The U.S. commercial real estate market continues to enjoy relatively low interest rates and an abundant — or perhaps excess — supply of investment capital. The flow of capital into U.S. commercial real estate equity, mezzanine and senior debt instruments has created intense competition among investors.
In the aftermath of 9/11 and the fallout from the collapse of the tech sector, real estate has become an investment of choice both for domestic and foreign capital. Stocks and bonds were not generating the desired returns sought by many investors, and with interest rates reaching historic lows the smart money found alternatives.
Commercial real estate fit the bill for investors seeking to shift investments to hard assets. This asset class has performed well, consistently providing double-digit returns to investors over the last few years and continuing to offer attractive returns on a relative basis. The National Association of Real Estate Investment Trust's Equity REIT Index serves as evidence. REIT stocks over a five-year period (2000-2004) produced a compound annual total return of 22.56%, compared with only 8.91% for the Russell 2000, and a minus 0.71% for the S&P 500.
Throughout the commercial real estate industry, however, there is mounting concern that the fierce competition among investors for commercial real estate deals might have some undesirable results. In markets across the United States, the abundance of liquidity in the real estate sector has contributed to increasingly low cap rates in nearly every commercial real estate property type and caused ongoing compression in margins within the entire capital stack.
This gives rise to questions about the disconnect between values and real estate fundamentals, the possibility of deteriorating underwriting standards and the level of risk investors will — or should — tolerate.
Many lenders have eased underwriting standards by consenting to more highly leveraged deals and allowing longer interest-only terms. But for the most part, this has been a measured response to the strong performance of the commercial real estate market. Consequently, the increased flexibility afforded by a moderate loosening of underwriting guidelines is no cause for concern.
Although operating property fundamentals for some of the core sectors were moderate to soft during 2003 and 2004, most seem poised for recovery in the second half of 2005.
In some sectors, such as hospitality, higher valuations have been the result of marked improvements in operating performance combined with increased liquidity. Other sectors, such as multifamily, have experienced weak to moderate improvement in performance, but have experienced higher valuations mostly driven by the excess supply of capital. Many investors prefer to put their money in U.S. commercial real estate, and with good reason. The U.S. market is mature, fairly predictable and transparent. The risk-adjusted yields are good, if not better, than alternative investments. This is in large part attributable to the underwriting standards and disciplines imposed by the commercial mortgage-backed securities (CMBS) industry.
These standards, which have influenced the entire commercial real estate industry, have helped keep the default rate relatively low, reducing the risk to investors. Commercial loans made by life insurance companies continued their near-flawless performance through 2003 and 2004 (see table below). CMBS delinquencies trended lower in 2004, as did delinquencies for commercial real estate loans made by commercial banks.
Further, the evolution of the CMBS industry has resulted in a high level of transparency and improved capital efficiency, benefiting borrowers and investors. The increasingly creative structuring of CMBS offerings into ever more tranches gives investors additional options to choose from in deciding where they want to be in the capital structure, optimizing their risk-adjusted returns.
Expect the trend to continue
The flow of excess capital into U.S. commercial real estate is expected to continue as both domestic and foreign investors target the sector. Investment and hedge funds awash with cash to invest will continue to bolster liquidity in the sector. The question is, for how long? Although the unprecedented level of investment capital flooding the market is not likely to be sustained on a permanent basis, the strong performance of commercial real estate will ensure that investment capital remains abundant in future cycles.
The competition for investment opportunities will remain strong, and that is a testament to the discipline and ingenuity that have made U.S. commercial real estate an investment of choice.
Thomas MacManus is president and CEO of North American Operations for GMAC Commercial Mortgage Corp.
FALLING LOAN DELINQUENCY RATES
|4Q 2004||4Q 2003||4Q 2002|
|American Council of Life Insurers (ACLI)||0.08%||0.12%||0.40%|