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Seven Real Estate
Finance Myths Unveiled |
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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.
Myth No. 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 values.
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