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The Number of ‘Other’ Debt Sources Is Gaining Momentum

March 12, 2018



The Number of ‘Other’ Debt Sources Is Gaining Momentum

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. (Colorado Real Estate Journal/Eric Tupler)

Yield Curve Still Has Power to Predict Recessions, San Francisco Fed Paper Says

The yield curve has flattened over most of the current economic recovery. The yield curve, which plots yields across Treasury maturities, is still by far the most accurate predictor of recessions, according to new research released Monday by the San Francisco Federal Reserve. The spread between 2- and 10-year yields is a widely watched section of the curve for its indications of economic health. An upward sloping curve, with longer-term yields higher than their short-term counterparts, is typical, especially in an expanding economy. An inversion between these two maturities — in other words, if the yield on the 2-year is higher than the 10-year — reliably predicts low future output growth and indicates a high probability of a recession, the Fed branch said in its report. An inverted yield curve has correctly signaled all nine recessions, with only one false positive in the 1960s. The Fed has penciled in three rate hikes this year and says it will push rates as high as 3.1% in 2020, slightly overshooting its long-run projected value of 2.8%. And after Fed Chairman Jerome Powell’s testimony to Congress, many economists expect four rate hikes this year and a steeper path of rates. Doves on the rate-setting panel, like St. Louis Fed President James Bullard, want the central bank to go slower, and point to the risk of a yield curve inversion as a reason for caution. A number of analysts have suggested that the current environment of low interest rates may be a reason to worry less about a recession. In such an environment, increases in short-term policy rates may slow down the economy less than usual. And low long-term rates are not seen as pessimistic, but as a new normal. The researchers, Michael Bauer and Thomas Mertens of the San Francisco Fed’s economic research department, dismiss these claims. “While these hypotheses have some intuitive appeal, our analysis shows that they are not substantiated by statistical analysis,” the paper concluded. Exactly why yield curve inversion has predictive power is not obvious, the paper conceded. One explanation might be that a flatter yield curve makes it less profitable for banks to borrow short term and lend long, shutting off a funding source to an expansion. The researchers said they were not focused so much on why the negative yield curve has predictive powers, only on whether it does. As of the end of February, the estimated recession probability is 11%. (MarketWatch)