Eric L. Tupler
Senior managing director, HFF, Denver
As we surpass 10 years since the peak of the last cycle activity, it is a good time to look back and re-orient our current position. For those who participated in the market in 2007, you may remember the record velocity of investment sales activity ($571 billion) and debt issuance ($510 billion) transacting at that time. Despite the factors that led to those volumes, how does it compare today?
One must recognize the amount of capital earmarked for U.S. commercial real estate. Not only in the U.S., but also globally, investors share a perception the U.S. market still provides the best risk-adjusted returns and protections. That being said, U.S. investment activity in 2017 declined 7 percent from 2016 levels and represents a 15 percent decline from the post “great financial crisis” peak of $547 billion closed in 2015.
So why is it not more activity? Is it due to the challenges of reinvesting proceeds in new deals, a perceived buy/sell price gap, ownership formations that do not force a sale at a point in time or the availability of inexpensive financing as an alternative means of creating higher yields and return of equity?
I think the answer is “all of the above,” and one cannot ignore the debt capital markets activity as a contributing factor. 2017 originations totaled $564 billion, which is 10 percent higher than the 2007 record volume and 15 percent above 2016. Agency lending (Freddie Mac, Fannie Mae, Housing and Urban Development, and Federal Housing Administration) increased 23 percent year over year to $127 billion followed by commercial mortgage-backed securities lending up 20 percent year over year to $82 billion. Meanwhile, bank and insurance company volumes declined 6 percent and 9 percent, respectively, year over year, with volumes of $148 billion and $61 billion, respectively. Overall, these primary sources of debt combined to originate 75 percent market share of approximately $415 billion in debt transactions.
What category provided more than $150 billion in 2017? Let’s call it the “other” category, which continues to gain momentum as investors seek yield and protection from potentially investing at the peak. Debt funds, mortgage real estate investment trusts, pension funds, foreign capital, and high net-worth families and investors make up a large component of this category. Those lending programs are primarily focused on shorter-term, floating-rate loans or subordinate (mezzanine and preferred equity) debt, but many other sources have started to provide longer-term, fixed-rate lending as well. Although most of these sources were originally targeting higher-leverage financings and receiving higher yields than the primary sources of capital, the last year demonstrated the leverage levels remaining high, but a large compression in yields or cost of that debt. These programs are designed to lend up to 80 percent (plus or minus) of value and are seeking all-in yields of 5 to 7 percent. For lower-leverage opportunities (65 percent loan to value or less), we are actually finding these sources competing directly with banks at all-in yields of 4 to 4.5 percent. The abundant supply of capital in the “other” category and lack of transactions also has diverted some of this capital to fill the void of construction debt, as the banks continue to limit their exposure, especially for nonrecourse construction loans. The other lenders will advance more proceeds while requiring no repayment guarantee at yields significantly less than the cost of equity.
Is this “other” category the previous cycle CMBS that often is blamed for overleveraging commercial real estate or is it simply filling the void needed to keep the prosperity on track? For now, it represents a growing resource for commercial real estate landlords, but it does not represent the 54 percent market share CMBS lenders boasted prior to the great financial crisis. Accordingly, today is one of the best times to consume debt since 2007, but don’t miss sight of the risks of over leveraging in a down cycle.
