October 16, 2016

By Andrew Little

Pop rock songwriter P.F. Sloan wrote the quintessential anti­ establishment tune in 1964 and Barry McGuire made it famous in 1965 singing the lyrics “You don’t believe we’re on the eve of destruction” as it reached No. 1 on the charts.

Although most political observers would conclude the song applies to today’s state of affairs, “Eve of Destruction” would be an overstatement for most commercial real estate players.

In fact, the overall feeling in commercial real estate is that we are near the top of the cycle, but unlike 2007, there is no great fear that we are zooming straight for a cliff.

According to a number of metrics, market participants are showing amazing restraint.

For instance, according to a recent JP Morgan report, construction starts are down for office, apartment and retail properties which will help keep supply in balance. This is in contrast to tenant demand and apartment demand increasing.

And despite very accommodating pricing on debt, transaction volume is down for the first seven months of 2016 by about 15 percent compared with the same period in 2015, according to data from Real Capital Analytics.

Anecdotal evidence points to a lack of sellers to explain the drop in volume, but given that pricing for most property types is past prior peaks reached in 2007, it is more likely that buyers are showing some restraint this time by pulling back when pricing gets too aggressive.

Lenders also are showing discretion, although in fairness, it has been forced on them by regulators.
The risk­retention rules that come into play in late December will require conduit lenders hold a 5 percent retained interest in loan packages that they securitize.

As the deadline approaches, two impacts are taking place.

The first is an increase in pricing. Most conduits now are providing one price for loans that close before Nov. 15 and a higher price for those that close later.

The expectation is that risk retention will increase pricing by 0.15 percent to 0.35 percent. If a loan is not closed by Nov. 15, it is assumed it will not get securitized prior to Dec. 24 when the new regulation kicks in.

The second impact on conduit lenders is underwriting is becoming more conservative, which is exactly what the rule makers intended.

Conduit lenders are not alone. Many bankers also are finding that regulators are breathing downs their necks, forcing them to pull back from full multifamily loans.

Despite these disciplinary brakes on the market, overall real estate lending actually increased by 1.4 percent in the second quarter compared with the first quarter of 2016, according to data from the Mortgage Bankers Association.

Uncertainty surrounding the upcoming election, the Federal Funds Rate and corporate profits have made overall market conditions tough to predict this fall.

In turn, this has made pricing on commercial real estate loans somewhat volatile, but nonetheless, still quite good.

The most conservative loans of 5 to 10 years in term are pricing in the 3.25 percent to 3.65 percent range, and higher leverage conduit loans are pricing in the 4.3 percent to 4.5 percent range for 10 years, according to the John B. Levy & Co.’s National Mortgage Survey.

Investors are still enamored with commercial real estate, but they are showing discipline in their appetites.

Secondary markets such as Richmond are attractive to institutional buyers if they can acquire the best properties at comparatively attractive pricing.

Another avenue to getting real estate exposure without the risk associated with owning is higher leverage loans offered by large institutional debt funds.

Most of the larger value­added transactions that have occurred in Richmond over the past 12 months to 24 months have included bridge funding of this sort. Expect this trend to continue as investors continue to navigate the top of the cycle without self­destructing.