CRE Capital Flows Through a Changing Landscape
Commercial real estate debt and equity markets have been more or less in balance for several years now, and the consensus is that this state of equilibrium may continue through 2019, barring unforeseen problems. The impact of the biggest problems we were facing—the global impact of Brexit, the “wall of maturities” in the CMBS market, Dodd-Frank’s strict lending rules—has been mostly absorbed without throwing CRE capital markets out of balance.
There’s more than enough capital for good real estate deals, but investors and lenders aren’t stretching beyond their limits just to get the money out. As a result, property prices have remained tethered to current income and very few markets have been overbuilt. Cap rates have tightened but are still considered to be within historical norms.
The price of restraint is that investment capital earmarked for real estate has gone unspent. Dry powder, capital earmarked for real estate but unspent, rose to $249 billion by the end of 2017, according to Preqin. A recent investor survey revealed that 32 percent of institutions expect to increase their real estate allocation this year, and an additional 57 percent expect to maintain current allocation levels. This is despite the fact that half of institutional investors and fund managers believe we’ve reached the market’s peak, and most agree that competition is getting tougher.
Investors are concerned about increasing property prices. CoStar’s Repeat Sales Index shows that Industrial, multifamily and office property prices increased in 2017 by 12.1 per cent, 6.3 percent and 4.2 percent, respectively. But investors have balked at making low-cap rate deals. That’s partly why rising prices have been accompanied by decline sales volume. Multi-family deals dropped by 7.1 percent in 2017 compared to 2016, while office volume fell 12.3 percent and retail plummeted by 19.7 percent. The industrial investment market increased 2.1 percent over 2016 volume but fell far below its peak level in 2015.
Competition for Foreign Capital
One reason that investment volumes are off in the past two years is that foreign investors are less focused on U.S. investment as they see more opportunity in other countries. Direct foreign investment peaked in 2015 both nominally and as a share of total U.S. volume. Foreign investment in the office market, which represented 15 percent of total volume in 2006-2007, rose to nearly 25 percent in 2013-2015 due to the relative yield of U.S. real estate. In 2017, foreign investment dropped to about 8 percent of all U.S. volume.
China led the drop in foreign investment volume across all property types, as capital flows to U.S. real estate declined 55 percent from 2016 to 2017. The U.S. is still considered a highly stable market, but Chinese institutions and sovereign wealth funds are focusing more on cities like London that are viewed as having more room to increase property values, according to Cushman & Wakefield.
Foreign investors that remain active in the U.S. tend to prefer industrial opportunities over other property types, continuing a three-year trend. Survey results released by the Association of Foreign Investors in Real Estate (AFIRE) in January show that industrial remains the most popular property type for the third year running, based on the strong one-year and five-year yields relative to other property types. Multifamily product is also viewed favorably by investors despite warnings that some markets may be overbuilt. AFIRE members anticipate less strength in the office sector than in apartments or industrial, but international investors expect to put more money into office than any other sector in 2018. The retail property market is currently in decline across the board– in terms of investor sentiment, transaction volume and average property values.
Foreign and domestic investors are also widening their scope to boost deal flow while holding the line on cap rates. As prices rise on CBD properties, the risk exposure of rising interest rates becomes more acute; as a result, more investors are focusing on suburban markets. Currently, average rental rates are growing faster in suburban multifamily and office markets than in urban areas. Further fueling investor interest is that fact that income growth in suburban markets is above its long-term average.
Debt Crisis Averted
The equity real estate market owes some of its current strength to the cautious stance taken by lenders in recent years. When Dodd-Frank regulations on high volatility commercial real estate (HVCRE) loans went into effect in 2016, banks responded by lowering loan-to-value ratio limits, and by requiring recourse from many borrowers. As a result, new development has barely kept pace with net absorption in many markets.
Debt players have also been concerned about volatility in the CMBS market, particularly as more than $450 billion of CMBS issuance– the so-called wall of maturities– came due in 2016 and 2017 with no clear way to refinance them. Many in the investment community worried that a wave of CMBS defaults could have a chilling effect on property prices. In fact, the delinquency rate rose 160 basis points in 2016, peaking at 5.75 percent before declining 86 basis points in 2017.
CMBS issuance has rebounded somewhat in recent years, but volume was less than half that of a decade earlier. What saved the market from a wave of defaults was increased lending volume by banks, insurers and the private equity market. In 2016, U.S. banks held $1.63 trillion in commercial real estate loans, surpassing the previous peak in 2008 of $1.52 trillion.
Hybrid Debt-Equity Structures
To make CMBS refinancing possible at reduced LTV ratios, many deals required mezzanine financing or preferred equity structures, often from private equity sources. These hybrid debt-equity structures fill the gap between the 60 percent LTV limits imposed by many banks and the 80 percent LTV ratios often required by borrowers to make deals work. Sources of mezzanine and preferred equity capital get strong yields with less downside risk than direct investment, but also none of the upside potential. That tradeoff is acceptable to investors more worried about downside risk in a maturing part of the cycle.
In addition, lenders are more willing to go outside their comfort zone than they were a couple of years ago. When the HVCRE rules were first implemented, banks slowed down their processes to make sure they were in compliance. As more loans passed muster with regulators, banks became more confident
Recent actions within the federal government suggest that HVCRE rules may be less restrictive in the near future. Currently, the “high volatility” label is applied to all real estate loans, but the U.S. Senate recently passed bipartisan legislation known as the Consumer Protection Act that would differentiate between loans on cash-flowing properties and those that rely on future income, such as construction or redevelopment loans. The proposed change would also make it easier for community banks to make real estate loans.
Arguably, the treatment of HVCRE rules and the wall of CMBS maturities were the two biggest threats to healthy CRE capital markets three years ago. Today, both concerns have been resolved without major disruption to the market—but that doesn’t mean it’s clear sailing for investors and lenders. Going forward, the issue to watch is the pace of rising interest rates.
Yields on 10-year Treasuries rose to 2.70 percent in January, an increase of nearly 70 basis points over last September. This places additional pressure on cap rates that can only be alleviated by solid NOI growth or an adjustment in property pricing. Given the way that capital markets have navigated the dangers of the past few years, there’s every reason to be optimistic about the market in the near future, but investors and lenders still need to temper that optimism with caution.