Commercial real estate investors are addicted to debt. There are exceptions, of course. Some buyers out there do all-cash deals. But the industry as a whole cannot sustain itself without a continuous stream of money from commercial and investment banks, conduit lenders, life insurance firms and other creditors.
The experience of the last several years proves that definitively. Easy money fueled the boom years. As we know now, things definitely got out of control. Remember the days of 100 percent financing? And how about those underwriting assumptions that forecast rent bumps, sky-high occupancy rates and rising valuations as far as the eye could see, all to justify larger loans?
When the flow of capital rapidly stopped—especially in the CMBS sector—the commercial real estate party abruptly ended. Since then, investors have suffered through a prolonged hangover. And the throbbing headache, while easing, just won’t go away entirely.
Credit conditions recovered first for top-quality borrowers, class-A assets and in primary markets. Assets with any sort of risk profile and borrowers without a strong track record, however, remain more difficult to finance.
So what does 2012 hold for capital flows?
The good news is that although the economic recovery has been tortured, it is unquestionably a recovery that is taking place. The U.S. gross domestic product continues to grow. Unemployment is falling as well (although some of that is due to people dropping out of the labor force rather than getting jobs).
Moreover, the low interest rate environment has persisted far longer than borrowers or lenders expected. That has created a much needed cushion. Even with lenders being more stringent, borrowing costs are reasonable. And the fact that rates have been so low for so long has provided ample time for commercial real estate owners to deal with property level problems and refinance at reasonable rates.
In other words, the “pretend and extend” tactic that lenders employed has worked. Today, both lenders and borrowers have more options when dealing with distressed assets than they did 24 months ago.
The capital stack today
In 2012, conditions borrowing conditions should continue on their slow ascent.
Our annual Borrower Trends Survey, had more than 300 respondents this year, including both borrowers and lenders. Overall, borrowers are expecting to take out more loans and lenders are anticipating placing more debt. That, in turn, should lead to a further rise in investment sales volumes.
The biggest question remains the CMBS sector. In 2011, more than $35 billion in new issuance occurred. That was more than 2007, 2008 and 2009 combined. But it fell short of what some expected when the year began, thanks to some problems in the summer that led to a slow end to the year. In 2012, expectations are for issuance to rise to perhaps $50 billion. That would put the industry roughly on par with 2002, when $54.03 billion in issuance occurred. But it is a far cry from 2006 and 2007 when $202.69 billion and $230.17 billion in issuance took place, respectively. So there remains a big financing gap in the market.
On the other hand, life insurance companies, historically the most diligent commercial real estate lenders, had a record year in 2011. In the first three quarters alone, life companies placed $34.66 billion—a 71 percent jump from 2010 and a number greater than any previous full year figure. Life insurance firms have their sights set on placing another $45 billion to $50 billion in debt in 2012.
Commercial banks, the largest source of financing for the sector, also are in solid shape. Many firms anticipate placing more debt in 2012 than in 2011 and are increasingly willing to take on higher levels of risk.
Lastly, mezzanine financing is increasingly returning to the picture. That means borrowers facing lower loan-to-value ratios on senior debt (60 percent to 70 percent today vs. 75 percent to 85 percent at the market’s peak) will have options in building capital stacks that go beyond trying to raise additional equity.
Questions remain, however. How long will low interest rates last? Will austerity measures and government budget cutting slow the economy? How will the European sovereign debt crisis affect capital markets? Will commercial real estate fundamentals improve further? And there is the ever-present issue of Fannie Mae and Freddie Mac. Reform of those institutions would alter the financing picture for multifamily properties.
In the end, the picture for 2012 is one of a slow recovery. It will build on 2011, but don’t expect any miracles.