One session at the Spring Convention, billed as “Permanent Financing Outlook,” focused exclusively on what all the participants regarded as a temporary phenomenon: a lending environment that has become detached from the realities of industry fundamentals. With lenders competing to get money into the market, it's a great time for borrowers — too good to last.
Michael J. Mazzei, managing director of Barclays Capital, described the current situation as anomalous and untenable. “There's a huge amount of engines that have to put out money,” he said. The need to make deals — despite compressed cap rates that make many buyers hesitate — has led to lower lending standards and enabled some incautious buyers to bid up asset prices. “In the past year the cap rate compression we have seen has not been fueled by demand or by a love of real estate fundamentals,” he said. “It has been fueled by lenders.”
How loose has underwriting gotten?
The panelists all insisted that their firms walk away from situations in which they would have to bend their underwriting rules to win. But they eagerly cited examples of other lenders who do. The combination of aggressive lenders and borrowers who are smart enough to press their advantage has produced loans that would have been unheard of a few years ago — 80 percent or 100 percent leverage on properties that cannot even produce 1.0X debt coverage, long-term interest-only products, minute spreads and lots of goodies, such as reduced penalties for conversion to fixed. This adds up to a huge subsidy to borrowers that is already cutting into lender profits. “I know lenders who doubled their volume last year — and saw their revenue go down,” said Mazzei.
At some point, interest-rate increases and stubbornly low cap rates will collide. “You can't buy stuff at a 5, 5.5 or 6 caps and pay 6 percent interest. That won't work,” Mazzei said. “There will be a jarring jolt of reality eventually,” he says. But it will create new opportunities too. Lenders and investors will make money — probably more than they are making now — on restructurings, distressed debt, workouts, etc. When the correction does come, the panelists said, the enormous liquidity that has been created in the CMBS market will help cushion the blow.
Richard Katzenstein, senior managing director of MMA Realty Capital, took a longer view of the current investing cycle, noting that after the dot-com market blowout and the collapse of Enron, investors flocked to hard assets. That has had a salutary effect — by repricing real estate in relation to other investments.
“The risk premium in real estate was too high versus other asset classes,” he said. “That's real and that should stick. But this is an extreme situation now and no extreme is good.” The bottom line: Get ready for a nice, soft, well-organized crash — or maybe something a bit more chaotic. But when the smoke clears, says Mazzei, the markets will have proved their resilience: “The market will correct itself, but sometimes we have to break it first.”