Market upturn makes mood upbeat, despite underwriting concerns, writes Al Barbarino
“Right now it feels good,” said Mark Zytko, co-founder of portfolio lender Mesa West Capital. “The US economy has recovered and has made itself into real estate fundamentals.”
Delegates anticipated strong investor demand, greater loan volume and improving property fundamentals in the year to come, and spoke of positive leasing velocity and growing rents.
But in the background there was talk of potential interest rate hikes and new regulations on banks and commercial mortgage lending in coming years. One delegate said: “I see no difference between the behaviour now and five years ago. We’ve learned nothing.” Another asked: “Is something lurking out there? Something we didn’t do wrong last time?”
Delegates spoke of increasing leverage on deals; deterioration of credit standards; inflated property values; riskier behaviour from lenders looking to boost yields amid increased competition; and potential interest rate spikes.
“Will we forget how to survive in a more normal interest rate environment?” asked one attendee. “We’re forgetting how to live in a world where Libor equals six.”
Questioning loan quality
There was also concern about the CMBS market’s expansion, with the number of originators hovering around 40 and interest-only deals increasingly prevalent. Delegates asked tough questions about loan quality, leverage levels and underwriting. Although most attendees thought 2015 CMBS issuance would break the triple-digit mark, one panellist called CMBS “a good place to put your junk”; another called the market “over-banked”.
A discussion on the state of the CRE finance sector provided mixed opinions. One speaker noted that while there is a looming wave of CMBS maturities, there’s also “a wave of liquidity” with “a lot of new investor interest in the market”.
The same speaker noted that “of the $4trn of real estate needing to be financed, a majority of it is financeable”.
However, another speaker argued that while there are strong fundamentals, the real estate market has “separated itself from the macro economy… whereas the rest of the economy has kind of just bumped along”.
He asked whether “a huge bubble” will form as the real estate market continues to improve and expressed concern about the high-end residential market in gateway cities like New York, where there is “a huge amount of supply. Whether you call that a glut depends who you’re talking to.”
A third panellist agreed that while asset prices have spiked, “the fundamental side is not quite there”. And while the “primary markets are frothy and healthy”, the secondary and tertiary markets may run into trouble because “higher cap rates translate into risk around keeping current cash flow in place”, the banker said.
Canadians offer some pointers
Canadian lending executives outlined major differences that make the comparatively tiny Canadian CMBS market, with $4.8bn of issuance at its 2006 peak, less volatile than that of the US. “The real difference is that we don’t underwrite CMBS loans any differently from the other platforms,” said Norm Camire, head of Canadian CMBS, Royal Bank of Canada. “The credit metrics are essentially the same.”
They also noted a big contrast between the number of interest-only loans in the US and Canada; nearly 70% of US CMBS loans are now interest only, while in Canada this practice is nonexistent (see chart, right).
Backing up the Canadians’ claims, some estimates put losses on the more than $25bn of Canadian CMBS issued since 1998 at less than 0.1%.
The fact that Canadian CMBS carries longer terms (five to 10 years) than balance-sheet loans was cited as a reason for its return, with anticipated issuance this year of perhaps $2bn. The Canadian market is finding its footing again after virtually vanishing between mid 2007 and mid 2012.
“As a mortgage lender we like to offer the full suite of terms available in the market,” Camire said. “Between 2010 and 2014, when no new CMBS loans were written, there was a gap in five to 10-year terms… that’s one of the reasons we came back in.
“Our underwriting approach is exactly the same on a one-year balance sheet loan or 10-year CMBS,” he added, noting that the loan-to-value ratios on those loans are generally 60-70%, with debt-service coverage between 1.4 to 1.5.
Other Canadian players who disappeared during the recession have reemerged. Last month First National Financial Corporation, Canada’s largest non-bank originator and underwriter of mortgages, returned to contribute $105m to a $283.7m pool of 10-year loans, with Moray Tawse, executive vice president of First National, saying the move was driven by investor demand.
The number of Canadian originators can still be counted on one hand, but when Real Estate Capital asked for issuance predictions for 2015, panellists agreed that there were likely to be about eight originators, accounting for roughly $2bn in issuance.
CREFC takes the pulse of US property
A pre-conference CREFC survey questioned 77 commercial real estate organisations on their expectations for 2015 compared to 2014. In many cases they echoed the sentiments of delegates at CREFC Miami.
Key findings from the survey included:
Liquidity: 38% predicted similar availability, 47% expected “somewhat more” and only 3% believed liquidity will be less available.
Interest rates: 75% of respondents expected a 25bps to 50bps rates increase.
CMBS issuance: New issues this year were expected to exceed 2014’s $94.1bn total;
70% put the 2015 total between $100bn and $125bn, 18% at above $125bn, and 12% at $75bn-$99bn.
Economy: Only 1% believed the economy would be worse than it was in 2014.
Underwriting: About 75% of respondents predicted more aggressive underwriting standards in 2015. The remainder expected standards to remain “about the same.”
Anti-terrorism law allays industry fears
During the conference the US Senate voted 93-4 to reauthorise the Terrorism Risk Insurance Act (TRIA) for six years, with the CREFC noting its position at the forefront of the advocacy effort to renew the legislation.
The law, created after the September 11 terrorist attacks, allows the government to repay business costs after an attack causing more than $100m in damages. It expired on December 31, after lawmakers failed to reauthorise it in what CREFC president Stephen Renna called a “December fumble”, sending jitters through the real estate industry.
The House of Representatives voted 416-5 to renew the legislation in early January and president Obama signed the legislation on 12 January.
The renewal raises the programme’s “event trigger” from $100m to $200m over several years and eliminates language that would have treated nuclear, chemical and biological attacks differently. It increases the mandatory recoupment surcharge to policyholders from $27.5bn to $37.5bn, among other stipulations.