In the most active U.S. commercial real estate investment markets, New York City chief among them, measures of quality for newly originated mortgages declined between the first and second quarters of this year, according to a report released last week by Chandan Economics.
The deterioration in debt yield at origination, a statistically valid predictor of a commercial mortgage’s lifetime default probability, was most evident for loans secured by central business district office properties and by high-rise apartment buildings. This finding is consistent with a rapid rebound in prices for these assets, fueled by more aggressive competition between investors and among lenders seeking to make loans secured by core assets in the most liquid markets.
While apartment and office loan standards are easing, neither investors nor lenders have shown the same vigor in pursuing industrial and retail properties. Across all markets, industrial debt yield has fallen only slightly over the past six quarters, converging on retail debt yield levels in the second quarter. Apartment and office yields have fallen more precipitously, however, as lending has responded to improving property values and rising expectations of future income growth.
In effect, apartment and office borrowers are encumbered with more debt for every dollar of cash flow their properties produce, heightening downside risks should property values adjust or cash flow growth fall short of projections.
Isolating three cardinal markets in particular—Manhattan, Washington and San Francisco—sharply lower debt yields were readily observable during the timeframe of the report’s analysis. It is in this subset of the overall lending market that the increasing reliance on prospective cash flow is most apparent. Apartment debt yield fell by 30 basis points, to 7.5 percent in the second quarter; office, by 20 basis points, to 7.8 percent.
Controlling for the influence of these markets, loan quality is relatively more stable across the broader U.S.
Are Standards Just Normalizing?
Given a sharp tightening of lending standards during the financial crisis and recession, it is reasonable to assume that current declines in debt yield simply reflect a normalization of underwriting terms.
The larger volume of loans, an increase in the number of active lenders and the direction of results in the Federal Reserve’s just-released Senior Loan Officer Opinion Survey on Bank Lending Practices are consistent with this hypothesis. In the Fed survey, which has just begun to show moderation by banks, 12.7 percent of banks reported easing standards in the second quarter, slightly more than the 7.3 percent that reported further tightening. Among large banks, 18.2 percent reported easing.
Since the ex post performance of commercial mortgage loans cannot be directly observed at the time of the initial assessment of risk, the judgment with regard to loan quality requires a qualitative assessment of the quantifiable loan descriptors.
The alternative means relying on model estimates of cumulative default probability and loss severity. But this is an exercise that should be undertaken with skepticism, since the results of complex default models by a range of market participants are qualified by their weak predictive capacity over the past cycle as much as by their opacity.
Drawing on long-term measures of composite debt yield for securitized loans across property types, which have approached 10 percent in only one previous period, in the lead-up to the most recent cyclical peak, current office and apartment lending trends in major markets do warrant some concern. While the loan-to-value ratio in these markets remains low as compared to the heady days of 2006 and 2007, current debt yield trends reflect valuations that have outpaced underlying property cash flow, in part because of low financing costs, and in a manner not observed before.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.