BY ANDREW LITTLE, Special correspondent - September 17, 2017
The caution flags are out and deal activity is down, but the threats to commercial real estate are hard to enumerate, according to a panel of experts who fielded questions at a commercial real estate investors conference last week.
The event featured three speakers representing a wide spectrum of interests — Mike Cotler, a senior portfolio manager who runs real estate debt and equity investments at Loews Corp.; Adam Randall, a managing director at Berkeley Point Capital LLC, a Fannie Mae/Freddie Mac agency lender; and Dan Zwirn, CEO of Arena Investors LP, a non-bank capital provider that crosses all market sectors looking for attractive risk-adjusted returns.
The general consensus was commercial real estate does seem to be peaking, but discipline in underwriting imposed by banking regulations have kept a lid on overly aggressive lending.
The panelists agreed the downturn, when it comes, would be a shallower one for commercial real estate because of this discipline.
Challenged with identifying “the canaries in the real estate coal mine,” Zwirn pointed out several threats already on the horizon that did not necessarily relate to real estate but could easily impact all credit markets.
For instance, he indicated that banks are so restricted in their lending that loans are making up a smaller part of their balance sheet and equity and debt securities are making up a larger portion.
While Zwirn indicated there were very few stressed banks, he advised caution in investing as many issues could ramp up quickly to seize up the flow of money. He cited aggressive auto lending as another non-real estate related problem that is a concern.
The sentiments shared by the panelists fits into data provided by Real Capital Analytics for the second quarter ended June 30.
Sales of commercial real estate across the country have been down for five of the past six quarters when measuring year-over-year changes, and sales volume in the second quarter of 2017 was about 5 percent lower than the same quarter in 2016.
Coming as no great surprise, the same data show apartments continue to get more expensive as cap rates fell in the last year from 5.8 percent on average across the country in the second quarter of 2016 to 5.6 percent in the second quarter of 2017. As cap rates go down, values go up.
Virtually every other property type showed increasing cap rates during that same time period.
The decline in investment sales are almost directly tied to a decline in the issuance of commercial mortgage-backed securities bonds over the same period.
Recent activity in the market, however, could reverse the trend. A resurgent appetite for commercial mortgage-backed securities bonds has allowed conduits to actively bid on new mortgages. Attractive pricing and quick closings are luring borrowers back.
According to data from Morningstar, quarterly bond issuance averaged $23.8 billion in 2015 before falling over the past six quarters to an average of $17 billion. This trend is expected to reverse itself in the third quarter of 2017.
Data from Commercial Mortgage Alert shows issuance is expected to exceed $30 billion for July, August and September. The quarterly total would eclipse the highest post-recession output.
Rates have continued a downward trajectory and are currently in the 3.25 to 3.65 percent range for five- and 10-year loans offered by life insurance companies, according to the John B. Levy National Mortgage Survey.
Conduit pricing also has come down and for 10-year loans now averages 4 to 4.35 percent for higher leverage loans.
The increase in CMBS issuance combined with lower rates is pushing life insurance companies to sharpen their pricing pencils.
The lower interest rate environment should continue to bolster commercial real estate around the country and in the Richmond region as well.
Randall made a point during the panel discussion that low cap rates and high prices in larger markets is spurring multifamily activity in Richmond.
Investors are looking in their backyard, which may be New York or Baltimore or Philadelphia, and they can’t get excited because the yield is too low.
Instead, investors come to Richmond and get excited about the yield they can get, so there is a lot of activity.
Full disclosure: The moderator of this conference was John B. Levy, a partner at John B. Levy & Co. Inc., a real estate investment banking firm in Richmond where I’m also a partner.
John B. Levy & Co. partner and investment banker Andrew Little can be reached at email@example.com.