2012 Commercial Real Estate Outlook: Financing
We have discussed the implications for the supply/demand dynamics for the commercial real estate market in terms of the coming maturity cliff approaching for office, retail, and industrial space, as well as the coming shadow inventory approaching for the multi-family sector.
There are two other major components that will determine future price direction. The first is the availability of financing and the second is the sentiment in the market (the price investors are willing to pay for the income stream known as the cap rate).
The availability of financing has diminished considerably since the peak in 2007. The following chart shows all commercial loans at all commercial banks. As you can see the loan issuance skyrocketed year after year reaching a peak of $1.6 trillion in 2008.
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It since has collapsed downward along with prices. A major portion for this rise in demand came from the securitization market: Commercial Mortgage Backed Securities (CMBS). This market essentially disappeared following the financial crash of 2008. Small local banks, who also had an enormous appetite for commercial loans during the boom, have seen their balance sheets impaired with the extend and pretend program. This has hindered their ability to take on new loans.
The big buyers of new commercial loans after the financial crisis have been pension funds, insurance companies, and the government sponsored entities; Fannie Mae and Freddie Mac. Fannie Mae and Freddie Mac purchase only multi-family loans. They are lending to top quality buyers with significant down payments.
Pension funds and insurance companies have begun to lend to all commercial products. Just as with Fannie/Freddie, they are only lending to A+ properties and top quality buyers with significant down payments.
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This had put liquidity into the highest property tiers (A+ buildings) in strong markets such as Washington DC and New York. This high grade product has seen the largest recovery in pricing because the capital is available to purchase.
However, the gaping hold left from the CMBS and local bank lending market has severely impacted the availability of loans available. The increased scrutiny on who money is lent to and the significant down payments have lowered the supply of willing buyers who are able to purchase. The concept of stricter loan requirements on financing and its impact on pricing was discussed in detail in the 2012 Real Estate Outlook.
The following provides a snapshot of where we are today in terms of financing availability and cost. The information comes from RealtyRates.com. Click for larger view:
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The current spread over the 10 year treasury (I will explain all of these in a moment) is at 3.10%. The current average debt coverage ratio is 2.00 and the average interest rate on a loan is 5.11%. The average loan to value ratio is 67.5%.
Let’s begin with the spread. Most banks determine the rate they will lend at based on the 10 year government bond yield. The 10 year is currently hovering around 2%. This means that if the banks want to keep a “spread” of 3% they will give out a commercial real estate loan with an interest rate of 5%. This provides an example of why Ben Bernanke and our Federal Reserve desperately want to keep rates low. It has eased the financing cost for commercial loans (lower rates allow buyers to pay a higher price).
The debt coverage ratio was discussed in a previous section but we’ll go back to Bob our retail owner to explain. If Bob’s building currently has $60,000 per year in NOI then the bank will lend him a maximum of $30,000 per year in interest payments. This provides the bank a 2.0 DCR.
The average loan to value ratio is 67.5%. This means that lenders are currently requiring a 32.5% down payment (lenders were providing 80% loans at the peak of the bubble).
The question is where are these lending restrictions moving in the future?
I believe that a 32.5% down payment and 2.0 DCR are healthy requirement for lenders. Eventually the DCR will move back down to its more standard 1.3 range and the down payments will eventually move closer to 25%.
The trouble I see is in the interest rates. Right now Bob is purchasing a building financed at 5% interest. This provides him a great opportunity for current cash flow today. What he is not considered is what the interest rates will be when he is selling his property. Or to think of it another way, what will be the monthly interest payments his buyers will use to determine the price they will pay for his building?
As previously mentioned interest rates are bench marked off the 10 year treasury yield. This means an investor's future outlook for real estate values should be heavily weighted on where you believe the 10 year treasury yield will be in the future.
For reasons discussed on this site in great detail over the past few years, I believe that government bonds are currently at the end of a 32 year bull market. I believe they are close to or have already entered the bubble/mania phase of this bull market.
Investors purchasing buildings today have priced in low interest rates forever. Where else has this been applied in the commercial real estate market?
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