A Window Opens
Tom Acitelli April 23, 2010, 1:24 p.m.
The downward march of commercial mortgage rates continues unabated, with coupons on 10-year fixed-rate commercial loans dipping into the mid-to-upper 5s, but it has been joined by an inevitable countervailing force: rising index rates.
The headline of a recent front-page article in The New York Times screamed “Interest Rates Have Nowhere to Go but Up.” Property owners in New York City would be well advised to take action, and there are a variety of ways to do so. A window of opportunity has arrived in which frustrated capital from all over the world is converging on city real estate willing to accept significantly lower yields—but it is likely that “the early bird will get the worm.”
At a time when index rates are still historically low (LIBOR well below 1 percent, and 10-year treasuries still below 4 percent), investor and lender frustration has led to a dramatic reduction in the spreads that result in mortgage rates, cap rates and accepted investment yields. There is a significant scarcity premium priced into good deals today because so many of the world’s real estate investment managers have been unable to push enough money out the door over the five quarters or so since the original panic subsided. Each successive conversation seems to bring a lower reported spread offer, or a greater willingness to consider a lower multiple or IRR.
However, even a modest rise in treasury rates could very quickly serve both to wipe out the benefit of such low spreads and lead to a devastating rise in cap rates. Although many investors expected to see a quick rise in cap rates in 2008 or 2009 as a result of the credit upheaval, the reality has been more of a slow upward creep. It can be argued whether this fact is a cause or a result of the general dearth of transactions during this period.
However, while absolute going-in cap rates may not have risen much on the deals that have traded, the exceptionally low index rates mean that the spread between cap rates and alternative safe investments has actually increased. Without a corresponding drop in that typically ignored spread, the inevitable rise in index rates will bring a concomitant rise in cap rates.
WITH REGARD TO DEBT underwriting, in many respects we are living in a 2004 redux. In spite of overwhelming amounts of available capital, senior debt lenders have held the line with regard to sizing discipline. First mortgage debt is plentiful and aggressive, but not out of context with historical norms: Leverage levels for most stabilized transactions top out between 65 and 70 percent, and require amortization. The cheapest pricing in the market comes from institutional lenders who are willing and able to accept lower yields in order to book the most conservative loans on the most attractive properties.
Nontraditional lenders are devising creative structures to boost debt levels up as high as 80 percent, but only for strong projects and in exchange for high yields. Similarly, construction loans are possible to arrange, but carry lower leverage based on conservative underwriting, are tough to close, require strong track records and personal liability and must be supportable on a rental basis.
The appetite of institutional lenders has reached a fever pitch due to the combination of across-the-board allocation increases and a continuing dearth of transactions, but this potentially toxic mix has so far led primarily to a decrease in pricing rather than an increase in leverage. But the effect on pricing has been dramatic, with a select few insurance companies and banks beginning to outprice even Fannie Mae and Freddie Mac to win multifamily transactions for prized clients.
It might require a pair of flimsy, old-style 3-D glasses to correctly view the state of the capital markets today. One lens is rose-colored, the other is blue; and the new reality jumps out only when the two are melded together. There is an overabundance of unexpectedly inexpensive debt and equity capital that is dying to be put to work-with appetite for every product type of every size, in every major market in the world.
But winds of change are blowing, and they all point in one direction: to an increase in the index rates. Rising indexes are almost certain to bring with them several associated rate rises that will have a direct and dramatic effect on real estate activities: rising mortgage rates, rising cap rates, rising equity yield thresholds.
The true prices or valuations that can be achieved today may be both far less than what existed several years ago, and somewhat less than most owners would like to accept. They may, though, also be higher than would be found in a not-hard-to-imagine future in which allocations have been satisfied,
Treasury rates have reacted to global demand levels insufficient to meet historically high supply, and yield requirements have begun a steady march upward. Now is the time to act.
Scott A. Singer is principal of the Singer & Bassuk Organization, LLC and a member of REBNY’s Finance Committee. He writes monthly for The Commercial Observer about real estate finance.