Are We There Yet? Real Estate’s Next Leverage Problem

By Bob Dougherty, Buchanan Street Partners:
A tidal wave approaches in the form of an estimated $1.2 trillion of United States commercial mortgages that are scheduled to mature between 2011 and 2014. Surviving this tsunami of debt is a test that many feel will threaten any budding real estate recovery and may send property values tumbling again, proving the current respite to be not an oasis but a mirage. This is the bogeyman that haunts industry watchers and participants alike.

Parents who have taken their children on car trips are familiar with the plaintive refrain “Are we there yet?” While a question common amongst kids, few analysts of the commercial real estate industry would dare to pose it in reference to commercial real estate reaching its safe harbor. A tidal wave approaches in the form of an estimated $1.2 trillion of United States commercial mortgages that are scheduled to mature between 2011 and 2014. Surviving this tsunami of debt is a test that many feel will threaten any budding real estate recovery and may send property values tumbling again, proving the current respite to be not an oasis but a mirage. This is the bogeyman that haunts industry watchers and participants alike.

While these fears are surely not misplaced, another fearsome beast awaits around the corner from the bogeyman. His mere shadow, when seen, sends shivers through the global economy, and everyone knows he is out there yet many prefer to blissfully ignore his presence. This scary monster is $13.5 trillion large and is now growing at the rate of $1.4 trillion annually. Just feeding this beast costs an estimated $400 billion per year, consuming nearly three percent of his keeper’s annual GDP. This creature is, of course, the U.S. national debt.

The relative sense of calm and relief which has washed over the commercial real estate industry this year seems to stem from Armageddon averted. Sure, it was a powerful storm with massive destruction of fortunes and personal livelihoods. It will take a while to sift through the wreckage, and rebuilding will take even longer. However, believe it or not, it could have been worse. Massive foreclosures have been avoided or at least delayed. Banks have failed but at nowhere near the rate feared by many prognosticators, and the global financial system, while shaken to its core, did not crumble altogether.

How did capital markets survive this onslaught? Where did all the losses go? The answer, of course, is that everyone took some lumps. Equity investors have seen a substantial swath cut out of their holdings. Lender capital has substantially eroded, as well. However, it is probably fair to say that many of these players would not have a leg to stand on were it not for the federal government’s rescue efforts in the form of the alphabet soup of bailouts and stimulus we have witnessed over the past two years.

Between the American Reinvestment and Recovery Act, the Troubled Asset Relief Program and the Term Asset-Backed Securities Loan Facility, the federal government has committed an estimated $2.3 trillion to resuscitate our ailing economy. Thanks to its role in these bailouts and reflecting the effects of printing cheap money over the past two years in order to maintain near-zero short-term interest rates, the Federal Reserve’s balance sheet has ballooned from $900 billion to $2.3 trillion. All the while, the U.S. has been waging ground wars in two theaters at a total estimated cost of $900 billion, and fighting a broader global war on terrorism while seeing its tax revenues shrink dramatically due to lower incomes and employment.

The losses averted by the financial sector did not disappear. Many of them were simply transferred to the federal balance sheet and thereby dispersed to be absorbed in a very small portion by each and every American citizen. Our leverage problem has not been solved, but instead deferred. However, just as U.S. households and its financial system have been forced into a painful deleveraging, so too will the federal credit card max out or face substantial remargining. The national debt is now equal to approximately 90 percent of annual GDP, its highest proportion since World War II.

What will be the effect of this unsustainable level of federal deficits on commercial real estate? First off, interest rates will eventually increase once currency fears surrounding other global denominations abate, diminishing the flight-to-safety phenomenon which has bolstered the dollar. Low-yielding Treasury bonds will attract fewer buyers once the domestic and global economies offer more attractive risk-adjusted alternative investments and a general appetite for risk-taking returns. Who wants to invest in equities today? But when investors do again, bond prices will drop and yields will rise. When this happens with government bonds, almost surely the increase in the risk-free index rate will cause mortgage rates to rise.

While this should coincide with a more buoyant economy, which will have spurred investors to stray from the safety of Treasuries, capital markets and economic fundamentals can get out of sync. Furthermore, real estate’s fundamentals tend to lag those of the broader economy, suggesting that increased mortgage rates might precede reduced vacancy rates and growth in rental rates. With spreads over the risk-free rate still wide relative to historical norms, borrowers can only hope that competition amongst lenders causes these spreads to narrow before the index rate increases translate to overall mortgage rates rising. However, what would narrowing spreads do to the supply of mortgage capital which is sorely needed to meet the coming maturities? Will banks and other lenders who were burned by debt in this last cycle, and lured back in only by greed, retrench once their scrape is not so beneficial, or will unprecedented mortgage demand keep spreads high even while index rates rise?

As for short-term rates, the Federal Reserve will have to slow down the printing press which has kept the U.S. awash in liquidity over the past several years. They will do so once the economy’s “green shoots” show sustainable life in order to keep inflation from running amok. While printing money is the time-honored global method for repaying a rampant budget deficit, the U.S. has shown little appetite for this over its history. Expect inflation to be moderate and short-term rates to revert to historical averages. When this happens, those borrowers with floating rate mortgage loans that have achieved break-even coverage only because LIBOR plus150 basis points was under two percent will find debt service increasingly difficult to meet absent increased property cash flows. If the latter lags, as it often does, expect a rash of long-deferred defaults to finally occur.

Finally, consider tax policy. The rate of fiscal spending increases may slow once stimulus programs are withdrawn and as the U.S. untangles itself from Iraq. However, Afghanistan remains perplexing, our aging population will continue to swell healthcare and Social Security entitlements even if we had not witnessed this year’s massive expansion of healthcare coverage, and the cost of servicing the U.S. debt will increase as interest rates rise. If the deficit beast is to be tamed, an increase in taxes is inevitable. When our economy is on firmer footing but remains saddled by the out-of-control deficit, the calls for deficit reduction will be loud and bipartisan. While it is difficult to predict the type and levels of taxes, expect tax rates to rise, particularly on businesses and the wealthiest Americans – our investment class – and consider the implications such a policy will have upon earnings and investments in commercial real estate.

Given our fragile economy, we cannot afford for Uncle Sam to be parsimonious right now. However, the transfer of over-leverage from the private sector to the federal balance sheet has foisted on the government a debt burden that will threaten our prosperity as a nation. Uncle Sam must delever – gradually, for sure – in the same manner as the private sector. This deleveraging may not be sudden, but its impact on commercial real estate’s future prospects will be as profound as any factor influencing our industry over the next 10 years.