Integrated Mortgage Markets for 2011
A necessary condition for last year’s positive trends in commercial real estate investment, credit conditions for new deals, as well as for the refinancing of existing debt, have improved substantially. These improvements have been uneven, however.
Just as the uptick in investor activity has favored major markets like New York City, the amelioration in the lending environment has been largely isolated to the markets exhibiting the most robust investment trends and the clearest pricing signals. Potential transactions in less visible and relatively illiquid markets have struggled to attract lenders in cases where deal activity has been isolated, even if stronger economic and property fundamentals are readily apparent.
These dynamics are set to change in 2011, with market bifurcation ceding to early evidence in recent months of more integrated investment and lending patterns.
The Haves and Have-Nots
Leading the improvement in their underlying economics, the concentration of equity and debt capital in major markets was a definite hallmark of 2010, allowing both cap rates and lending rates to fall substantially from peak levels in late 2009.
From commercial real estate’s investment nadir, the Moody’s/REAL price index for sales unrelated to distress in three trophy markets–New York, Washington, D.C., and San Francisco–jumped 38 percent as of October. In the balance of markets, the index has measured a modest 6 percent rise from the bottom. The improvement in pricing metrics and credit availability has been most pronounced for apartment and office assets, the former benefiting from an early return to occupancy gains and muted volatility in potential cash flow.
More than any other market, the bifurcation of pricing trends and investors’ narrow focus has been clearly observable in Manhattan’s office sector, where the volume of closed and in-contract sales in the fourth quarter has nearly tripled the third quarter’s tally. As prices have risen, lenders have also been encouraged by strong recovery rates on loan workouts and by a definite sense that, barring a shift in the regulatory bias, the outflow of distress into the marketplace will remain highly intermediated in 2011. This latter expectation remains a critical factor in lenders’ assessments of the downside risks to price stability and the probability of default and loss on new loans.
All else being equal, the virtuous cycle between investment activity, price discovery and lending is likely to develop additional momentum in 2011, supporting even more competitive credit terms, captured in narrower lending spreads over rising risk-free rates, and a further strengthening of pricing metrics. At the same time, investor interest and a supportive lending environment will also find their ways into hitherto less liquid markets, drawn by relatively wider margins for buyers and lenders alike.
A Range of Lenders, Though Not All Successful
While improvements in credit have been narrowly focused for much of the last year, an increasing diversity of lenders is just beginning to support a wider range of investor activity. Financing in 2011 will be more readily available for assets outside of major markets and for relatively smaller assets, provided in each case that lending risk is mitigated by a balance of strong sponsorship and tenancy.
Among the range of lenders more actively engaged recently, life companies and new foreign lenders have made some of the most visible acquisition and refinancing loans on trophy properties in Manhattan, Boston and Washington. And while these two groups share the distinction of being relatively unencumbered by high default rates on legacy commercial mortgages, other lenders that are struggling with problematic legacy portfolios are also returning to the market. These latecomers are generally more inclined to consider a broader set of lending opportunities.
Among the lending groups supporting a measure of diversification, the reemergence of CMBS conduit originators portends a greater role for CMBS lending in the coming year. Notwithstanding continued increases in legacy CMBS delinquency and default rates, investors remain surprisingly unprejudiced in their assessments of new issuance, demonstrating an appetite for new, more cautiously underwritten securitization. CMBS issuance in the first quarter is likely to exceed $14 billion, prompting a number of conduit originators to reenter the market.
Not all lenders are enjoying an equal measure of success in their commercial real estate activities. For example, regional and local banks have seen their collective share of lending decline slightly, from 15 percent in 2009 to 13 percent in 2010, according to Real Capital’s tracking of acquisition and refinancing activity.
The absolute volume of commercial loans on banks’ balance sheets has fallen as well, as they have been slow to replace amortizing and maturing balances with new lending. But even within this group, lenders that have weathered the downturn with fewer losses are now actively competing for opportunities to lend. Over the next year, only agency financing is likely to moderate, as private-market lenders further supplant the dominant role assumed by Fannie Mae and Freddie Mac in 2008 and 2009.
Bring Your Umbrella: It Still Might Rain
There are risks to the generally positive outlook for credit availability. Deviations from baseline economic projections and the political environment remain key sources of uncertainty over the next year. Apart from these concerns, the potential for a sharp rise in interests rates to negatively impact property values and borrowing costs requires a cautious tone.
The low interest rate environment has been a boon to the commercial real estate sector, a key driver of the sector’s recovery, and the linchpin of banks’ and special servicers’ loss-mitigation strategies. Thus far into the recovery, short-term interest rates have remained very low. Meanwhile, long-dated treasuries have risen measurably in recent months, coming up from their October lows and exerting upward pressure on residential mortgage rates even as commercial rates have trended lower.
Wharton professor Jeremy Siegel, in a Dec. 14 Wall Street Journal opinion piece, offered that “the combined impact of the tax cuts and the Fed’s QE2 policy will continue to stimulate the economy and send long-term interest rates higher.”
The current outlook for treasuries anticipates a measured rate increase that can be absorbed into spreads. But long-term rates are not within the full control of the policy makers who must now contend with investors’ increasing risk tolerance–which leads dollars out of treasuries–and near-record debt issuance in 2011. If broader rates rise more dramatically than projected, cap rates and commercial real estate borrowing costs could easily be forced higher as well, undercutting the investment outlook and lenders’ capacity to manage legacy distress.
In a follow-up column next week, Dr. Chandan will address the interest rate outlook and the likelihood of a destabilizing rise in borrowing costs in 2011.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.