Is 2015 Too Spooky for the Capital Markets?
- Oct 15, 2014
We are very close to putting an end to 2014, and many investors are scrambling to either buy or sell, as 2015 will bring varying degrees of uncertainty for commercial real estate. As we near Halloween, are you haunted by the ghost of Great Recessions Past?
Interest Rates Rising: A lot of uncertainty stems from the general consensus that the Fed will begin to raise the federal funds rate at some point in 2015, which will buoy interest rates across the board, including CMBS. During the peak of the securitization markets in 2006 and 2007, we saw total securitizations of $203 billion and $230 billion, respectively. The time frame beginning around the fourth quarter and running through the end of 2017 will see approximately $601 billion in maturing CMBS notes. Of those maturing loans at current interest rates, 5.8 percent of them are projected to have trouble refinancing. That percentage represents an average across the four food groups of property sectors and is based on properties that would fall below a 1.2x debt service coverage ratio (DSCR), per CMBS underwriting standards. If interest rates were to climb just 1.5 percent as those loans mature, that average across the four property sectors climbs to 14.8 percent.
The silver bullet for these maturing loans is largely based on improving economic conditions that will allow rents to rise, and therefore, owners would have a better shot at meeting lenders’ DSCR requirements. That has been happening in many markets and sectors. On a national level, we are seeing rent growth, but the growth is not balanced throughout all sectors. Continued and stable rental growth in 2015 would be welcomed through all sectors of the commercial real estate markets.
Quantitative Easing: QE is something else that keeps people up at night. The Fed has been tapering it down since the beginning of 2014 and says it plans to end it this month. The Fed whittled down QE to about $35 billion a month in asset purchases from its peak of $85 billion a month. The debate continues about what the ending of QE means for the economy. Undoubtedly, it has pumped tremendous liquidity into the markets, which has most likely driven equities much higher in the past few years. No one knows exactly what will happen, but the fact that the Fed has weaned the economy off of QE will somewhat mitigate the impact as the program officially ends. There are some market watchers who theorize that the ending of QE could trigger a pullback in the stock market, which could affect the broader economy.
Underwriting Standards: As demand for CRE financing increases and the economy shows signs of improvement in general, the real estate community must keep its eyes on underwriting standards and credit quality. We are seeing compression in spreads and we have already seen a return of at least partial-term interest-only CMBS loans due to the competition in lending. Coming out of the downturn in 2011, we had 12 CMBS groups. Today, there are approximately 37 CMBS groups. All of that competition can begin to erode underwriting standards. Lenient underwriting is a huge part of what got the CMBS markets into so much trouble during the downturn, so it will be critically important to remember lessons learned and not allow underwriting standards or credit quality to fall.
Despite the unknowns mentioned above, next year doesn’t have to be a scary thought. It is important to weigh all the fundamental factors when it comes to acquiring property and the loan that comes along with it—and remember that despite where we fall in the cycle, there is always opportunity to be realized.