Warning Bells Are Getting Deafening
Dan Gorczycki Oct. 7, 2016, 4:46 p.m.
“It would be wonderful if we could avoid the setbacks with timely exits, but nobody has figured out how to predict them.”—Peter Lynch
Doom and gloom articles have been around for hundreds of years. Fortunes have been made by bold investors as prices skyrocketed while others sat on their hands. This phenomenon exists for both stocks as well as the real estate markets. However, at some point, the fundamentals point to the fact that it isn’t a matter of if asset values drop—it’s a question of when. Recent data suggest that we are reaching that inflection point, for all asset types.
The first warning signs flashed in 2015. Luxury condominiums in Manhattan and Brooklyn started to downtick, with units over $10 million decreasing in sales volume by 18 percent in the first half of 2016 and prices falling slightly (Source: New York Times/Olshan Realty). For larger luxury properties, an example of the recent softness might be the Baccarat Hotel and Residences on West 53rd Street, which sold for $42.55 million in June after being listed for $60 million. While it’s not unusual for a market to pause versus going straight up, this correction hit everything from the mid-priced to the luxury units, even with foreign money continuing to pour into the market and interest rates remaining at historic lows.
Let’s take a step back and look at what has changed since the residential mortgage implosion of eight years ago: 1) Central banks have increased their balance sheets by $20 trillion; 2) governments have added tens of trillions of dollars in debt; 3) corporates and consumers have added $60 trillion of debt worldwide; 4) a substantial number of bonds trade at negative interest rates; 5) the government took over Fannie, Freddie and the FHLB, effectively taking over student loans. Since the major economies all expanded their balance sheets in tandem, no one currency took the hit that would ordinarily result in these actions if only one economy took these measures. The net result has been to buffer any fall in asset values to this point.
But besides the aforementioned luxury NYC condo market, is there any widespread evidence of softening nationally? Well, let’s look at the supposedly bulletproof multifamily market in big markets. According to the Zumper National Rent Report, median one bedroom asking rents in August fell in 10 of the 12 largest markets. For example, New York fell 2.2 percent (0.9 percent year-over-year) while Los Angeles, Miami and Seattle all fell over 3.5 percent. On a year-over-year basis, Chicago has fallen 8.9 percent! These asking rents don’t even included negotiated actual rents and incentives so it is almost certain that items like “one month free rent” mean that the numbers are far worse in reality. New supply is driving this trend as developers all tried to get in on the mania trend of skyrocketing rents and razor thin cap rates. However, in recent months, there is evidence that demand has dried up too as employment numbers remain fairly weak so there is a limited base of candidates to pay top dollar rent in any given market. Columbus and Cleveland have fallen 10.3 percent and 9.4 percent respectively year-over-year in terms of rent. The cause of this decline isn’t because of a building boon in Ohio; this is becoming a demand-driven phenomenon.
On the interest rate front, sub-5 percent interest commercial loans are now commonplace (sub-4 percent on multifamily). This has kept asset levels high as positive leverage is the result at almost any cap rate. However, the downtick in the commercial market is occurring at the very time that the banking sector is undergoing the greatest amount of regulatory change in decades. Regulatory cost increases are causing banks to raise interest rates by 50 to 75 basis points on construction and other short-term loans simply to offset these costs. Simultaneously, commercial mortgage-backed securities lenders may be raising interest rates by a similar 50 basis points in 2017 due to new regulatory reserve requirements imposed due to Basel III—in a year when $137 billion of CMBS loans come due. Capital retention for commercial real estate loans could be as much as 25 percent due to Basel III, thus a corresponding interest rate increase is likely. So if interest rates for loans ranging from construction loans to CMBS loans are all going up by 50 basis points, can a corresponding move in cap rates be too far behind? There is usually a six-month lag so expect cap rates to rise in the second half of 2017. And if cap rates do indeed rise in lockstep to match the rise in borrowing rates, what would happen if interest rates rise so that a still further increase in cap rates occurs? Smart investors are pricing in this risk and taking some chips off the table. A perfect storm could be brewing.
Dan E. Gorczycki is a senior director in the Debt, Joint Venture and Structuring Group with Avison Young New York and specializes in capital structures across all tranches of the capital stack.