Full speed ahead for Commercial Real Estate in 2015

Improving rental rates, lower vacancy rates, muted construction with low interest rates caused price appreciation and continued CRE growth in 2014. Although construction was muted overall there was sizable growth of multifamily and hotel construction expected to moderate in 2015. The Urban Land Institute and Ernst and Young forecasts 2015 real estate transaction volume increasing 6% to $425 billion and Dodge’s Construction Forecast expects a 9% increase to $612 billion in 2015. Leveraged purchasers and investors are competing fiercely for product requesting lowered underwriting criteria and lower investor IRR. 2015 is expected to be even stronger in dollar volume and transaction count as the same market characteristics are motivating buyers and sellers.

New construction has been slow to gain momentum but will be increasing growth across most real estate types creating greater inventory in major markets. This continued growth is supported by the positive economic environment, construction financing becoming more available, (reflecting some easing of bank lending standards) a greater focus on the real estate by the investment community and more construction bonding available. Dodge Construction Forecast is forecasting the following:

2015 2014
% increase $ in Billions % increase $ in Billions
Commercial 15% 32.3 14% 27.1
Retail 11% 18.9 9% 17.0
Office 19% 32.3 23% 27.1
Institutional 9% 103.6 4% 95.4
Single Family 15% 189.7 11% 165.4
Multifamily 9% 67.2 22% 61.9
Public Works -9% 118.8 -9% 113.4
Mfg. Plants -16% 24.4 57% 20.5
Utilities -9% 20.5 -28% 22.5
Other 4.4 13.7
Total 9% 612 5% 564

 

The one trillion dollars of real estate sales and new construction will be supported by capital formation and debt. Hedge funds are expected to raise $90 billion, Private Real Estate funds $90 billion, Private Real Estate focusing on debt investing $26 billion, increased REIT investing with total returns in excess of 20% and increased debt funding of $407 billion. All investors are chasing yield and some are funding mezzanine loans up to 90% LTV at rates floating in the 9% to 11% range. Ultimately the need will be greater for the debt / mezzanine funding given the CMBS “wall of maturities”.

Mortgage total debt outstanding grew to $2.57 trillion and 2014 annualized originations were $379 billion according to The Mortgage Bankers Association. The lenders were led by Banks who provided 66% of the increased net outstanding mortgage debt and grew construction and development outstanding year over year for the first time since 2008. CMBS closed volume increased $14 billion year over year but outstanding was flat. Most other debt providers had slight year over year net growth.

Bank, Government Agency, Financial, Insurance, CMBS and Private / Other capital lending sources are all growing in absolute numbers and fighting for share. They are supported by going-on cap rates which compressed nationally across all product types and classes in 2014. The many all-time low cap rates supported sellers, investors and lenders. Commercial real estate cash flow is improving slowly with escalating rental rates and decreasing vacancy while long term interest rates remain low. These projections are causing REIT purchases often unleveraged to compete aggressively with leverage buyers causing CMBS and Bank’s to push underwriting criteria to compete with this activity. Much of the valuation and sales price increases of the future will be supported by increasing NOI rather than reducing cap rates.

CMBS issuance grew 18% to $94 billion in 2014 and according to Moody’s an additional 40 CMBS originator companies were added to the competition. 2015 issuance is expected to grow to $125M with a good % of origination from the maturing CMBS “Wall of Maturities”. It is expected $300 billion will mature in the next 3 years originally issued in 2005 thru 2007 with weaker underwriting. Trepp estimates that over 20% of the maturities will require additional capital when the properties are refinanced or sold. New CMBS loan to value and debt yields will continue to be stretched to allow refinancing. Moody’s Commercial Property Price Index indicated LTV and debt yield ratios are beginning to resemble 2007 sold transactions. In April 2014 Moody’s Investors Service warned CMBS issuers of the “boiling frog syndrome”. The metaphor is that a frog put in boiling water will jump out, while one in cold water won’t notice the danger if the temperature heats up slowly. Hence lenders are relaxing their standards, will continue to do so in 2015 making it more important to understand “the temperature of the water”

Bank balance sheet lending growth has dwarfed any other lending type of origination according to The Mortgage Association and balances are now in excess of $920 billion or 36% of the entire market. Banks now fund 78 cents of every dollar, on net, of all multifamily loans. GSE make up 21 cents of every multifamily net dollar but they have lost share for the last 18 months. Banks must increase lending in this low rate and spread environment. It is expected product type and secondary / tertiary markets will become acceptable risks in 2015 as overall markets improve. This continued need by the market leader and similar needs by other lenders will provide even greater production and outstanding in 2015.

All the pieces are in place to continue the 2014 trend of increasing real estate transactions and construction growth. Domestic and foreign investors are seeking yield and the upside of the trend. Lenders, REIT’s and Funds are liquid seeking opportunities and in spite of the following unknown risks greater growth is expected in 2015:

  • Will the anticipated short term interest rate movement cause excessive long term interest rate movement?
  • Will TRIA (Terror Risk Insurance Act) be again supported by congress?
  • Will regulatory uncertainty of key regulations FIRPTA and lease accounting standards be determined?
  • Will oil prices remain below $50 per barrel and what impact will it have on commercial real estate?
  • Will “an event” create geopolitical instability for governments, investors and lenders?


The Wall of Maturities: Something’s Gotta Give

Published November 13, 2014

Commercial real estate lenders, borrowers, and CMBS investors alike are looking at the next three years as a true test of the strength of recovering capital markets. Property values have rebounded in many markets, interest rates are low, and foreign investment is boosting US properties in gateway cities. On the other hand, big box retailers continue to close stores at a rapid pace, big banks and law firms are cutting their office footprints, and new construction is slowing down multifamily appreciation. Rising rates and higher relative underwriting standards could lead to volatility both in CMBS prices and commercial real estate values just as more loans than ever before reach maturity.

CMBS issuance volumes were higher than ever in 2005, 2006, and 2007 with a peak volume of about $230 billion in 2007. The far majority of this issuance was made up of ten year balloon loans, creating a wall of maturities from 2015 to 2017. Over the next three years, more than $300 billion in Conduit CMBS loan balance will mature. That’s more than 2.5 times the amount that matured from 2012 to 2014.

Office and retail loans make up 63% of the loan balance maturing in the next three years with multifamily in third at 14%.

“Refinancability”

With 2014 issuance set to reach just below $100 billion and 2015 forecasts calling for a marginal increase, the CMBS origination engine will have to pick up the pace to digest the wall of maturities, especially in the heavy 2016 and 2017 years. Headwinds include the threat of rising rates, the end of quantitative easing, and the implementation of new risk retention regulations coming in January of 2017. Currently, multifamily and industrial have the highest rate of maturing delinquent or specially serviced loans at 12.4% and 12.0% respectively. Multifamily delinquency in 2016 maturities comes mainly from the $3 billion StuyTown loan which actually suffers more from risk of extension and litigation than of low valuation. The Schron Industrial Portfolio ($208.5 million) and Bush Terminal ($292.5 million) loans contribute to the high rates in 2015 and 2017 in the Industrial category.

The-Wall-of-Maturities-Maturing-Balance-3

Comparing debt yields, cap rates, LTVs, and DSCRs of loans originated so far this year with those coming due gives us an idea of how easily borrowers will be able to refinance or sell their properties when their balloon payment arrives. Below is a comparison of all conduit loans originated so far in 2014 and the loans coming due in the next three years. Cap rates on average have been lower on new issuance than what’s coming due while DSCR on new loans is significantly higher than those coming due. Maturing loan LTV ratios are also higher than what the average lender is doing this year especially in loans coming due in 2016 and 2017. Debt yields on maturing loans are generally lower than what lenders are requiring on new loans so far this year. Highlighted cells show where maturing debt yields, cap rates, and DSCR are lower than current origination as well as where LTV is higher.

For further detail, we break out these measures by property type to find pockets of opportunity for originators to find value in maturing loans as well as sectors where additional capital will be necessary.

 

 

So far in 2014, new loan interest rates average 4.94% for all property types with a high of 5.08% in lodging and a low of 4.89% in office. Doing a simple analysis of maturing loans, applying a 5% interest only payment to current loan balances and looking at current Net Cash Flow measures gives a rough estimate of what DSCRs on a refinance loan might be. Assuming lenders require at least a 1.50x DSCR on new loans, 82% of loans maturing between 2015 and 2017 would be eligible for refinance at current debt and income levels. Loans maturing in 2015 have the highest percentage of loans at or above the threshold while 2017 maturities are the lowest.

Breaking down hypothetical “new loans” by property type shows office properties will have the hardest time refinancing at current debt and income levels and all property types get worse moving into 2017.

Going Forward

Looking ahead, the wall of maturities presents an opportunity for originators and a worry for legacy CMBS bondholders. In 2012, a mini-wave of maturities resulting from 5 year loans done in 2007 sent the Trepp delinquency rate to its highest level of all time. Maturing volume that year was 40% of what it will be in both 2016 and 2017. With nearly 60% of the entire CMBS public conduit universe maturing in the next three years, property transaction and origination volumes will have to continue and accelerate their upward trends. Almost 20% of those maturities will also require additional capital either from current borrowers or new buyers when the loan is refinanced or the property is sold. All of this will have to happen in an environment of uncertainty in terms of interest rates, property values, and a shifting landscape in office and retail property usage. CMBS investors are well aware of the risks inherent in the wall of maturities, the question is what will the economy look like in six months, in a year, in two years when the brunt of this wave is set to hit the CRE market. Lower for longer interest rates, continued property value appreciation, and fundamental performance growth would make the wall much easier to scale.