At the halfway mark of 2007, leveraged investors are saying goodbye to the lowest commercial mortgage rates in 40 years and are coming to grips with increased capital costs. Fixed mortgage rates rose an average of 50 to 75 basis points from early April through June to approach 7%, increasing debt service on loans and decreasing loan-to-value ratios.

The higher borrowing costs are at least partially responsible for the flattening sales volume of non-institutional grade properties and could force cap rates to widen later this year, experts say.

“We're seeing a number of acquisitions that are falling apart because the investors cannot get the leverage they could previously,” says Gary M. Tenzer, principal at real estate investment bank George Smith Partners Inc. in Los Angeles.

The pendulum has swung quickly. At the beginning of the year, for example, an investor could expect to finance 85% to 90% of an unanchored strip shopping center for 10 years with an interest-only loan. “That deal would be very difficult to get done today,” says John H. Pelusi Jr., executive managing director of lending intermediary Holliday Fenoglio Fowler in Pittsburgh. Today, an investor in that same retail deal would likely be required to pay principal plus interest, with financing at 80% or less of the purchase price.

The underwriting has tightened to reflect investors' concerns over risky loans. “The 85% leveraged conduit loans are few and far between now, and they were plentiful,” says Tom Sherlock, managing partner of Newport Beach, Calif.-based lender Buchanan Street Partners. “Interest-only deals, and accepting less than break-even debt-service coverage ratios — most of that got washed out the window.”

The debt-service coverage ratio (DSCR) on a stabilized office property five years ago was about 1.1. In recent years that average dropped to about 1.05, with some loans at 1.03 or lower, reducing the cash flow required for debt service.

Horror stories

Even if coverage ratios don't change, debt service has increased because most borrowers must now pay amortization, or principal plus interest. That increased demand on a property's cash flow will limit available loan proceeds.

While borrowers and lenders are reluctant to discuss specific loans, it's clear that deals are suffering. In a recent example, a non-institutional buyer hit by increased capital costs asked to renegotiate the purchase price of a mid-rise office building developed by The Alter Group, a Skokie, Ill.-based firm. The two parties are negotiating, but Alter Group CFO Ron Siegel says the buyer's reduced purchasing power will likely kill the deal.

Lender Philip Carroll, southeast regional manager of KeyBank Real Estate Capital in Miami, says clients have told him “horror stories” about other lenders reneging on previously negotiated terms to impose higher mortgage rates and underwriting requirements. “They've tightened the screws on the origination shops,” he says.

In response to the changing interest-rate environment, owners will need to execute a real estate strategy to increase the value of their holdings, says Earl Webb, CEO of the capital markets group at real estate services provider Jones Lang LaSalle in Chicago. “There is still value to be created in real estate, and lots of it, but it will be value created through improvement of properties, leasing, redevelopment, aggressive management and expense control,” Webb says.

Markets re-price risk

Much of the climate change in lending is traceable to a single event. On April 11, Moody's Investors Service declared that lax underwriting on CMBS loans had increased investors' risk, so the rating agency vowed to increase subordination levels in future transactions.

The spread on BBB-rated bonds has spiked 44 basis points above its 52-week average as of late June, while spreads for B-rated bonds soared 85 points for the same period.

The cost of capital for CMBS issuers increased in order to pay a higher yield to investors at each tranche. CMBS bond buyers, shaken by rating agencies, grew more conservative and even began to kick out undesirable conduit loans from CMBS pools deemed too risky. In turn, conduit lenders began to increase mortgage rates.

As rating agencies had intended, lenders reacted almost overnight by tightening underwriting standards, shunning interest-only periods, boosting equity requirements and effectively reducing the proceeds available on senior loans. As a result, loans that would have provided 80% financing in the first quarter are down to about 70%.

However, repricing of risk only accounts for a fraction of today's higher mortgage rates. A more significant factor is the benchmark 10-year Treasury yield, which climbed more than 50 basis points from 4.50% on March 13 to 5.16% in late June (see sidebar p. 28).

Floating-rate fallout

The one-month LIBOR (short for London Interbank Offered Rate), a benchmark for short-term lending, has remained stable for the past year at about 5.3% with competition among banks keeping floating-rate mortgages low. Nevertheless, investors who use construction loans and other short-term financing report that less loan proceeds are available to them.

Borrowers say lenders are reducing loan amounts to ensure owners can refinance later and supplementing the smaller loans with costlier mezzanine debt. TCB Development Co., based in Tinley Park, Ill., is still landing construction financing for its projects, but company CFO John Atkenson expects to see some reduction in the availability of loan proceeds for individual projects.

Atkenson says amortization requirements on fixed-rate loans create a ripple effect through construction lending. Fixed-rate lenders are cutting back on loan proceeds because borrowers must pay more to cover principal and interest payments, rather than interest alone. In turn, short-term lenders don't want to approve loans that will be too large to refinance in the permanent market.

TCB Development is navigating the more restrictive financial landscape by working with lenders with which it has established relationships. “Lenders are just working harder along with us to address this issue on take-out financing,” Atkenson says.

Real estate researchers say the spread between the 10-year Treasury yield and interest rates on fixed-rate mortgages will remain at 115 to 120 basis points and won't return to the first quarter's 90 to 100 basis point spread, now that lenders are re-pricing risk. Yet buyers could regain some of their recently lost buying power later this year, if interest rates or asset prices begin to fall as some predict.

Most economists expect the 10-year Treasury yield to stay perched above 5% and gradually trend upward next year, barring a recession. The highly leveraged buyer is more likely to make his way back into the game through a reduction in asset prices.

Ceiling on cap rates

In light of the re-pricing of risk, some asset prices are peaking, researchers say. Capitalization rates, or initial yields on acquisitions based on the purchase price, are leveling off and have even widened 25 to 50 basis points in cities off the radar screens of equity-rich investors, according to Hessam Nadji, managing director of research services at Marcus & Millichap. That's not the case in major cities dominated by institutional investors, which use less leverage than most private investors.

Commercial real estate prices have soared over the past three years and caused cap rates to compress. The average cap rate for multi-tenant office properties plummeted from 8.5% in the first quarter of 2004 to 5.75% in the first quarter this year, according to Real Capital Analytics, which tracks deals $5 million and higher.

Deal volume has flattened for properties valued below $10 million, which are less likely to draw interest from institutional investors. In smaller markets dominated by private investors, Nadji expects cap rates to rise this year, bringing prices within the shortened reach of leveraged buyers.

That presents a problem for passive investors, who are less likely to see asset values appreciate without leasing, management, or property improvements.

Whether loan volumes will drop in response to the surge in capital costs remains to be seen. The most recent data available from the Mortgage Bankers Association shows commercial real estate lending volume in the first quarter up 37% from a year ago. Volume was down 15% from the fourth quarter, attributable to an end-of-year rush to close deals.

Time to strategize

Investors who grew accustomed to highly leveraged deals have two options: come up with more equity or seek additional leverage outside conduit lending. That leverage is available for borrowers willing to pay for it.

Mezzanine loans, which are secured by an interest in a property's owner, are plentiful and helping to fill the void left by shrinking senior loan proceeds, says Carroll, the regional manager at KeyBank Real Estate Capital.

“There's still plenty of capital out there for a good project,” Carroll says. “It's just that the capital is more expensive than it was.” Interest rates on mezzanine loans now range from 8% to 15%, unchanged from a year ago, according to KeyBank.

Lenders that provide mezzanine and other bridge loans are enjoying the increased demand for floating-rate debt, says Ryan Krauch, principal of Los Angeles-based Mesa West Capital LLC. The influx, he says, marks a return to more traditional borrowing patterns, in which floating-rate debt is used for value-add or transitional properties and fixed-rate loans serve stabilized properties.

“The question is whether this hiccup in the fixed-rate side is short term or long term. Most people are preparing for it to be a long-term adjustment,” says Krauch.

Borrower beware

Investors feeling overwhelmed by capital costs should shop around before selecting a loan because some lenders are overreacting to risk aversion in the CMBS markets and charging higher rates than their competitors, says Pelusi of Holliday Fenoglio Fowler.

“Three to six months ago, if you took a property out and exposed it to the market, all of the [loan] bids might have been within five basis points of each other. Today that spread could be as wide as 25 basis points between better quotes and run-of-the-mill quotes,” Pelusi says. “It really pays to expose your property to the market and do your due diligence as a borrower.”

Borrowers shouldn't despair over rising capital costs. Mortgage rates below 7% are still attractive. The challenge in the second half of 2007 and beyond is to adapt investment strategies and prepare to come up with a little more equity, or a little more cash flow, to make deals work.

“It's not the end of the real estate market,” says Tenzer of George Smith Partners. “Investors are borrowing in the sixes [percent]. Historically, that's an incredibly low rate, and that has to be kept in mind. And there's still a tremendous amount of liquidity.”

Matt Hudgins is an Austin-based writer.

PREDICTIONS FOR YEAR-END 2007

NREI asked eight forecasters to predict the direction of key indices. Here are their responses:

Dr. Rajeev Dhawan: Director, Economic Forecasting, Georgia State University

Prediction: “The Fed will cut interest rates by a total of 75 basis points this summer.”

Dana Johnson: Chief Economist, Comerica Bank

Prediction: “We're in what will turn out to be the longest post-war expansion we've ever seen.”

Hessam Nadji: Managing Director of Research Services, Marcus & Millichap

Prediction: “The positives are going to outweigh the negatives, and we'll avoid recession.”

Josh Scoville: Director, Strategic Research, Property & Portfolio Research Inc.

Prediction: “Some of the underwriting assumptions being made today, especially in terms of future rent growth, will fail to materialize.”

James Smith: Chief Economist, Parsec Financial Management

Prediction: “The economy will come out of a six-month recession in the fourth quarter of 2007 and make up all its lost ground.”

Diane Swonk: Chief Economist, Mesirow Financial

Prediction: “Prepare for irrational exuberance from foreign investment.”

Craig Thomas: Senior Vice President, Torto Wheaton Research

Prediction: “The economy begins 2008 stronger than it began 2007.”

Jamie Woodwell: Senior Director, Commercial Research, Mortgage

Bankers Association Prediction: “No Fed movement, upward or downward, in 2007.”


GDP (%) growth Core CPI inflation rate (%) Monthly job growth 10-year Treasury yield (%) Crude oil ($ per barrel)
Dhawan 1.9 2.2 72,000 4.75 $58
Johnson 2.25 2.2 130,000 5.25 $60
Nadji 2.3 2.2 75,000 4.75 $60
Scoville 2.5 2.3 100,000 5.1 $55
Smith 0.5 1.1 196,000 4.14 $31.75
Swonk 3.0 2.0 140,000 5.1 $63
Thomas 3.0 2.9 129,200 5.17 $60
Woodwell 2.2 2.3 120,000 5.0 $69
Recession or resurgence? Economists' views differ

The U.S. economy has continued to slow in the year since the Federal Reserve halted a series of 17 hikes in the Fed funds rate, which stood at 5.25% in late June. Economists differ on whether the Fed succeeded in damping inflation without driving the nation into recession.

Dana Johnson, chief economist at Comerica Bank in Ann Arbor, Mich., says the Fed executed a near-perfect soft landing. “There's definitely been a slowdown, but there had to be. That's what the Fed was trying to do,” he says. “Moderate growth in the last four quarters has laid the foundation for what is likely to be an extended period of growth.”

The Gross Domestic Product (GDP) rose 0.6% in the first quarter, the lowest quarterly increase in four years. But Diane Swonk, chief economist at Mesirow Financial, predicts that better days are ahead. The manufacturing sector will provide a boost in the second quarter as depleted inventories such as cars are replaced, the result of a resilient consumer, Swonk says.

Some economists believe the economy hasn't stopped slowing, and is already in a recession or will be by the end of summer. Technically a recession is defined as two consecutive quarters of decline in GDP.

Consumer spending, which makes up 71% of GDP, is the chief reason the nation hasn't already slipped into negative growth. That saving grace is fading, however, and is expected to show about 2% annualized growth in the second quarter, down from about 4.3% in the first quarter.

A low unemployment rate of 4.5% has buoyed the consumer, experts say, but spending is sagging under the weight of gasoline prices of $3 per gallon and food prices that were up 6.7% in the first four months of 2007 compared with the same period a year ago.

The government reports that core inflation, which excludes volatile food and energy costs, dropped from an annualized rate of 2.3% in April to 2.2% in May. That's closer to the Fed's comfort level of 2%.

Jim Rogers, economist and author, disagrees that inflation is being held in check. “There is inflation in the land, and if you're in the real estate business, you know it,” says Rogers, who questions the current methods the federal government uses to track inflation.

Rogers says commodity prices have increased 250% since August 1998, but the federal government excludes raw materials from the Core Price Index in order to make inflation appear lower and keep consumers happy.

Perhaps concern over non-core inflation explains why the Fed hasn't intervened with an interest rate cut to stimulate slowing GDP growth. Some forecasters even believe the Fed will increase rates soon in order to head off inflation.

That would be bad news for the economy, says Dr. Rajeev Dhawan, an economist at Georgia State University. Dhawan believes the Fed could dodge a recession by lowering interest rates now. “If they come into the game late, then you are talking the ‘R’ word, and they will have to do more rate cuts just to shore up the economy.”
— Matt Hudgins

Why higher rates aren't likely a blip

The 10-year Treasury yield reached a five-year high of 5.26% on June, 12, rising 75 basis points in just three months. While that benchmark for long-term, fixed-rate financing has eased since, economists say borrowers better get used to higher interest rates.

“Anybody who relies a lot on leverage would be hurt most in an environment of rising interest rates,” explains Robert Bach, research director at Grubb & Ellis. “Institutions would probably welcome higher interest rates to eliminate some competition.”

The future direction of interest rates depends on several factors. Core inflation has fallen to near 2%, but non-core items like food and fuel are climbing well above that rate. Bond buyers want higher yields to reflect their growing risk of loss due to inflation.

If core inflation follows suit, the Fed is likely to raise short-term interest rates to slow the economy. “We would not be surprised if they raise rates before they lower them again,” says Josh Scoville, director of strategic research at Boston-based Property & Portfolio Research.

For nearly three years, the 10-year Treasury yield resisted the historical tendency to run higher than short-term rates, and in fact fell below short-term rates for the past year to form an inverted yield curve. The 10-year bond's odd behavior reflected massive purchases of U.S. Treasury bonds by foreign central banks as they sought to bolster the economy.

With the shrinking trade deficit, banks are less inclined to intervene. Improving international interest rates are providing venues for capital that had poured into U.S. securities. The shift has enabled the 10-year yield to climb above the three-month Treasury yield, which registered 4.7% on June 21.

Most economists expect the 10-year Treasury yield to stay above 5% and trend upward into 2008, but not everyone. James Smith, professor at the Institute for the Economy and the Future at Western Carolina University, expects a recession this summer and a 10-year yield of 4.14% by year's end. “People buy into Treasuries for safety,” concludes Smith, “and it drives prices up and yields down.”
— Matt Hudgins