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FINANCIAL FAITH
Financial players hope market fundamentals continue
to lead interest rates in 2004.
Mark Strauss
In the final quarter of 2003, low interest rates and strong
capital flows are dominating the real estate market as they
have for the past 18 months. This trend should continue to drive
asset pricing. However, an underlying fear in the market is
that if interest rates move upward asset values will suffer.
The last 18 months have seen weak property market fundamentals,
rising vacancies, increasing expenses and stagnant rent, yet
an increase in job formation may change this course as the economy
rebounds in 2004. The argument can be made that we will soon
see improving property fundamentals and sustained property values
based on an economic rebound in the job market and interest
rates that remain relatively low.
The Macro View
With rising delinquency rates and loan-to-value ratios in CMBS
issues and falling subordination levels, it becomes apparent
that investors have not been concerned about weaker fundamentals
in property markets or CMBS pools. According to Credit Suisse
First Boston’s October remittance reports, the 60-plus
days delinquency rate is 1.66 percent, up 36 basis points from
last year and up 6 basis points since September. The 707 delinquent
loans amount to a $3.8 billion outstanding balance for an increase
of 41 percent year-over-year. Delinquent multifamily and office
loan balances increased more than twofold to $585 million and
$560 million, respectively. Delinquent retail loan balances
increased to $828 million, followed by the worst performing
sector, hotels, at $105 billion. Despite the recent decline
in performance, the current delinquency rates are relatively
small compared to the recession in the early 1990s when delinquencies
peaked at 7.53 percent. With that in mind, investor demand for
securities has kept CMBS spreads from widening despite an ample
supply of new issues. According to John B. Levy & Company,
triple-A spreads are at their tightest levels in more than 5
years, suggesting that investors are taking on more risk today
in order to win business.
The American Counsel of Life Insurers has reported that loan
delinquency rates in insurance company portfolios have fallen
5 basis points to 0.35 percent in the second quarter. The average
loan-to-value ratio for new commercial mortgages was about 68
percent, while the average debt service coverage ratio climbed
to more than 2 percent. It appears that even though there remains
intense competition among lenders to fund deals, the portfolio
lenders have not relaxed their underwriting standards like they
did a decade ago.
The Interest Rate Scenario
William Gross, managing director of PIMCO, points out that the
private sector debt, as a percentage of disposable income, is
now 25 percent higher than it was at the beginning of the last
recovery. What does this mean? If rates go up, the economy will
flounder as the consumer struggles to pay his higher debt burden.
He says, “It’s important to point out that most
U.S. corporations are finance-dominated companies — whether
they make widgets or cars, whether they sell insurance or overalls.
Many, if not most, American companies are profitable primarily
because of their financing activities. General Motors, in second
quarter 2003, earned almost all of its money from its mortgage
subsidiary, GE. It’s really more of a financial conglomerate/leasing
company.” Almost all of these companies, says Gross, benefit
from swapping their long-term debt back into LIBOR-based/short
rate sensitive hedges. If the Federal Reserve raises interest
rates, companies like this will pay dearly, as will the economy.
Federal Reserve Chairman Alan Greenspan will only raise short-term
yields if and when the U.S. economy appears to have the legs
to withstand such a shock, maintains Gross.
What’s Changing
With October employment data indicating the expansion of non-farm
payrolls, the Bureau of Labor Statistics altered its assessment
of the labor market from persistent weakness to modest but distinctive
improvement. Job gains from the 2 previous months were revised
upward, creating the biggest 3-month consecutive gain since
December 2000. The Institute of Supply Management’s employment
index for non-manufacturing businesses jumped to a 3-year high
and employment in the temporary help industry grew for the sixth
straight month.
With increased job formation, real estate fundamentals should
improve. Many real estate owners will wish for Gross’s
interest rate scenario, hoping that rising interest rates do
not put excess pressure on cash flows before the increasing
market fundamentals can compensate.
The Next Step?
Now for some what-ifs: If interest rates do rise, how will floating
rate lenders and the fixed-rate market react? If short-term
interest rates increase ahead of demand for commercial real
estate, commercial banks may experience problems in their construction
or value-added bridge loan portfolios. Commercial banks are
the industry’s dominant debt capital provider, possessing
approximately $833 billion in outstanding commercial mortgage
assets. Although they have been relatively disciplined in their
loan portfolio underwriting, maturing loans for properties in
under-performing markets could cause a problem. Furthermore,
if there is an upturn in long-term rates there may also be a
short fall between the amount of money that the sponsor was
able to borrow on a short-term floating basis and the amount
that can now be borrowed long term. The good news is that this
gap can potentially be filled by an array of mezzanine debt
providers currently offering rates ranging from 9 to 18 percent
depending on the amount of leverage required.
The CMBS market is the second largest debt provider to the real
estate industry with more than $360 billion in loans outstanding
and 16.9 percent of the domestic market. This year’s production
could reach $70 billion. While the talk of fiscal discipline
has so far been compelling, recent competing loan amounts have
varied by as much as 10 percent, with reserves varying by 50
percent and underwriting debt coverage ratios by 20 percent
as conduits compete to win deals. This market is betting that
increasing fundamentals will outpace interest rate increases.
The life companies, with $236 billion of outstanding mortgages,
command a market share of 12 percent, down from 22 percent in
1992. These lenders have set up their own securitization arms
(e.g., Prudential and Principal) to compete with the conduit
and have become very aggressive in pricing their portfolio loans.
In certain product types, the competition to place money has
not led to an easing of underwriting standards. Stabilized office
buildings are being underwritten at 60 to 70 percent loan-to-value
ratios with significant reserves being taken for leasing commissions
and tenant improvements based on property rollover schedules.
What’s Hot and What’s Not
Grocery-anchored retail is still in high demand. Consumer spending
has held up well through the jobless recovery and capital sources
are competing to provide proceeds at high loan-to-value levels
or are pricing at very low spreads for low loan-to-value financing.
However, lately there has been more focus placed on the sales
figures of the major tenants as well as the inline shops. On
the other hand, there is the hospitality industry, the weakest
link in the real estate chain with approximately 7 percent of
hotel loans currently delinquent — nearly three times
the level of the real estate industry overall. However, there
is money for hotels if they are underwritten properly. Lenders
are expecting 1.5 debt cover ratios and maximum loan-to-value
ratios of 60 to 65 percent. There are mezzanine loans available
for this category that can increase the leverage to 75 or 80
percent, but that gap money is being priced at 20 percent combining
a pay rate, look-back rate and backend participation.
There will be plenty of capital available in 2004 with interest
rates remaining relatively low when compared to the last 40
years. Capital providers will not throw caution to the wind,
however, as the lessons of the last bust are still fresh in
their minds. The economic recovery will begin to add jobs and
therefore strengthen real estate fundamentals, and assets will
hold their value even if interest rates move slightly higher.
Mark Strauss is the director of the Capital Markets Unit
for Cohen Financial in Newport Beach, California.
©2003 France Publications, Inc. Duplication
or reproduction of this article not permitted without authorization
from France Publications, Inc. For information on reprints of
this article contact Barbara
Sherer at (630) 554-6054.
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