Emerging Trends - Where’s The Money? Part III
The 2009 Urban Land Institute’s annual Emerging Trends in Real Estate weighs in on the capital markets. We all know that real estate is a debt-driven business, but what we may have forgotten (in the drunken stupor of easy money) is how the lack of debt looks, feels, and plays out in the market place, and how the lack thereof can bring the real estate market to its knees.
The wall went up for capital for most real estate deals in the fall of 2007. Just dried up and disappeared for all practical purposes. Markets went from being inundated with capital to being drastically undersupplied. The subprime wake-up call convinced investors that they had no idea about the value of the collateral backing their mortgage-backed securities, and “suddenly everyone realized the property markets had been overplayed."
Things would probably have been manageable if the problems had been contained to subprime mortgages, but when the market woke up, the binging became apparent. The out-of-control lending, which utilized few underwriting skills, extended across all residential and commercial real estate as well as corporate markets. Voilà … a global financial maelstrom.
“Low interest rates, tax regulation, untested financial instruments, and garden-variety greed conspired to upend the property markets…borrowers kept bidding up prices on anything with a foundation, flipping their acquisitions as soon as possible to the next leveraged buyer. ‘Swampland in Florida found its way into AAA securities’.” (Perhaps they should be called insecurities.)
The multi-billion dollar question for 2009… when will the money return to the strangled real estate markets and who will be investing and at what levels? “As markets deleverage and correct, the length and severity of the repricing process will influence the resumption and intensity of capital flows.” In other words, we have not a clue when capital will flow again for the real estate market.
Once markets stabilize the investors will return to the market prompted by the opportunity to buy at market bottom, but it is doubtful that the lenders or the Commercial Mortgage-Backed Securities market will reenter the fray with the same enthusiasm. Yes, we see the problem here. Without debt capital, equity capital may wither on the vine with small returns being the order of the day.
Emerging Trends speculates that the stock market will recover before real estate. If so, will investors be tempted to reallocate portfolio funds out of real estate and into the stock market? With modest 5 percent returns on real estate being predicted by one research leader, the risk to reward ratio seems hardly worth the trouble if, IF, a higher return can be obtained elsewhere.
“Capital markets’ dynamics have changed dramatically.”
The consensus from industry leaders surveyed by ULI for Emerging Trends is decidedly dire. “Not surprisingly in light of the credit cataclysm, respondents appear certain that capital availability for both debt and equity will be constrained in 2009 and investment will be ‘rather muted.’ In fact, overall capital availability rates are the lowest in the survey’s history.” And then repairing the CMBS markets and rebuilding investor confidence will be difficult and likely slow to evolve.
The last players to the real estate party are likely to be quick victims to the market deleveraging and repricing. Owners who bought or refinanced in 2006-2007 may now be underwater on properties that were overpriced and over-leveraged. With few ways out of the morass we are likely to see more maturity defaults. Trends’ respondents predict commercial foreclosure rates to increase and “could rise to 3 percent to 4 percent of outstanding loans. (Defaults and delinquencies should not approach levels seen in early 1990s.)
Many lenders are now afraid to underwrite mortgages with any degree of risk. Risk is fabulously expensive these days. Significant borrower equity, recourse, secure property cash flows are the credit terms du jour. And forget about mortgages over $100 million. The typical large mixed-use projects are dead in the water for the most part.
Lenders are more favorably disposed to apartments and Class A office in strong markets such as 24-hour cities. Lenders are reserving funds for their premier borrowers and are favoring trophy properties. It will take time and a recovered economy to fix balance sheets to the point where lending will loosen again. One developer said “in ten years it will be reckless and undisciplined again.”
“At best, 2009 offers a chance for banks to stabilize, but lending will continue to be severely constrained.” Any degree of risk for lenders will carry a high price tag, at least for the near-term.
Real Concepts Series based on ULI's Emerging Trends in Real Estate 2009:
Part I - Hold On and Try to Lose Less
Part II - Best Bets for Real Estate in 2009
Part III - Where's the Money?
Part IV - Markets to Watch
Part V - Property Types in Perspective
Emerging Trends Charts & Graphs
Click here to obtain the entire Emerging Trends report from the Urban Land Institute.