Quick programming note: This will be my last post for 2018 and I’m heading out of town for a family ski trip through the 10th so don’t expect much blog activity the first couple of weeks in January either. Wishing all of you a happy new year and a great beginning to 2019!
Lead Story: One of the most consistent themes around the Landmark office over the past few months has been the compression in spread between equity returns and debt yields on commercial real estate properties since late 2016. I wrote about how this was making it very difficult to find accretive debt – a loan where the property yield exceeds the mortgage constant – back in October. In that post titled The Great Compression, I noted the following:
Ultimately, there are two parts of the real estate cycle. In the growth phase, the spread between debt yields (borrowing costs) and equity returns widens. In the contraction phase it compresses. Stable cap rates and increased interest rates have resulted in a compression where debt yields are rising while equity returns are actually falling. As such, we now find ourselves very solidly in the contractionary part of the cycle. We are also at a point where traditional fixed rate debt with 25-30 year amortization tables is no longer accretive to cash flow. For example, a 4.98% interest rate (10-Year Treasury + 175) has a loan constant of 6.43% (the loan constant takes the portion of the payment that goes towards amortization into account as well as the interest payment) . However, good luck trying to find a well-located, leased property that yields much above 5.5% on a stabilized basis in this environment in top performing markets. If you borrow at 6.43% on an investment that yields 5.5%, you have a problem. By way of example, that same spread would have resulted in a constant of only 5.34% on a loan with a rate locked in the final weekend of October, 2016 – a full 100 basis points lower. Lenders have largely accommodated this negative movement in rates by allowing for ever-longer interest only periods in exchange for steadily lower leverage – effectively pre-amortizing a loan. However, the lower leverage requires more equity and, as such, lowers the returns on that equity even further. This can only continue for so long until borrowers and their equity partners cry “uncle!” and demand a higher return on their capital for the risk that they are taking versus those in junior and senior lien positions.
Debt yields have fallen since I wrote that post but the issue still remains: debt is more expensive than it has been in the past and equity returns are falling. Peter Grant of the WSJ ran with the return compression theme in the Wall Street Journal earlier this month. From the WSJ (emphasis mine):
Now, a crucial relationship between property market yields and rates offers another reason for concern.
Commercial property yields have stayed relatively flat for the past 12 months. Meanwhile, mortgage rates have started climbing this year tracking global interest rates, which are rising as expanding global growth is stoking concerns of higher inflation.
At the end of the third quarter the average rate borrowers paid on loans packaged into commercial mortgage-backed securities was 5.03%.
One year earlier it was 4.52%, Trepp said. That increase “is a big deal on multimillion-dollar properties,” said Joe McBride, Trepp’s research director.
The last time yields were this close to interest rates was near the market’s previous peak in 2007, which was followed by a 35% decline in commercial property prices when the market was pounded by the financial crisis and recession.
Not everyone thinks it is time to head for the exits. A still expanding U.S. economy and the amount of money sloshing around the market suggest the bull run can continue.
The WSJ article also featured the following chart from Trepp, Inc to help illustrate the compression that the market is experiencing.
First off, I’m glad that they picked up the theme as it is arguably the biggest story in the commercial real estate world right now and isn’t getting much play in mainstream financial publications. That being said, I do have a bit of a quibble with the way that the data was presented. The entire WSJ story mentioned the interest rate but never mentioned the loan constant, which is the true metric that should be used to judge whether or not a loan is accretive since it measures free cash flow (amortization is typically not optional and must be accounted for). As such, the picture is substantially worse than that portrayed above. For example, the Q3 2018 data provided by Trepp shows an average property yield of 6.45% and an average lending rate of 5.03% or a spread of 142 basis points. However, its safe to assume that property owners who are borrowing at that 5.03% rate are not all taking out interest only loans. Assuming a 30-year amortization (this is best case as many commercial loans have 25-year amortization), a loan with a 5.03% interest rate has a constant of 6.46% which means that, on average debt was slightly unaccretive in the 3rd quarter. The numbers are considerably worse for certain property types (mostly industrial and multi-family) and in coastal markets where property yields are substantially lower.
This compression is something that can go on for a while. Borrowers and lenders will go with lower advance rates in exchange for interest only loans but that means that more equity will generally be required which pushes equity returns down further. Eventually something has to give but it remains to be seen when.
Holding the Line: The Fed raised rates again this month and issued hawkish guidance as well but it is a decision that could come back to bite them.
On the Books: Banks are now stuck with $1.6 billion of unsold loans amid the ongoing market rout.
Unscathed: Australia has managed to avoid recession for nearly 30 years thanks largely to a boring banking system, an aversion to austerity and openness to immigration.
Hoarder Nation: Wall Street is starting to worry that America’s for-rent storage space may be outpacing the volume of the country’s excess belongings. However, demand has shown no sign of backing off. (h/t Scott Ramser)
Piling On: Looming tariffs mean that retailers are stocking up, filling warehouses to the ceiling, driving demand for more space and exacerbating an already incredibly tight market.
Dabonomics: Clemson’s top tier college football program has led to a boom in demand for alumni 2nd homes near the university and an economic renaissance.
Recap: How the financial crisis led to a housing shortage and a substantially lower home ownership percentage over the past decade.
Tunnel Vision: Elon Musk is unveiling his tunnel system for LA cars. However, the better application may be for freight.
Stumbling: Amazon’s grocery push has not gone as planned post Whole Foods acquisition.
Fake it Till You Make It: The insane story of a counterfeit Saudi Prince who scammed investors out of millions.
Heroes: Everyone loathes robocalls. Some people try to get even.
Chart of the Day
One has to wonder what this will look like when things actually get ugly.
Gotta Hear Both Sides: Lindsay Lohan’s step mother attacked a bus driver and attempted to drive off because Florida. Also because alcohol.
Devil Made Me Do It: A man said that he rammed a school bus to escape from Satan because drugs.
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