But wouldn’t it be better to take a measured approach to commercial real estate loan origination on the way up? It is possible to create a model to calibrate offered leverage with movements in a commercial property index with the goal of keeping loan amounts below the implied forward pricing line. Such a model links commercial real estate asset value movements and LTV so that lenders can exercise leverage management based on objective observations throughout the cycle. This is an alternative to a herd mentality where momentum can push aside rational behavior and competitive forces result in compressed interest margins and more aggressive loan amounts during expansion. On the way down, the ability to lend is crimped because of problem loan accumulation due to aggressive lending during expansion.

With a countercyclical leverage strategy a lender’s revenue growth from commercial real estate lending may decline in the expansion period as competition shrinks both loan volumes and interest rate margins. However, pricing power returns on the downside as lenders who have large exposure built on the upswing pull back on commercial real estate lending. This is when the countercyclical lender gains loan pricing and structuring power and has the ability to lend on select assets and borrowers.

By being mindful of where we are in the real estate cycle, strategic decisions can be made about loan allocations and asset concentrations. It is up to bank management and credit officers to go against the grain if the market begins to behave irrationally, as it has in the past — and most likely will again.

Patrick Fitzgerald, CCIM, is vice president of commercial real estate for BankUnited in Orlando, Fla. Contact him at


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