It’s hard to open a paper and not find a headline talking about all the foreclosures and the rather grim housing and lending markets. I even saw a report that ranked the Cleveland area as having some of the highest foreclosure rates in the mid-west — obviously that’s not a list you want to be on the top of. I guess this is the 2008 version of the savings and loan crisis of the late 1980’s and hopefully the country will work it’s way out of this one with equal success. In the meantime there’s been a lot of talk about what effect the sub-prime problems may have in Kent. We’re still working on figuring that out too but here’s a few things we’ve been hearing.
After listening to the city manager from Normal Illinois come talk to our Council last week about how they borrowed $80 million to buy land and redevelop their old downtown into a new “uptown” — we got to talking about the cost of borrowing in Kent these days. As you know, the interest rates are actually exceptionally low which is good (Normal Illinois actually got a 1.25% variable bond rate) but with all the foreclosures lately the banks are a lot more skiddish about who they’re willing to lend to and how much risk that loan may present. That means lenders are looking for more insurance to cover new loans and in our case some of the equity insurance firms that we use have had to shut their doors — pushing that part of borrowing up quite high right now.
As far as annual city revenues go, the troubles in lending and the housing market fortunately have a buffered impact on the city government because the City only gets about .10 cents on the dollar of property tax. Property tax is critical to the School system but it’s a comparatively small revenue source for the City. But these days revenues big and small are important so we are closely watching the housing market and hoping for some stabilization soon.
For the most part, Kent housing sales have been slow but until recently prices had been holding better than some of our peers in the suburb communities. It’s hard to say whether that will continue but I know that local realtors are optimistic for the spring sales season to hurry up and get started.
Kent’s Finance Director told me last week that there is usually a lag between market lows and impacts on City revenues by almost a couple of years. So she’s figuring our 2009-10 budget will be when we first start to see a drop in property tax revenues if the trend doesn’t correct soon. We are worried that if the resale market doesn’t pick up unsuccessful sellers will look to convert single family homes into rental properties — which is a problem since close to 70% of our housing stock has already gone rental.
I’m not anti-rental, rentals in proportion with home ownership can be good — but like vitamins too much of a good thing can be bad — and I’m worried that we are nearing a tipping point in many of our traditional neighborhoods where increasing numbers of absentee landlords and the coinciding loss of pride in ownership has strained the fabric that holds a neighborhood together and has contributed to the erosion of property values. And the more those values fall, the more people look to convert properties to rentals in an escalating cycle of decline.
We’re looking at ways to turn that tide but without a little help from the real estate market, our efforts are dwarfed by the dynamics of the larger economy. For example, we have federal housing rehabilitation dollars that we’ve been trying to use to encourage more home ownership in some of our at-risk neighborhoods but even with our assistance we’re having a hard time finding people that can qualify and meet the federal lending standards. So in the meantime more properties get converted into rentals with minimal reinvestment because economically that’s what makes sense in the short term but long term that spells real trouble for Kent neighborhoods.
Now that being said one of my favorite phrases is “a crisis is a terrible thing to waste” which makes me hopeful that the sense of urgency that rises up from the housing and lending troubles may give us the motivation we need to get more innovative than we might be during better times. I don’t want a crisis but if you have to have one, let’s make the most of it.
The adage of buy low sell high still applies and I have to believe that if prices continue to fall there will be some good buys out there and savvy investors will be ready to jump at them. I’ve actually started to already see it happen in parts of Kent where prices have dropped and a new breed of investor has emerged looking to buy and flip the property for a profit. Flipping properties isn’t necessarily the way to rebuild the sense of neighborhood that we’re looking for but it may be the first step towards where we want to go because those flippers see an opportunity to buy low enough that they believe they can reinvest to fix the property up and still sell it for a profit.
It’s that reinvestment piece that has been missing and it’s been my observation that investors are a competitive lot and where there’s a dollar to be made they gather quickly so if there’s a silver lining to all this I’m hopeful that it affords us the chance to see more reinvestment happen more quickly than it has in the past. I guess time will tell.
In the meantime, here’s a few rather somber facts and figures about the state of our economy today from the point of view of the financial analysts.
Real Estate Investment Trust Returns of January 2008
|Regional Malls||-2.61%||– 2.61%||4.76%|
|Equity REIT Index||-1.03%||– 1.03%||4.97%|
“What a difference a year makes”
|January 25, 2008||One Year Ago||Change|
|Federal Funds Rate||3.50%||5.25%||-1.75%|
Year-to-Date Equity Market Performance
S & P 500(2): -9.33%
Russell 2000(4): -8.76%
MSCI U.S. REIT(5): -4.52%
(1) Dow Jones Industrial Average.
(2) Standard & Poor’s 500 Stock Index.
(3) NASD Composite Index.
(4) Small Capitalization segment of U.S. equity universe.
(5) Morgan Stanley REIT Index.
U.S. Treasury Yields (as of February 9, 2008)
Pricing of Various Tranches of Commercial Mortgage-Backed Securities (as of January 30, 2008)
Rating; Term; Spread to U.S. Treasury Bonds
AAA; 5 years; +308 basis points
AAA; 10 years; +283 basis points
AA; 10 years; +514 basis points
A; 10 years; +764 basis points
BBB; 10 years; +1314 basis points
BBB-; 10 years; +1464 basis points
BB; 10 years; +1500 basis points
B; 10 years; +1600 basis points
Indicated Spreads for Conventional Commercial Mortgages (as of January 31, 2008)
|Commercial Mortgage Rate Spreads for 5-10 Year Fixed-Rate Mortgages|
|Property Type||<65% LTV||>65% LTV|
|Multifamily||+170 – 200||+180 – 240|
|Regional Malls||+170 – 190||+180 – 220|
|Strip/Power Centers||+180 – 200||+190 – 250|
|Multi-Tenant Industrial||+180 – 210||+190 – 230|
|CBD Office||+170 – 210||+195 – 225|
|Suburban Office||+180 – 200||+220 – 250|
|Full-Service Hotel||+180 – 220||+200 – 300|
|Limited-Service Hotel||+190 – 210||+220 – 300|
|5-Year Treasury – 2.80%; 10-Year Treasury – 3.61%|
|Source: Cushman & Wakefield Sonnenblick-Goldman, LLC.|
Real Estate Capital Markets Update – February 8, 2008
Volume 10, Number 3
Brace Yourself…Massive stimulus packages, both on the monetary and fiscal sides in the U.S., have combined with talk of capital infusion to further support troubled segments of the monoline insurers—and all quickly assembled in order to put a floor under debilitating market sentiments and perhaps engender a turnaround. There was much discussion about whether the American economy would enter into a troubled recession and what effect it would have on the rest of the world. In an effort to stave off what seemed like a broadening financial panic, America’s Federal Reserve cut its key interest rate by three-quarters of a percentage point, to 3.5%, the biggest single cut in a quarter of a century. The unusual intervention, a week ahead of the Fed’s scheduled January meeting, soothed nerves in American markets when they reopened after a holiday. And a push to offer fiscal stimulus was quickly offered up in support. So many of current stresses are unprecedented in scope that even in the face of market rebounds, one needs to worry whether more pain was around the corner. The failures in mortgage finance with all its intricacies of financial engineering are actually troubling precursors of what may still unfold in the world of business credit. So many layers of debt have been created in recent years and packaged and syndicated under the very best of circumstances that unraveling this web when business opportunities shrink will be no easy task. It is noteworthy that the majority of leveraged business loans today trade below par, an amazing about face from the past few years when virtually every loan traded above par. And the gap between where loans and bonds are trading may be a harbinger of more corporate stress that is on the way. Given all the financial ingenuity and complexities, the level of corporate stress will be way higher than the official count of defaults. Beware the contagion.
The Risks… The Federal Reserve policy minutes reveal the extent of their concerns and they run deep. Not only were mortgage-related losses impairing balance sheets at major financial institutions, the policymakers were also worried about credit losses spreading out to credit cards, auto loans and other forms of consumer credit. These potential losses were leading to tighter credit standards for most lenders. Balance sheet pressures could also be exacerbated by concerns over “rating-agency and regulatory capital requirements.” In addition, banks were experiencing unanticipated (and unwanted) growth in loans because of illiquidity in the market for leveraged loans. In other words, banks could not sell loans that backed leveraged buy-outs, and these loans were now unexpectedly adding to capital requirements. Some members of the Committee worried that an “unfavorable feedback loop” could develop in which deteriorating credit market conditions would restrain economic growth further, leading to additional tightening of credit and even slower economic growth. Such a development “could require a substantial further easing of policy.”
Bond insurers spark new fears over credit crisis
Fears that the credit crunch might be entering a traumatic new phase grew yesterday as investors lost confidence in the insurers that guarantee payments on billions of dollars in bonds. Shares in Ambac Financial and MBIA, the world’s biggest bond insurers, fell 52 per cent and 31 per cent, respectively, as Moody’s Investors’ Service raised the possibility that both might lose the triple-A credit rating on which they depend. The sector was dealt another blow when Merrill Lynch said it was writing down $3.1bn in hedges with bond insurers, mostly with ACA Capital, a guarantor that has lost its investment-grade rating and needs to raise $1.7bn by today to avoid insolvency The triple-A credit rating of the bigger bond insurers is crucial because any demotion could lead to downgrades of the $2,400bn of municipal and structured bonds they guarantee. This could force banks to increase the amount of capital held against bonds and hedges with bond insurers – a worrying prospect at a time when lenders such as Citigroup and Merrill are scrambling to raise capital.
Analysts predict it could be a long time before money markets return to normal
“We’re not going to go back to normal,” were the grim words of a New York money market trader in early December, as central banks prepared to pump billions of dollars into the inter-bank markets to revive liquidity. Their efforts gave some temporary relief and the cost of short-term borrowing fell, but traders and fund managers believe it may take until the second half of this year for liquidity to return to this part of the market. Pressures are worse than Y2K or the advent of the Euro. Even with the passage of year end spreads remain elevated. Our take is that central banks have put the financial system on life support.” Unlike in 1998, during the Russian Ruble crisis and the collapse of hedge fund Long-Term Capital Management when money markets continued to operate normally, these markets, among the most liquid in the world, froze overnight in August.
Private Real Estate Debt Capital Markets
First big worry;…pricing; second big worry…capacity.
Pricing first. Spreads in the conventional, portfolio/balance sheet lender market (65% loan-to-value ratio, 1.2 +/- debt service coverage ratio, covenants, amortization, funded reserves, and underwriting based upon in-place income and expenses) seem to have stabilized, for the moment, in the ranges shown in the following chart although there is limited anecdotal evidence of actual term sheets being circulated and application letters being executed. While some have expressed consternation—actually they were more expressive—as to the width of spreads given demand, the strength of real estate fundamentals, etc., the downward path of the 10-year Treasury has effectively muted most of the impact of the widening in spreads.
Indicated Spreads for Conventional Commercial Mortgages (as of January 31, 2008)
Commercial Mortgage Rate Spreads for
5-10 Year Fixed-Rate Mortgages
+170 – 200
+180 – 240
+170 – 190
+180 – 220
+180 – 200
+190 – 250
+180 – 210
+190 – 230
+170 – 210
+195 – 225
+180 – 200
+220 – 250
+180 – 220
+200 – 300
+190 – 210
+220 – 300
5-Year Treasury-2.80%; 10-Year Treasury-3.61%
|Source: Cushman & Wakefield Sonnenblick-Goldman, LLC.|
The securitized commercial mortgage market is not quite so benign with spreads continuing to widen, regardless of the path of Treasury yields. The following survey, effective January 26th, was provided by CohenFinancial:
The second big worry is capacity (or overall availability) of lenders to “lend”. Based upon the volume of transactions last year, which was a record year even though the markets were “closed” for a portion of the year, the markets have come to depend upon the securitized markets for as much as 80% of the long-term capital used to finance the real estate business. Estimates for 2008 show the life insurance sector committing a high of $50 billion to commercial and multifamily mortgage financing market and the conduit sector committing a similar amount. So…capital will be dear, hard to come by, rationed, constrained, and expensive…say it any way you want.
Not surprising are the results of the Federal Reserve Board’s most recent Senior Loan Officer Opinion Survey which indicated continued tightening of lending standards for all “sizes” (large, medium, and small) of commercial and industrial borrowers as well as for all forms of residential mortgage finance. The survey also noted weaker demand for commercial [real estate] mortgage loans.
Moody’s Economy.com noted in its analysis of the survey that when banks were queried as to why they had “tightened standards on C & I [commercial and industrial] loans during the period [October 2007 to January 2008], most banks cited a more uncertain or less favorable economic outlook, worsening of industry-specific problems and a reduced tolerance for risk”.
And speaking of reduced tolerance for risk, Economy.com noted: “The January survey also included a special question on the outlook for loan quality in 2008. The majority of the respondents expect to see further deterioration in loan quality in 2008. Between 75% and 85% of respondents expect deterioration in the C & I loans. A similar percent expect to see weakening in mortgage loans, while 70% expect credit quality in both credit cards and other consumer loans to worsen”. Ugh!
Opportunities or Anguish? Analysts are beginning to try to quantify the issue of refinancing risk, which together with depressed homebuilder stocks and single family lot deals, seems—at present—to the opportunistic plays in the cycle. According to Realpoint, approximately $25 billion of securitized commercial mortgage loans are maturing in the ensuing 12 months. Our sense is that we do not have to worry too much about loans written before 2004 being able to be refinanced as enough time has gone by for improvement in property fundamentals to offset weak and/or aggressive underwriting.
But, the 160+ loans which have an aggregate loan balance in excess of $19.0 billion+, that were funded during the “heady” days (high loan-to-value ratios, low debt service coverage, interest-only, few covenants, etc.) certainly could face difficulty in the current lending environment and therefore represent opportunities for well-capitalized investors to assist “over-leveraged” borrowers in getting their financial house in order—at a price.
|Real Estate Capital Markets Update, resident fellows, blank|