Landmark Links June 8th – Long in the Tooth


Lead Story….  One of the most tiresome and overplayed tropes in the real estate industry is the baseball analogy.  Anyone who has ever attended a commercial or residential real estate conference has heard some version of the “what inning of the cycle are we in?” question posed to panel members who inevitably roll their eyes and give some sort of canned answer.  The problem with the question is that it’s mostly subjective since there are no clearly-established thresholds as to what puts a cycle into say the 7th inning as opposed to the 6th.  I suppose this is part of the reason that the question is so popular on conference panels: there is no wrong answer at the time and, with so many innings to choose from, positions are fairly easily defensible after the fact..

When it comes to the commercial real estate cycle, I prefer a different gauge based on permanent loan underwriting.  There are four cycle segments in so perhaps a football analogy using quarters is more appropriate (I know, just can’t quit the lame sports references).  The primary difference here is that unlike the baseball analogy, there are some fairly clearly defined lines between segments that tie back to how aggressive loans are underwritten.  Here are my “what quarter are we in?” guidelines:

  1. 1st Quarter: Early in a cycle and emerging from a recession, lenders tend to have very tight credit standards with high debt service coverage and yield to debt ratios .  There is less competition in the market so the relatively-few lenders who have capital to deploy coming out of a recession are able to originate new loans, even with very conservative underwriting and protective covenants.
  2. 2nd Quarter: As the cycle matures and it becomes more obvious that the market is now on solid footing, lenders begin to get more aggressive.  New capital coming in levels the playing field between borrowers and lenders.  Lenders lower their debt service coverage, debt yield covenants and amortization periods back to the historical norm in order to remain competitive.
  3. 3rd Quarter: New money continues to come to the table and lenders continue to push debt service coverage and yield covenants below the historic mean as the lending landscape becomes more competitive.  Partial-term interest only loans begin to re-surface in the CMBS world.  Underwriting gets aggressive but not yet crazy.
  4. 4th Quarter: Lender underwriting gets even more aggressive in an incredibly competitive landscape as more capital enters the market.  Values and rents have been going up for several years now and emboldened lenders compete with one another, lowering underwriting standards in order to get money out the door.  Low debt service coverage ratios, full-term interest only loans and low debt yields become the norm.  Lenders begin to size loans assuming a property is sold rather than refinanced in order to make the numbers work.  The more aggressive that things get, the less margin of error there is when the economic cycle turns and conditions begin to deteriorate.

Perhaps the best type of real estate debt provider to use for this gauge is CMBS since it is far less exposed to regulatory forces than bank lenders, is not geographically constrained and has substantial lending volume.  If we look at the CMBS market today, it is very clearly flashing signs that we are late in the cycle.  Via Bloomberg’s Claire Boston on how interest only loans are taking over CMBS (emphasis mine):

Commercial mortgage bonds are getting stuffed with the lowest-quality loans since the financial crisis by one measure, according to Moody’s Investors Service, a warning sign that the $517 billion market may be headed for harder times.

The securities are backed by as many interest-only mortgages as they were in late 2006 and early 2007, Moody’s said. Those loans are riskier because borrowers don’t pay any principal early in the debt’s life. When that period expires, the property owners are on the hook for much higher payments.

The percentage of interest-only loans in a commercial mortgage bond is an “important bellwether” for the industry, according to Moody’s analysts, because the loans are more likely to default and to bring bigger losses to lenders when they do. Underwriters aren’t taking steps to fully offset the rising risks, the ratings firm said.

The riskier debt getting packaged into commercial mortgage bonds mirrors a trend that’s infiltrated many corners of the credit markets, from leveraged loans to residential mortgage securities: As investors have flocked to debt investments that seem safe, underwriters have been emboldened to make the instruments riskier and keep yields relatively high by removing or watering down protections.

Moody’s said fierce competition in lending has allowed “the vast majority” of borrowers with good properties to get the loosest kind of interest-only loans, and even debt tied to “lower-quality properties in secondary markets” now often has the borrower-friendly terms.

The growing percentage of interest-only loans is “a significant negative credit trend, as well as an important warning sign of deteriorating underwriting standards,” analysts led by Kevin Fagan wrote in a note this week.

In the first three months of the year, more than 75 percent of loans in commercial mortgage bonds with multiple borrowers were interest-only, the highest share since late 2006. On average, a borrower can wait nearly six years before paying principal, up from 2.2 years four years ago. Almost half of the pools of loans backing bonds included “full-term” interest-only debt, which doesn’t require principal payments until the full loan is due.

While interest only loans in the residential mortgage space are mostly a thing of the past thanks to better regulations, they are still very much alive in the commercial space as stated above.  Perhaps the biggest problem with where we currently sit is that commercial real estate lenders are running out of ways to ease borrowing conditions further and competition in the space is still fierce.  I suppose that full-term interest only loans could still get to a larger share of the market (they were well over 50% back in 2007), but I can’t imagine that is a great place for the market to be headed.  To be sure, the fundamentals in most commercial real estate markets and product types in the US still look very strong as vacancy is low, job growth is robust and rents are generally going up.  However, a look behind the curtain at how many projects are being financed does not paint nearly as rosy a picture, especially with rates on the rise.  Perhaps this uptick in interest only loans will prove to be benign as overall debt levels remain on the low end but the latest data from Moody’s on CMBS sure makes it feel an awful lot like we are in the 4th quarter.


Closing In: Two more Federal Reserve hikes will put interest rates at just about the bottom end of what is estimated to be a neutral monetary policy meaning that the autopilot is about to switch off.

Time to Get Busy: US births decreased again in 2017 for the third straight year.

Inverted: There are now officially more job openings than unemployed people in the US.


Big Data: Tenant rep specialist Savills Studley is rolling out an AI-powered platform that extracts data from leases.


Unintended Consequences: CEQA was designed to protect the environment, not fight housing for homeless people.  However, that is exactly what NIMBYs are using it for.

Misfit: Why shiny new apartment towers likely won’t fit the future housing needs of Millennials as well as new suburban housing would.

It’s All Relative:  Vancouver’s housing market is even more insane when you consider how low its median household income is relative to other high priced markets like San Francisco.


Hype Factor: This is a rather depressing take on the current state of Silicon Valley:

Moreover, the Silicon Valley game changes from “who’s smartest and does the best job serving customers” on relatively equivalent funding to “who can raise the most capital, generate the most hype, and buy the most customers.” In the old game, the customers decide the winners; in the new one, Sand Hill Road tries to, picking them in a somewhat self-fulfilling prophecy.

Depressing: How robocallers make money even if you don’t pick up the phone.  I wish that someone would make a move where the main character snaps due to excessive robocalls, goes rogue and hunts them down one by one.

Money Back: Tesla is facing accelerating rate of Model 3 refunds as production woes continue and buyers become frustrated with extended wait times.

Real Life Sopranos: This ProPublica story about a sketchy trash hauler in NYC with mob ties is insane.

Chart of the Day



Beam Me Up: A man who was caught masturbating at a bus stop told police that he was Captain Kirk from Star Trek because Florida.

I Can’t Believe This Worked: A man who claimed that his girlfriend chocked to death because he was well-endowed was found not guilty because Florida.

I Give Up: Google is eliminating it’s egg from their salad emoji because apparently it was offensive to vegans.  Ladies and gentlemen, 2018.

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