Archives for 2019

As we enter into the second half of 2019, we approach 10 years of recovery in the real estate markets. One question on the mind of investors is the concern over when the end of the cycle hits, one of the 2019-2020 Top Ten Issues Affecting Real Estate. While transaction volume has slowed, there is a growing disconnect between seller prices and buyer bids. One place where the market continues to be flush with liquidity is on the debt side of the capital stack. While CMBS continues to be a viable product, volume of issuance is down almost 15% year over year for the first quarter 2019 vs. 2018, and down over 12% for year end 2018 vs. 2017. Other capital markets debt products have grown in popularity and are contributing to the liquidity in the market.
Mortgage REITs is a product that has been around since inception back in 1969. While they had perception issues that impacted them in the late 1970’s, they have made a comeback over the last decade, with firms like Blackstone, TPG, ARES and Starwood creating publicly traded Mortgage REITs over the last few years. The Mortgage REITs have many financing tools at their disposal today. Part of their financing toolbox include leveraging the equity raised in the public markets with commercial real estate CLO transactions as well as securing multiple warehouse lines from investment banks and large commercial banks. Pricing, flexibility and cost will drive which financing levers are pulled.
The commercial real estate CLO market, which is a way for lenders to leverage their business, has been growing over the last few years, and is expected to continue as long as there is investor appetite for bonds. Commercial real estate CLO’s are structured finance securities collateralized primarily by below investment grade floating rate commercial real estate loans backed by bridge/transitional loans. The lender that is using the commercial real estate CLO execution, will securitize a pool of floating rate loans creating various rated bonds for investor consumption. The commercial real estate CLO issuer retains the “equity” in the commercial real estate CLO, being the most subordinate part of the structure.
The commercial real estate CLO business is a far cry from the CDO business of 12 years ago where everything and “the kitchen sink” could be put into a deal. Post crash, deals tend to be more conservative and deals tend to see senior mortgages only. Early on CRE CLO transactions were static only and like CMBS transactions needed all loans contributed in the pools by the closing. That said, CRE CLO’s still tend to have more transitional assets than CMBS whether static or not.
As the market has matured, there has been a growth of a more flexible pool, the managed pool. A managed pool differs from static in a couple of key ways. First, there is a ramp up period to add loans into the pool after the deal closes. Second, loans can be replaced in the pool. In so doing, the duration of the deals can be pushed out longer, as it is less impacted by prepayment since loans are replaced. That said, investors pay more for a static deal, not managed, because of the certainty of what the make-up of the pool is. To mitigate this concern, managed deals do have eligibility criteria to keep the quality of the pool similar to the level at closing. Managed pools are becoming more popular and the spread premium is tightening. In 2018, 54% of all deals were managed and 46% were static. In 2016 the percentages were quite different, with 25% managed and 75% static. On a year over year basis, Q1 2018 had $3.2B of issuance while Q1 2019 was at $3.6B, so the size of the market continues to grow.
Another source of significant capital in the marketplace is coming from Debt Funds, which have been established to provide both senior bridge loans as well as mezzanine loans which are secured by the equity in the borrower. The number of Debt Funds has grown exponentially over the last few years, with a universe which includes small-balance high-yield shops, and large debt funds raising capital from high net worth investors, pension funds and endowments (like Calmwater Capital) or from foreign and domestic institutional capital (like Acore Capital and Prime Finance). Time will tell if capital will shift to troubled or distressed loans in the never-ending search for yield as rough waters lie ahead.
Insurance companies like NY Life, Principal, John Handcock, MetLife and Nuveen, are leveraging their organization’s infrastructure and managing third party accounts interested in issuing debt. Even several major development firms like Silverstein, Mack Real Estate, Related Properties, S.L. Green, and Brookfield have entered the lending business. Private equity has its role in the marketplace as well, with Blackstone, Colony, Oaktree, INVESCO, CIM and Starwood providing liquidity to the market, particularly on larger deals. Investment Banks and Commercial Banks like Morgan Stanley, Citigroup, JP Morgan, Wells Fargo and Bank of America are wearing multiple hats, originating loans, providing leverage via warehouse lines, or managing the execution of CLO’s. In fact, the Commercial Banks use their ability to provide warehouse lines to garner the CLO business from their borrower clients! Whether a borrower needs a $2M, $20M or $200M loan, there are multiple options for the debt.
When we look at the composition of lenders in the market, CMBS, Debt Funds and REIT’s represented 26% of total issuance in both 2017 and 2018. Within that segment, we did see a shift from CMBS to Debt Funds and REITs, with CMBS at 19% of the 26% in 2017 and 16% of the total in 2018. Liquidity from Funds and REITs are providing alternatives, and with the debt markets flush with liquidity and competition for transactions fierce, the question to ask is whether we are headed for rough waters with the possibility of credit and structural deterioration.
By: Constantine Korologos, CRE®, MAI, MRICS and Jeffrey Lavine, Esq (CRE)
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The Counselors of Real Estate has identified the current and emerging issues expected to have the most significant impact on real estate, with U.S. infrastructure being the leading concern of the 1,100-member organization. The Counselors once again released its annual list of the Top Ten Issues Affecting Real Estate™ as the keynote address of the National Association of Real Estate Editors’ annual conference in Austin, Texas.
“Many of these issues are interrelated and thus influence one another,” said Julie Melander, 2019 Chair of The Counselors of Real Estate. “Clients of Counselors seek unbiased, objective advice on the critical factors that will impact all property sectors today, as well as those issues that may affect their decisions over the next ten years. This thought leadership initiative is an invaluable service to those clients and to the real estate industry in general.”

1. Infrastructure

In our survey, more than 50% of responding Counselors ranked Infrastructure as one of the top three issues. Respondents urged that this not be “put on the back burner” even though it is often displaced from public attention as more controversial matters capture headlines. One CRE commented, “Without substantial infrastructure improvements, several large U.S. cities (including New York and Washington D.C.) will become untenable for corporate expansions and top talent.” Much of America’s future economic growth depends upon improved productivity. Productivity, in turn, will be a function of efficiencies across the core systems in the economy.

2. Housing In America

Millennials and Gen Z have trouble affording housing in neighborhoods near employment centers. Meanwhile, Baby Boomers have had difficulty selling their homes. The underlying causes are on both the supply and demand side. Construction costs have increased, and new construction has occurred mainly in the high-end market. On the demand side, younger households have student loan debt and high healthcare costs. Unemployment may be at a fifty-year low, but real income for 80% of the population has diminished. This widens the gap between an increasingly expensive supply of housing and a decreasing ability to pay.

3. Weather and Climate-Related Risks

Climate risk has emerged as an important aspect of fiduciary duty and investment risk management. Weather and climate-related events present physical and operational risks for real assets, both in terms of acute risk from natural disasters, but also chronic risks from sea level rise, drought, heat waves, water scarcity, and food security. The year 2017 was the most expensive year in recorded history, costing the U.S. more than $300 billion in weather and climate-related insurance losses. For all property types, natural disasters dramatically decrease property values.

4. The Technology Effect

Real estate has had a different technological adoption path from other industries. Technological advances move faster than the industry can adopt them and have a wide variety of solutions and results. This has operational and cybersecurity risk implications. In the back office, data costs and needs for specialized skills pose a challenge for small businesses competing with larger firms. Building technology is rapidly transformed by occupant experience and behavior monitoring, requiring integration and automation like never before. Consumer adoption of e-commerce has impacted industrial real estate positively and retail somewhat negatively.

5. End-of-Cycle Economics

The U.S. economy is in the tenth year of recovery. While there are a greater number of available jobs than workers to fill them, inflation and interest rates remain low and consumer confidence levels are relatively elevated. Low unemployment rates create little room for growth and yield curves have recently inverted. Watching the property markets specifically, construction cycles are well underway in growth markets and cap rates reflect a mature cycle. A Counselor warned, “Lessons never seem to be learned. Market participants are once again lacking discipline.”

6. Political Division

Political gridlock and/or infighting is either creating problems or frustrating solutions to many of the other issues identified on our list. The state of America’s political dysfunction has intensified over the past several years. Policies which might otherwise elicit bipartisan action have been blocked by the political chasm.
While our members hold a broad spectrum of political views, it is the effect of the partisan division itself that prompts concern. One CRE described it this way, “Political differences make our options more limited, increase the cost of solutions, and cost us more and more of our competitive advantage around the world.”

7. Capital Market Risk

Long-term treasury rates declined recently as investors seek safety reflecting recent market volatility and uncertainty, and inverted to levels below short-term rates as of mid 2019, a frequent indicator of upcoming recessions. Transaction volume fell by 4% year-over-year in Q2 2019 according to Real Capital Analytics as cap rates are at record lows in high demand markets. Public REITs faltered in 2018 but posted solid returns so far in 2019, and high-grade debt issuance is strong. Since 2008, the outstanding aggregate mortgage balance for GSEs, which include Ginnie Mae, Freddie Mac, and Fannie Mae, has grown from under $100 billion to over $670 billion.

8. Population Migration

The map of population change from 2010 to 2018 shows gains in coastal cities. Big cities are prospering in California, the Pacific Northwest, Florida, the major Texas metros, and the Atlantic corridor from Boston to Washington, DC. Secondary cities are also growing. Meanwhile, there has been demographic shrinkage in the rural Midwest, South, the “Rust Belt”, and Appalachia. Long-term trends have altered opportunities for workers in agriculture, heavy industry, and mining. Population growth has decelerated due to constrained immigration and the lack of “natural increase” (the excess of births over deaths) from the existing population.

9. Volatility and Confidence

Market sentiments are prone to change rapidly and sometimes quite dramatically. Consumer confidence often reaches high points just prior to recessions, yet many mistakenly interpret these polls as predictors of future consumer behavior. The deceleration in employment over the first half of 2019 may combine with financial market jitters over tariffs and the inverted yield curve to weaken confidence. Investment in existing and new property is an expression of performance expectations, and data suggests that confidence in sustained demand for residential and commercial property assets is faltering.

10. Public & Private Indebtedness

The real estate industry typically views debt as a financial tool that can enhance return for equity investors, when used responsibly. Therefore, it is telling when CREs sound alarms about debt. U.S. consumer debt has hit record highs, with rising delinquency rates damaging credit scores and the residential mortgage market. The U.S. Federal budget deficit has widened after tax cuts and increased spending. Most states are constitutionally obligated to maintain balanced budgets, driving property and real estate transaction tax increases. In Europe, the economy is largely buoyed by household debt subsidized by negative interest rates.
By: CRE
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