Commercial real estate lenders set new benchmark lows for interest rates and debt yields in the third quarter of 2012. Neither result, reported by Chandan Economics in late October, was unexpected. The broader decline in Treasuries and other benchmark rates virtually assured that borrowing costs would dip. Whether the 4,500 new acquisition, refinance and construction loan transactions recorded by our team in the third quarter can withstand the eventual rise in financing costs is the more pressing question. Evidence that third-quarter pricing and loan structures in the New York tristate area were less sensitive to asset quality implies more risk-taking by lenders, even if underwriting has held to in-place cash flow.
Monetary policy and global capital flows have underpinned the decline in borrowing costs. The benchmark 10-year Treasury yield dropped to an average of 1.64 percent during the third quarter, down 19 basis points from the second quarter and 77 basis points from a year earlier. Challenging the conventional model, capital flowed to Treasuries even as the inflation-indexed yield pushed deeper into negative territory.
Under these extreme circumstances, and absent a widespread shift in the perceived risk of commercial property lending, borrowing costs had nowhere to go but down in the third quarter. The attendant increases in up-front interest-only periods and in other leading indicators of underwriting quality were less mechanical, signaling a more bullish view of downside risks across all classes of lenders.
At the same time, the decline in multifamily and commercial mortgage rates did not match the third quarter’s slide in Treasuries. As a result, spreads were necessarily wider at the end of the quarter, supporting a generally favorable assessment of investment and lending trends.
Whether for cap rates or interest rates, comparing current spreads with their long-term averages has become a key input to the rationalization of prevailing trends. But the comparison relies on a flawed assumption if taken out of context. It ignores that current benchmarks are not determined in a well-functioning private market and that distortions of Treasury prices—attributable in part to experimental monetary policies—complicate a straightforward interpretation of the spread itself. If your downside scenario anticipates a rise in yields on the order of 300 basis points, the marginal properties in your portfolio will struggle to generate offsetting cash flow growth.
Comparing core markets like New York, San Francisco and Washington, D.C., with their relatively illiquid peers, differences in loan structure and pricing during the third quarter were still pronounced. In the office, retail and industrial sectors, debt yields were predictably higher in secondary markets. Metrics for loan quality were generally reflective of differences in property quality, sponsorship and asset liquidity. In many underserved markets, a low ratio of active lenders to the financeable inventory suggests lending standards and access to credit remain tight.
In contrast with commercial properties, borrowing costs and underwriting criteria for apartments showed further signs of converging in the quarter-to-quarter comparison. Differences across geographic areas and proxies for asset quality such as property size and age were less pronounced than for commercial assets.
The findings reflect competitive overlaps among agency and balance sheet lenders, as well as the stronger fundamentals that have distinguished apartments from other property types so far during the recovery. Default risks for apartment loans are judged to have migrated further out on the tail, with the result that conventional analytics—the likes of which characterized risk assessments prior to the market’s collapse—may fail to differentiate one market or asset’s expected loss from any other, whether taken on a case-by-case basis or in the evaluation of agency mortgage-backed securities.
While underwriting to current cash flow and projections for continued rent and occupancy gains mollify term risks, income growth varies widely across markets and submarkets even if spreads do not. Chandan Economics’s models show default risks clustered at maturity, principally due to a rising interest rate environment. Not every property will experience income growth that fully offsets higher benchmark yields and the pressures they will exert on exit cap rates and borrowing costs.
There was no shortage of headline-making loans in New York City during the third quarter. Financing for transformative development projects and trophy hotel and office trades distinguished New York from every other market in the country. The largest banks, life companies and other lenders have carried the trend into the fourth quarter, whether at Times Square’s Gateway Center or the Manhattan at Times Square Hotel.
Below the radar of the largest press-worthy deals, small- and mid-cap transactions in New York’s apartment sector were a microcosm of the national trends. Across the boroughs and their submarkets, borrowing costs in the third quarter show less differentiation in our proxies for asset quality and location.
Among the tractable metrics, apartment debt yields in New York registered well below 9.0 percent. The lowest debt yields were in Manhattan below 96th Street and along the East River in Brooklyn, where the averages fell below 8.0 percent. The highest debt yields were in the Bronx and then Northern Jersey—but the difference across all submarkets was just barely 100 basis points, narrowing from prior quarters.
For long-dated fixed-rate financing, including loans with initial interest only periods, rates were consistently below 4 percent in Manhattan and Brooklyn’s top submarkets. For loans with slightly shorter terms, rates sometimes dipped under 3 percent. At comparable leverage, North Jersey commanded the highest borrowing costs, but even in that case spreads on 10-year financing were not much higher than in parts of Manhattan.
Is New York’s median apartment loan a candidate for default at maturity? The credit risk exercise suggests it is definitely not. But the models do point to more limited variation in spreads and loan structures across assets of markedly varied quality and income potential. At a point when future income growth will make the difference at maturity, that convergence should serve as a note of caution to lenders.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School. The views expressed here are his own. He can be reached at firstname.lastname@example.org.
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