Commercial Real Estate Follow-Up: REIT Indicator
I may not always be fully informed, but at least I'm asking the right questions. That's the message I take from two articles that recently came out on the expected path of commercial real estate in the U.S., which opened my eyes a little further on the subject.
According to a recent Bloomberg article:
Federal Reserve Chairman Ben S. Bernanke is proving powerless to prevent a deteriorating commercial real estate market. While the yield on 10-year Treasury notes fell 1.43 percentage points in the past three months to the lowest since 2003 following four interest rate cuts, the cost of borrowing for apartment buildings, offices, retail properties and hotels climbed as much as 1.25 percentage points.
As can be seen from the chart on the right, the spread (or premium in yield) investors are demanding from 'AAA' Commercial Mortgage Backed Securities has risen significantly (higher costs to borrow to buy these assets; uptrend is negative in this case). We knew spreads had widened, forcing banks to write down the values of some of these CMBSs, but what really worries me is that the widening has continued even as the fed has slashed rates. Fed cuts rates and borrowing cost goes up, not the math we want to see. Calculated Risk is always reporting on the front lines of these metrics, and is a daily read for anyone interested in this type of analysis.Since cap rates (mutiples of net operating income) at which properties trade are directly correlated with borrowing rates (increased interest cost = increased cap rate) and increased cap rates equate to lower prices versus net operating income, assuming net operating incomes from commercial properties just stay flat, prices will fall. So even in a market with great dynamics like Manhattan, if borrowing costs rise, net operating incomes need to rise just to keep cap rates stable and keep prices from falling. Again, this equation isn't new news, but you really want to see borrowing costs stop rising.
Now there are bankers who don't use the CMBS market. They are called portfolio or balance sheet lenders, and they keep the loans they make on their books. In recent years they were squeezed out of the lending game by Wall Street's appetite for both product and risk (see chart on right). In fact according to Scott Tross, a mortgage specialist and partner at Herrick, Feinstein LLP, who was quoted in the Bloomberg article regarding commercial real estate loans:
"Lending standards became more lax because people knew they wouldn't be keeping the loans on their books".If these more judicious portfolio lenders step in to a fundamentally strong market like New York City, can they keep borrowing costs from rising? Not likely, they don't generally take the risk of lending the huge sums required to buy just one large building in New York City (although some of the insurance companies and pension funds may), and since they have to live with these loans for years, they charge premium rates if they can get them and require much tighter terms than CMBS intermediaries. (Nevertheless, I will be meeting with some of these folks to get their take on the environment and I will be reporting back anything germain that I learn.) Moreover, for the reason outlined below, I'm not holding my breath that lower fed funds rates or the re-emergence of portfolio lenders will stop borrowing costs from rising and save the commercial real estate market....and I'm less sure that tight supply conditions will.
This brings me to yesterday's article by Herb Greenberg at CBS Marketwatch - Why office real estate is headed lower. In the article Greenberg opines that commercial real estate prices aren't just going to correct, they are going a lot lower.
The proof can be found in the shares of real-estate investment trusts, which have a remarkable track record when it comes to predicting what will happen to the prices of commercial real estate. Six month's after REITs start trading at premiums or discounts to their net assets or underlying values, commercial real estate typically turns in robust or dismal returns over the subsequent 12 months.
Greenberg goes on to talk about Manhattan's own SL Green (whose management I quoted prominently here last week) as a poster child for this indicator. SL Green is reportedly trading at a 23% discount to its net asset value, despite being called one of the best office REITs and being focused almost exclusively on the strong New York City market. The stock is saying current NAV is over stated and is predicting lower operating incomes from the firm's office buildings.Gulp! I was unaware of the historical accuracy of this indicator, let's hope it's wrong this time!
P.S. This is not a negative commentary on SLG stock, which is already pricing in an NYC downturn, and technically looks like it may have hit a bottom and is way oversold. It's simply a discussion on the topic at hand.
Posted by Noah
Tue Jan 29th, 2008 09:47 AM
interesting Jeff. Markets are juiced up right now on 75 bsp of fed cuts, economic stumulus cialis (as Dan Fitzpatrick says), and bond insurer bailout talks.
Ahhhhh good times! Got to love free market capitalism. Oh and by the way, to all those that think America has a debt problem, I say to you, SAVE YOUR MONEY & EARN 2%!
yay!
Posted by Noah
Tue Jan 29th, 2008 10:06 AM
Steve Leisman & Rick Santelli literally JUST discussed the very topic of your post Jeff!
Dead on! Specifically, how fed rate cuts have not had any impact on widening credit spreads in commercial sector!
Posted by jeff
Tue Jan 29th, 2008 10:29 AM
This phenomenon of the fed lowering rates, but markets and/or banks not responding has a nasty nickname....pushing on a string. This condition usually only gets fixed when balance sheets get replenished and/or sentiment improves markedly (Japan is still waiting for the latter). Which is why I don't see liquidity miaculously getting better. If we have any more unanticipated debt bombs to drop, the fed will be forced to reliquify the consumer directly. In order to do this they will have to force rates down to levels where conforming mortgage rates fall to 5% or lower, where they briefly got to in 2002, in order to really have an impact on the consumer cash flow that fiscal policy just can't do.
Posted by Mike
Tue Jan 29th, 2008 10:39 AM
One key metric to note is the impact of hedge fund speculation on the index. CMBS bonds are thinly traded, so the synthetic index is all you have to speculate with. However, there hasn't been a new CMBS issuance since the first week of December. The lull makes it difficult to tell where spreads actually are. When the first actual issuance of 2008 happens, it's possible that spreads come back a lot. The fed apparently can't drum up investor confidence for securities that have to marked to market right now. Another rate cut probably won't help that either.
There hasn't been a deterioration in fundamentals, and in NYC, you're not going to see as many flips, but buildings purchased in 2003-2004 have had significant improvements in rents and NOI and would be likely worth significantly more than they were 4 years ago. Buyers will be forced to provide more equity on a purchase, but there are lenders out there even for giant NYC deals. NYC borrowers have been accustomed to 10 year IO loans since 2005 and low debt service coverage ratios, and that just won't be the norm in 2008.
Posted by jeff
Tue Jan 29th, 2008 12:30 PM
Mike,
It is really interesting how the markets are wagging the asset dog these days. The actual charge offs of bad loans are not doing near the damage to bank capital ratios that mark to markets are. As you point out these markets can be pushed around by specs....and you can't see a lot of the associated OTC credit hedging that may be offsetting some of these bets. This is a really weird, non-inventory, non-cap ex driven cycle where market activity and consumer balance sheets are driving and everything else is just getting taken along for the ride.
Posted by s
Tue Jan 29th, 2008 12:57 PM
What significance to assign to the fact that apartment construction grew at the most modest level? I understand the fundamentals behind hotel growth, as tourism has been surging since '06. Also, would it be fair to interpret the graph to mean that apartment construction was NOT overbuilt.
Posted by jeff
Tue Jan 29th, 2008 02:52 PM
The graph really just shows a strong uptrend in nationwide commercial real estate transactions in dollars, and illustrates the point that the market has been very active. It does not show net new construction data and since it's in dollars not units price inflation is a factor. It is nationwide data, and markets are local, so you really can't read anything from it regading supply growth or if a particular asset class is over-built.
Posted by John beckk
Tue Feb 5th, 2008 11:46 PM
It really effect on tourism surging since 2006 graph shows everything.NYC borrowers have been accustomed to 10 year IO loans since 2005 and low debt service coverage ratios.
http://www.johnbeck.tv/