Commercial Real Estate: From Towers of Gold to Pillars of Salt
Mix together mortar and lime with pressed hay and you too can construct a Tower of Gold, or at least the illusion of one.
If you have any doubts, pop on over to Seville, yes, the one in Spain, and have a look at the original Torre de Oro. Particularly entrancing is the vision of this 13th century dodecagonal watchtower at night. The gilded color reflected on the waters of the Guadalquivir River is as rich as you’ll ever be fortunate enough to behold.
The Spanish tower was originally one of two anchor points for a massive chain that blocked the river forming a defense against the Castilian fleet under Ramon de Bonifaz in the 1248 Reconquista. Unfortunately for the city’s residents, the chain did not hold and the besieged Muslim mecca eventually succumbed to the Christian forces. Despite its having been repeatedly under assault down through the ages, the Torre has withstood a series of attacks of the sort Mother Nature and revolutionary looters have thrown at it. So adored was the golden edifice, its destruction was never allowed. The Sevillians have demanded it be restored and re-restored over and over again. The time value of the building has clearly held strong to our aesthetic and architectural benefit.
As for the current generation of erected structures, today’s investors in commercial real estate (CRE) can be forgiven if they’ve got the urge of late to go soft on the sector. Fine, so the current CRE cycle is long in the tooth. The same could be said for the length of the rally in just about every other asset class and for that matter the current economic expansion.
What differentiates CRE from other asset classes is that it’s been hyper-driven by monetary policy gone wild. Flows into both U.S. commercial and high end residential real estate reflect the currency tug of war that started over three years ago. You remember that hissy fit the bond market threw at the mere mention the Fed might throttle back on its quantitative easing (QE) machine. Would inflation waltz hand in hand back onto stage? If so, might an inflation hedge into a hard asset naturally, dare say, logically follow? Well, then – let’s all join hands and pile hand over fist into real estate! For safety (never works out that way in numbers) that is.
In what can only be described as a full 360-degree turn from the initial days that followed the summer of 2013’s ‘taper tantrum,’ the Wall Street Journal recently ran an article titled, “Chinese Rethink U.S. Plans.” To say those trolling the Twittersphere took umbrage is an understatement. Vitriolic accusations of pots calling kettles black and casting stones in (overpriced) glass houses flew for days (good thing Tweets are capped at 140 characters as less is blessedly less when tempers flare).
Though few real estate consultancies are foolish enough to bite the hand that feeds them, there is a nascent acknowledgement that supply is becoming conspicuous in its abundance. “Supply rising but generally not over supply,” and “Real estate is late cycle,” are but two tentative subtitles to one to remain unnamed firm’s 2017 outlook. The real kicker, though, was, “Foreign buyers – from tailwind to headwind.” That gem speaks to the nitty gritty in the WSJ article, namely that foreign buyers, for all of their enthusiasm to jettison their capital, have hit their valuation threshold.
The specific deal punctuating the article draws the reader to a Street in Brooklyn, or more precisely, “a 22-acre, 15-building mixed use project in various stages of construction (that) is facing stiff headwinds.” As a nominal nod to said headwinds, the U.S.-based partner of the Chinese investor has taken a $307.6 million impairment charge and declared it will, “delay future vertical development.” The Chinese unequivocally deny any construction interruptions, insisting that they are, “meeting the goals and targets that were established when we invested in 2014.” Hmmm. Raise your hands if you want to read between those lines, in Mandarin, no less.
Rather than be plagued by such deep thoughts, perhaps at this point it would be best to step back and examine some basic metrics gauging the health of the commercial real estate market. If we start in the most amply supplied sectors and move our way down the spectrum, you may note that a pattern begins to emerge.
Let’s start with home away from home, as in hotels. To say we’ve built a few more lodging units in recent years than justified by the fundamentals insults veteran developers. In polite parlance, hotel room supply will outstrip corporate demand in 2017. In less genteel jargon, the main metric measuring the health of hotel profitability, as in RevPar, the product of a hotel’s daily room and occupancy rates, has tanked. The latest month’s read has RevPar nationwide growing at 1.6 percent over last year. In the event you like to keep score, that’s half the 3.2-percent rate thus far this year, and half the rate again of the 6.3-percent pace clocked in 2015. So yes, there’s a light on at the inn.
As for that stopover station in life, otherwise known as your apartment years, it’s a good thing cultural norms have shifted. It’s now cool to rent well into your prime earning years. Coming soon: it will also be economical as record supply finally chokes off rent growth. Over the past 12 months, 190,000 units were delivered across the 54 largest U.S. metros, a tad bit more than the 140,000 15-year average. But wait, there’s more! Another 244,000 units are slated for delivery in 2017, taking the bull run that started in 2013 in multifamily construction to a neat million unit. In the supply crosshairs, and in order of expected deliveries, are Houston, Dallas, New York, Washington D.C. and Austin. The deluge has finally cooled nationwide rental growth to 2.99 percent from a five percent pace a year ago.
It will come as no surprise that rents are outright falling in Houston (what’s the opposite term for ‘liftoff’?). But sliding rents are also a reality in New York. Would you believe Kings County, aka Brooklyn, is largely to blame? Just two years ago, as the Chinese were breaking ground on that mixed-use monster, 18 percent of the Big Apple’s supply entering the market was in Brooklyn; as of the third quarter that share had doubled.
It’s easy enough to attribute emerging stresses in CRE loans to oil patch woes. Take a drive through anywhere in suburbia and you’ll conclude quickly enough that retail is the next major source of loans behaving badly. Retail is a subject in and of itself. Rather than take a deep dive, take it on faith that there’s no way all of the excess supply can be absorbed and repurposed. E-commerce momentum cannot be contained and will push more household names into the netherworld. The true visionaries among real estate developers have long since slipped away from brick and mortar’s never ending funeral. They’ve got their sights set squarely on the lucrative potential for the fire sales of the land sitting under all those shuttered stores.
Less visible to the naked eye is the trouble brewing in office space. Be that as it may, the numbers don’t lie. Commercial mortgage-backed securities (CMBS) comprise a mere tenth of CRE debt. Still, they provide an ideal prism into the health of the overall market given they are publicly traded; performance metrics are readily available. With that said, the most recent batch of data reveal that office delinquencies have been ticking up since midyear. Moreover, at $5.1 billion, the balance of delinquent office CMBS is second in size only to retail, which is saddled with a $5.9 billion pool of debt gone bad.
Did a lightbulb just gone off over your head as you pondered the preponderance of pressured properties peppered across this great nation? Is it time to head for the hills? Even short real estate, which we already know to be underperforming the broad market? The short answer to your urge to swiftly short the sector is, “It depends.”
It’s no secret that rising interest rates are an enemy of real estate in all its forms. Tack on the slow grind of the current economic recovery and you quickly conclude that the insufficient income thrown off by plenty of properties will easily be engulfed by higher financing costs. It’s critical to note that this dynamic was rendered moot in a zero interest rate environment. Refinancing you name it – from junk bonds to malls in the morgue – wasn’t near the challenge it would have been otherwise.
The reality of, “It’s the level of interest rates, stupid!” has Morgan Stanley’s CRE team a bit worried headed into the new year. First, a term of endearment, for developers, that is. ‘Net operating income’ (NOI) is the revenue a property generates after deducting the expenses required to operate the property. Word is, the higher the better. Enter Richard Hill & Jerry Chen at Morgan Stanley and the aforementioned rising interest rates. To keep things simple in formulating their forecast, they assumed a one percentage point increase in rates, which happens to be one in the same with the rise in the yield of the benchmark U.S. Treasury, give or take a basis point.
“We estimate that NOI growth would need to average nearly five percent over 10 years to produce the same levered return as today,” Hill and Chen wrote. “If NOI growth remained stable at three percent, near the historical average, then property prices would fall over eight percent to produce the same levered return as today.”
At the risk of mixing apples and oranges, the flashy new Standard & Poor’s real estate sector in the S&P 500 is off by precisely that much since it premiered September 19th.
As for what’s to come…did someone mention an election upset in the United States?
Animal spirits are the one thing that can rescue CRE in the year to come as a magnificent wall of maturing debt comes due. Some $120 billion in CMBS is up for refinancing in 2017. Tack on all other forms of CRE debt and the figure rises to $400 billion. A special feature of this debt vintage is that only 40 percent produces sufficient income to ensure refinancing is a sure thing (For any CRE types out there reading this, pardon the paraphrasing of industry terminology. This ain’t easy stuff to communicate to us laypeople.)
Add up all the factors and throw in tightening lending conditions for good measure. Hill and Chen estimate that 60 percent of the debt maturing in 2017 will be successfully refinanced while 20 percent is modified and 20 percent liquidated. Call that the base case scenario.
How to improve upon that projection? In two words, premature allocation on the part of investors either hungry for management fees or starved for yield.
Private equity is sitting on a $230 billion mountain of dry powder, as in funds earmarked to buy up real estate. That’s up from $210 billion at the end of 2015 and a mere $156 billion four years ago due in large part to pensions chasing returns. Meanwhile, it looks like CMBS issuance will rise to $65 billion next year pushing up the sector’s market share to 15 percent. And don’t count out insurance companies. Some analysts predict their market share could double or more from 2016’s 13-percent base, a prediction that’s been validated by insurers’ rising share of lending volumes in recent months. No doubt some of these insurers are international, which is understandable given negative, albeit rising, yields in so many countries. For identical reasons, many other types of foreign investors, especially of the sovereign wealth fund ilk, continue to flood the U.S. market with funds.
Global property investment will easily top $1.5 trillion this year. And New York will be crowned as the top-ranked target city, unseating London. The US will also boast the largest share of growth, with 15 of the top 25 cities on the top-ranked investment list.
If I’ve just talked you back into your own personal real estate investments, you may want to beg to differ…with yourself. Recall that the outlook remains iffy at best. At this late stage in the cycle, it can be prudent to be early and live to be liquid another day.
Not every tower, you see, maintains its golden allure forever. Real estate developers are the first to say they must be optimists to succeed in their chosen line of work. That said, many developers have gone down in flames, denying that the party has ended. Like Lot’s wife, they refuse to relinquish the past. They too look back, destroying what riches they had built, turning them into pillars of salt.
Originally published on Danielle DiMartino Booth’s website.